1.6.6 Sunk Costs and Their Irrelevance in Marginal Analysis

What are sunk costs?

Sunk costs are costs that have already been incurred in the past and cannot be recovered, no matter what decision is made in the future. Once a cost has been paid and cannot be undone, it becomes a sunk cost. These costs are irrelevant to future economic decisions because they are unaffected by the outcomes of those decisions.

In economics, a fundamental rule of rational decision-making is to ignore sunk costs when evaluating current and future choices. Instead, decision-makers should focus on marginal costs and marginal benefits—the additional costs and benefits of the next unit of action.

Key characteristics of sunk costs

Irreversibility: Sunk costs cannot be refunded, reversed, or recovered once spent.
Past-oriented: These costs result from decisions made in the past and do not change regardless of what action is taken next.
Not avoidable: Unlike variable or fixed costs that may change over time or with production levels, sunk costs remain constant and cannot be avoided.

Common examples of sunk costs

Non-refundable ticket purchases: A movie, concert, or airline ticket that has been purchased and cannot be refunded.
Initial deposits or down payments: A hotel or venue reservation deposit that cannot be recovered if canceled.
Time and effort already spent: Hours of studying a subject, learning a skill, or working on a project that cannot be undone.
Business expenses already incurred: Past spending on research and development, marketing, or design of a discontinued product.

These examples illustrate that sunk costs are not only monetary—they can also include time, labor, and emotional investment.

Why sunk costs should be ignored in marginal analysis

Marginal analysis is the process of comparing the additional benefit (marginal benefit) and the additional cost (marginal cost) of an action to make optimal economic decisions. The guiding rule is:

If marginal benefit is greater than marginal cost, the action should be taken.

Since sunk costs are in the past and cannot be changed, they do not affect the marginal cost or marginal benefit of any future decision. Including them in decision-making leads to irrational and suboptimal outcomes.

Rational decision-making

Rational economic agents—both consumers and firms—make choices by focusing only on the costs and benefits that will change as a result of the decision. Any cost that does not change depending on the choice is considered irrelevant. Since sunk costs are constant regardless of the decision made, they should be ignored entirely.

For instance, imagine a firm has spent $1 million developing a software product. After development, market research shows that consumer interest is low and future profits are unlikely. If the company decides to launch the product anyway just because it already spent$ 1 million, it is committing a sunk cost fallacy. The 25 for a dinner at a restaurant. After a few bites, you realize the food is unpleasant and unappetizing. Despite this, you continue eating simply because you "paid for it." This is the sunk cost fallacy. The $25 is already spent. You should decide whether to continue eating based only on whether the additional bites provide more satisfaction than discomfort.<h4>Example 2: Staying through a boring movie</h4>You spend$ 15 on a movie ticket. Midway through, the movie turns out to be boring. Many people will stay to “get their money’s worth.” However, the 10,000 for a year-long lease on office space and cannot get the money back, that payment is a sunk cost.

If you have a lease that allows cancellation with notice, the future payments are fixed costs, but not sunk—because they can still be avoided.

Understanding these distinctions helps students apply the correct logic in economic analysis.

Avoiding the sunk cost fallacy

To make sound economic decisions, it is essential to recognize and disregard sunk costs. This requires a shift in thinking from emotional or backward-looking reasoning to rational and future-focused logic.

Tips for better decision-making

Ask the right questions: Instead of thinking “How much have I already spent?” ask, “What are the future benefits and costs of continuing this choice?”
Reframe the situation: Consider what decision you would make if you had no prior investment.
Acknowledge sunk costs consciously: Be aware when a cost is sunk, and remind yourself that it cannot be recovered.
Practice forward-thinking: Evaluate every choice in terms of how it affects the future, not how it justifies the past.

Application in business and daily life

Sunk cost logic can help both firms and individuals avoid throwing good money after bad.

In business:

Companies should shut down unprofitable projects, even if large investments have already been made.
Managers must evaluate each decision based on expected future revenues and costs only.
Firms that recognize sunk costs can quickly adapt, reduce losses, and reallocate resources efficiently.

In personal life:

Individuals can avoid staying in bad jobs, relationships, or commitments due to prior investment.
By focusing on marginal benefits, people can maximize satisfaction and minimize regret.
Being mindful of sunk costs leads to better financial, time, and emotional management.

The sunk cost concept, when fully understood, becomes a powerful tool in developing rational thinking and effective decision-making—key skills in economics and beyond.

