A new perspective on sunk costs

The fallacy of sunk costs occyrs when people take past expenditure into account when they make a decision, even though it cannot affect their future and cannot be changed. It is often regarded as a canonical example of a cognitive bias in humans because almost everybody does it. Of course, if it’s so suboptimal to take sunk costs into account then one has to wonder why humans have evolved to systematically make that error. Sandeep Baliga and Jeff Ely have a paper out where they suggest that it’s actually on optimal response to limited memory capacity:

We offer a theory of the sunk cost fallacy as an optimal response to limited memory. As new information arrives, a decision-maker may not remember all the reasons he began a project. The sunk cost gives additional information about future profits and informs subsequent decisions.

Essentially they say that, if you don’t remember all the reasons why you invested in the first place, then the level of past investment in a project tells you something about the conclusions you initially reached. You can then use that information to inform your decisions about whether to continue, without having to rethink everything from scratch.

Now I’m late to this because they also write the excellent Cheap Talk blog and discussed their working paper a year ago! So if you want to know the details of the ‘Concorde effect’ and ‘pro rata effect’ then head over and have a read.

2 replies
  1. WH
    WH says:

    Seems similar perspective to the ideas in Thinking Fast and Slow by Daniel Kahneman http://www.amazon.com/Thinking-Fast-Slow-Daniel-Kahneman/dp/0374275637 for a review see http://www.ft.com/intl/cms/s/2/15bb6522-04ac-11e1-91d9-00144feabdc0.html 

    The question I have for myself is: knowing that many decision makers, whether a politician or CEO, are prone to the fallacy of sunk costs (and other investment/decision bias) how do we improve the average quality of their decision making?

    Have frameworks for analysis (e.g., ROI, cost benefit analysis, RIS) measurably improved the quality of decisions? or because heuristic bias is largely inbuilt in people we end up on average making the same mistakes. Maybe this explains why someone who is an outlier (like Warren Buffett) is able to outperform other decision makers because relative to other decision makers he is slightly less prone to bias? 

    There seems to be link with the post there are too few smart people in the world  http://www.tvhe.co.nz/2012/03/06/there-are-too-few-smart-people-in-the-world/#comment-37023 

    • jamesz
      jamesz says:

      It’s certainly related to Kahneman’s ideas; he was really one of the originators of behavioural economics, which a lot of the material we’ve bene blogging lately draws upon. What I found really interesting about this study is that it goes one step further than most analyses of cognitive bias. Rather than just showing the bias exists, it asked why it exists and whether it might actually be an optimal adaptation even in the context of modern decision-making.

      The usefulness of frameworks is certainly an interesting topic. I haven’t read much on the topic but seminars I’ve attended (mostly related to forecasting) suggest that augmenting expert judgment with frameworks helps hugely.

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