Introduction
The concept of sunk costs dates back to the mid 18th century and was first used by economist Adam Smith. Sunk costs are costs that can not be recovered and are non-revenue generating. They are non-recurring expenses, meaning they will not be incurred again in the future. These include both past costs that have already been paid as well as costs that will not be recovered, such as the cost of purchasing equipment that cannot be resold or reused. The concept of sunk cost is important to understanding the behavior of decision makers and the development of successful strategies.
What are sunk costs?
Sunk costs are non-recurring costs that cannot be recovered and are non-revenue generating. These include past costs that have already been incurred, such as research and development expenses and the cost of purchasing equipment or facilities. They also include future costs that will not be recovered, such as investments in training for employees or marketing campaigns. Sunk costs are distinct from explicit costs, which are costs that can be recovered or are revenue-generating.
The sunk cost fallacy
One of the most important aspects of sunk costs is the sunk cost fallacy. This is the belief that decision makers should factor in sunk costs when making decisions. This can lead to bad decisions, as the decision maker may favor a certain course of action because of the sunk costs already invested even if it is not the most rational or profitable option. For example, if a company is considering whether to invest in a new product line, they may opt to continue developing the product even if it is not profitable or is likely to fail due to sunk costs.
The sunk cost effect and escalation of commitment
The sunk cost effect is a related phenomenon and is a bias where decision makers are influenced by sunk costs and commit to a goal due to the time, money, or resources that have already been invested. For example, a company may decide to move ahead with a project despite potential losses due to sunk costs already invested. This can lead to escalation of commitment, which is when decision makers continue investing in a failing project or strategy despite evidence that it is not working.
The importance of sunk costs
Sunk costs are important in economics, as they are part of the opportunity cost calculus that factors into rational decision making. Sunk costs also have important implications in business strategy, as they can shape how investments are made and how decisions are made. Understanding the concept of sunk costs and the sunk cost fallacy can help decision makers make more rational decisions and develop successful strategies.
Conclusion
Sunk costs are non-recurring costs that cannot be recovered and are non-revenue generating. The concept of sunk costs is important for understanding decision making behavior and developing successful strategies. The sunk cost fallacy is the belief that sunk costs should be taken into account when making decisions, which can lead to bad decisions. The sunk cost effect is a bias where decision makers are influenced by sunk costs and may commit to a goal due to the time, money or resources that have already been invested. This can lead to escalation of commitment, where decision makers continue investing in a failing project despite evidence that it is not working. Understanding the concept of sunk costs and the implications of sunk costs is essential for making rational decisions and developing successful strategies.