FAQ

People often struggle to ignore sunk costs due to emotional, psychological, and social factors that conflict with rational economic reasoning. One major reason is loss aversion—a behavioral bias where individuals experience more pain from a loss than pleasure from a gain. This makes them reluctant to “accept” a loss, even when continuing will make the loss worse. People also experience a strong desire for consistency and don’t want to feel like their previous decisions were mistakes. Social pressure or expectations may also play a role, especially when investments are known by others and there's fear of appearing wasteful or irresponsible. Additionally, time invested can create a personal attachment that makes it feel like quitting would make that effort meaningless. This emotional attachment can overpower rational analysis. These non-economic influences lead people to let sunk costs factor into decisions, even though economists emphasize that such costs are irrelevant and should be ignored.

In strictly economic terms, ignoring sunk costs leads to better decision-making, because sunk costs cannot be changed or recovered, so including them distorts future-oriented choices. However, in real-world contexts, ignoring sunk costs might seem to create short-term disadvantages, especially if one fails to consider reputation effects, team morale, or long-term relationships. For example, a business that cancels a project midway—even when it’s the economically optimal choice—might upset stakeholders, damage employee motivation, or lose customer trust. These consequences aren't part of the sunk cost but are real, forward-looking costs that must be considered. So, while the sunk cost itself remains irrelevant, decisions should still factor in any new, marginal costs and benefits (including indirect effects like public perception) that could result from walking away. The key is not that ignoring sunk costs is bad, but that other future consequences of the decision may matter just as much as the direct costs and benefits.

Sunk costs are irrelevant in both the short run and the long run when it comes to marginal analysis. Since they cannot be recovered or changed, they should never affect decisions about future resource allocation, regardless of the time frame. In long-run planning, firms evaluate whether to enter or exit markets, invest in new technology, or expand operations. These choices should still be based only on expected future revenues and future costs, including avoidable fixed costs and opportunity costs. While some fixed costs can become variable or avoidable in the long run, sunk costs never regain relevance. For example, the purchase of a custom machine that cannot be resold or repurposed is a sunk cost even in long-run decisions. It should not affect whether to continue using the machine or not. What matters is whether the ongoing benefits of using it outweigh any future costs, not the money spent acquiring it.

Yes, government and policy decisions are frequently influenced by sunk cost fallacies, often on a large scale. These are sometimes called “escalation of commitment” or “throwing good money after bad” in public finance and policy-making. For example, a government might continue funding a failing infrastructure project or military intervention because millions or billions have already been spent, even though analysis shows that continuing will not lead to net benefits. Decision-makers may fear political backlash for “wasting taxpayer money” or may be personally or politically invested in the outcome. This leads them to double down on a poor decision, even when cutting losses would be economically optimal. Public institutions also tend to move slowly, and admitting failure can be difficult in the public eye. These types of decisions demonstrate why recognizing and ignoring sunk costs is vital, not only for private individuals and firms but also for public sector efficiency and accountability.

Businesses can help employees and managers avoid the sunk cost fallacy by fostering a culture of rational decision-making, offering targeted training, and creating structured decision processes. Training sessions on behavioral economics and decision theory can make employees aware of common biases, including the sunk cost fallacy. Case studies showing real-world consequences of ignoring economic principles can be effective. Firms can also implement decision frameworks that require justification based on projected future costs and benefits rather than past expenditures. For example, business proposals and project evaluations can include specific sections that require identification and exclusion of sunk costs. Cross-functional review teams can offer a second opinion, helping to remove emotional or personal bias from decisions. Encouraging an environment where admitting a change in direction is seen as smart and adaptive, rather than a failure, also helps people feel comfortable abandoning unprofitable ventures. By institutionalizing this mindset, businesses can improve long-term profitability and resource efficiency.

Practice Questions

A firm has already spent $500,000 developing a product. New market research shows that demand for the product is extremely low and that future revenues will not cover production costs. Should the firm proceed with production? Explain using economic reasoning.

The firm should not proceed with production. The $500,000 already spent is a sunk cost and cannot be recovered. Economic decision-making relies on marginal analysis, which compares the additional benefits and costs of continuing. If the marginal cost of producing and selling the product exceeds the expected marginal benefit, the rational choice is to stop. Including sunk costs in the decision would be irrational, as they do not affect future outcomes. The firm should focus on minimizing future losses rather than trying to recover unrecoverable past expenses.

A student buys a $50 ticket for a concert but on the day of the event feels tired and would prefer to stay home. Should the student go to the concert? Justify your answer using economic principles.

The student should not attend the concert if the marginal benefit of staying home exceeds the marginal benefit of attending. The $50 spent on the ticket is a sunk cost—it cannot be recovered and should not affect the decision. Rational decision-making is based on evaluating future costs and benefits. If attending the concert provides less satisfaction than resting at home, the student should choose to stay home. Going simply because the ticket was paid for is an example of the sunk cost fallacy, which leads to suboptimal choices by considering irrelevant past expenses.

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