Sunk Cost Fallacy
What is Sunk Cost Fallacy? Sunk cost fallacy is when a cost has occurred and it cannot be recovered, but rather than make the most logical decision, a person continues in their original investment choices. This means continuing to invest in something even when it has become more costly to do so. It is a cognitive bias where a person makes a decision based on past financial investments instead of considering future costs or benefits.
In economics, sunk costs are any costs that cannot be recovered. These costs follow a “sunk cost fallacy” meaning they are costs incurred in the past, rather than the present or the future. Examples of sunk costs may include the cost of capital, labour, or materials. The underlying principle is that these costs cannot be recouped, so whether the project or product was worth it or not, the money spent is gone.
When it comes to making decisions that involve sunk costs, the most logical choice is often to cut your losses and forgo the investment altogether. Otherwise, you risk continuously investing more money into a project that may not reach profitability.
When a business invests in a project, they are usually looking to make a return on their investment. But when a project fails to reach profitability, continuing to invest in it is not always in the company’s best interest. Instead, the company should re-evaluate the project and decide whether or not to continue to invest or cut their losses and stop investing in the project altogether.
This can be a difficult decision to make, especially for those who are emotionally attached to the project. This is known as the sunk cost fallacy, which states that when faced with making a decision about a project or investment, people are more likely to continue with their original decision if the original investment was significant. This is because the longer an investment is made, the more emotionally attached a person or company can become to it, even if the project is unprofitable.
By avoiding making decisions based on sunk costs, businesses can ensure that they are making decisions based on what is best for their company in the long run. It means recognizing when an investment is no longer producing a return and making the decision to either make changes or cut your losses.
In summary, sunk cost fallacy is a cognitive bias where a person makes a decision based on past financial investments rather than considering future costs and benefits. This often leads to people continuing to invest in something even when it has become more costly than initially thought. Avoiding making decisions based on sunk costs is important for businesses, as it prevents them from continuing to invest in a project that is not likely to be profitable in the long run.
