How does the sunk cost fallacy affect economic decisions?

The sunk cost fallacy skews economic decisions by encouraging continued investment based on past irrecoverable costs, rather than future benefits.

The sunk cost fallacy, also known as the Concorde fallacy, is a common economic and psychological phenomenon that can significantly impact decision-making processes. It occurs when a person or organisation continues a behaviour or endeavour due to previously invested resources, such as time, money or effort, even if it's not in their best interest to do so. This is a fallacy because the decision to continue investing should be based on the expected future returns, not what has already been irretrievably invested.

In economics, a cost that has already been incurred and cannot be recovered is known as a 'sunk cost'. Rational economic theory suggests that sunk costs should not affect the decision-making process because they are past costs and cannot be changed. However, in reality, people often fall into the sunk cost fallacy, allowing these irrecoverable costs to influence their decisions about future investments. This can lead to sub-optimal economic decisions, as individuals or businesses continue to invest in projects or products that are no longer profitable or beneficial, simply because they have already invested heavily in them.

For example, consider a company that has invested heavily in a new product development. After some time, it becomes clear that the product is not going to be as profitable as initially thought. However, instead of cutting their losses and moving on, the company continues to invest in the product, influenced by the sunk cost fallacy. They reason that they have already invested so much money into the product that they can't afford to abandon it, even though continuing to invest is likely to lead to greater losses.

The sunk cost fallacy can also affect personal economic decisions. For instance, someone might continue to repair an old car, pouring money into it because they've already spent so much on it, even though it would be more economical to buy a new one.

Understanding the sunk cost fallacy is crucial for making rational economic decisions. It's important to remember that money, time, or resources that have already been spent are gone and cannot be recovered, and should therefore not influence decisions about future investments. Instead, decisions should be based on an assessment of the potential future benefits and costs. By avoiding the sunk cost fallacy, individuals and businesses can make more rational and economically sound decisions.