Nobel Prize-winning economist James Buchanan is fond of saying, “It takes varied reiterations to force alien concepts on unwilling minds.” That aphorism is surely true. Many basic ideas in economics require repeated attempts at explanation, and a variety of applications, before people fully grasp them and their importance. The one I want to focus on today is the concept of sunk costs and the related sunk-cost fallacy.
Choose the option that delivers the greatest net additional benefits.Understanding the concept of sunk costs first requires that one understand that, for economists, what matters for decision-making is what we call “action on the margin.” By “the margin” we simply mean the action we will take with respect to the concrete choice before us. When deciding whether a particular choice is worth making, the economic way of thinking tells us to compare the additional benefits that will come from that choice to the additional costs it will entail. This type of thinking then counsels: “Choose the option that delivers the greatest net additional benefits.”
Focusing on the additional benefits and costs that come from that specific action is what economists mean by acting on the margin. To forestall one objection, I will point out that what counts as a benefit or cost is of course subjective to the chooser. You and I could be in the identical situations but appraise the costs and benefits differently, and thereby end up making different choices. Economics says nothing about what should count as a benefit or cost, only that, whatever one chooses to count as benefits and costs, one should focus on the additional, or marginal, benefits and costs of a particular option and go with the one delivering the greatest net marginal benefits.
Irrelevant for Next Decision
An implication of this point is that costs that have already been incurred and that will not change with any of the specific choices now at the margin should be irrelevant to one’s decision. These are what we call sunk costs: The resources cannot be recovered, hence the costs are sunk. Such sunk costs should not matter for one’s next decision; only the costs now at the margin of choice count. No matter what we choose next, we can’t change the fact that we spent those resources in the past.
The idea of the irrelevance of sunk costs is all around us in folk wisdom and other places. For example, good poker players understand the idea when they say, “Don’t throw good money after bad.” Sometimes novice players will think, “Well, I’ve already bet five dollars on this hand, so I might as well see it through.” Good poker players know this is bad thinking: What matters is whether your hand is worth making the next bet. That you’ve bet five dollars already is beside the point. Bygones are bygones. You can’t put the toothpaste back in the tube. There’s no crying over spilled milk.
People who understand the sunk-cost fallacy know to beware when they hear people use phrases like, “You should get your money’s worth” or “You should finish what you started.” For example, suppose you pay a hundred dollars for a gym membership and never use it. Someone says to you, “You really should go to the gym and get something for your hundred dollars.” The problem, however, is that the money is gone whether you go to the gym or not. The relevant question is whether on any given day the benefits of exercising are worth the costs of going to the gym (or giving up your next best alternative). That’s action on the margin. The money spent is irrelevant.
Additional Costs Worth It?
The same is true of the argument that we should “finish what we started,” say, in Afghanistan or Iraq. We can’t change the past and undo the deaths and financial costs of those wars. The real question is whether the benefits of continued intervention are worth additional costs, regardless of what happened in the past. Are billions more spent, and many more dead Americans and their victims worth it, for the supposed additional gains of continuing those wars?
Sunk costs are sunk. Once they're gone, they're gone.Sunk costs are sunk. Eventually, of course, in facing new decisions, we can rethink the old decision that sunk those costs in the first place (such as, should we renew the gym membership, or should we enter a new war?). But until then, the past is irrelevant because whatever we choose, we can’t change it. What matters for the economic way of thinking is decision-making on the margin: the additional benefits and costs of the options in front of us right now.
Understanding that choice is always on the margin and that sunk costs are sunk can help you make better decisions in your personal life and spot fallacious reasoning by politicians. This is just another illustration that good economics is the key to critical thinking and good citizenship.