Monday, May 21, 2007

Sunk Costs -or- Why the $1300 you Just Put in your Car Doesn't Matter

Back in my school days, one of the economic principles they tried to force us to understand was Sunk Costs. The idea is fairly simple, to make a financial decision, you only weigh the costs and benefits going forward, whatever you have already spent should not be a factor.
For example:
You're ready to sell your house. It's currently worth $150k but if you invest $50k in adding an isolation chamber (they're all the rage, Oprah loves hers!), you could sell the house for $190k. Should you do it?
Looking at the numbers, the answer is clearly "no". You would be spending $50k to get an additional $40k for the house. That doesn't make financial sense.
But what if you had already spent $3k on installing some custom lighting that would really highlight the ISO-5000? Should you invest then? Again the numbers don't add up. The $3k is a Sunk Cost. You've paid for the lighting whether or not you get the matching chamber, and you'd still be taking a $10k loss if you make the purchase.
These analysis are usually pretty easy to see when we break down the numbers, but there's an emotional factor that makes it harder to let go of the money that has been spent, even if it's clear that it's a bad financial decision to go ahead. This becomes harder still when politics or reputation is involved. To abandon a half-finished project, even when it is the right economic decision, means to admit failure. Furthermore, if everyone doesn't know or understand the numbers involved, it opens the decision up to further criticism. "We can't stop now, we've already put $5 million into the escalator to nowhere".
Another, painfully non-hypothetical, example is the War in Iraq. I have heard arguments from both sides of the debate that cite casualties suffered or money spent as reasons why we should continue our mission there -or- get out now. The correct question is: what are the future costs, primarily in lives, of staying versus going.

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