Imagine a home builder during the 2008 bubble, caught up in a fix to continue with or abandon a project, having injected considerable resources into it, following a crash in the real estate market. What should he do? Ideally, he should give up the project (bewildering yet true). Empirically, he won’t. Why? Let’s talk about an interesting economic theory at play here- The Sunk Cost Dilemma.
In any organisation, decision making is a tricky task. While coherent decisions can escalate businesses to the pinnacle of success, fallacies in decision making can damage them irreparably.
Usually, erroneous decisions are a result of flawed decision-making processes. However, sometimes the flaw lies not in the way decisions were reached at but in the mind of the decision maker. We often undermine the rationality of our decisions, catering to our inherent psychological biases, one of which is the Sunk Cost Dilemma.
Sunk costs are the costs which have already been incurred and can’t be recovered regardless of the future course of action. Being independent of any future event, such costs shouldn’t be factored in while contemplating the next move.
The Sunk Cost Dilemma explains the perplexity faced by decision makers when faced with a choice to give up or continue with an unprofitable project, which has already seen a substantial investment in terms of time, efforts and money. While rational thinking may dictate managers to discontinue immediately and mitigate their losses, the tendency to place a greater emphasis on the loss of the unrecoverable resources prompts them to make inappropriate decisions.
Let’s take an example. You bought yourself advance movie tickets. Following the terrible reviews from your friends regarding the same you are dubious whether to go and watch it or stay back. What would you do?
Looking at it from a purely economic perspective would imply you wouldn’t want to go because the cost of the tickets are your irretrievable sunk costs. On a psychological level though, you might not want to miss out, thinking that the money you spent will be lost forever. Besides, what happens if you don’t like it? You end up incurring a loss both in terms of money and time.
This illustrates how sunk costs may act as a psychological trap, tricking you into taking counterproductive decisions.
A major reason behind people falling prey to this trap lies in the fear of criticism they might face on initiating a change. Hoping in vain to transform their initial wrong decision into a success appears more alluring to them than admitting their mistake and mitigating losses.
Though we can’t entirely get rid of these deep-seated biases hardwired in our psyche, familiarizing ourselves with the diverse forms of these traps can go a long way in ensuring sound decision making.
While orchestrating a change is not easy, throwing in good money after bad is never a viable option either. When confronted with such dilemmas, making a conscious effort to ‘act on the margins’ will always serve as the best solution.
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