9.3 Sunk Costs
When making decisions, knowing what to ignore can be as important as what to include. Although we have devoted much attention in this chapter to costs that are important to take into account when making a decision, some costs should be ignored when doing so. In this section we will focus on the kinds of costs that people should ignore when making decisions—what economists call sunk costs—and why they should be ignored.
To gain some intuition, consider the following scenario. You own a car that is a few years old, and you have just replaced the brake pads at a cost of $250. But then you find out that the entire brake system is defective and also must be replaced. This will cost you an additional $1500. Alternatively, you could sell the car and buy another of comparable quality, but with no brake defects, by spending an additional $1600. What should you do: fix your old car, or sell it and buy another?
Some might say that you should take the latter option. After all, this line of reasoning goes, if you repair your car, you will end up having spent $1750: $1500 for the brake system and $250 for the brake pads. If instead you sell your old car and buy another, you would spend only $1600.
But this reasoning, although it sounds plausible, is wrong. It is wrong because it ignores the fact that you have already spent $250 on brake pads, and that $250 is nonrecoverable. That is, having already been spent, the $250 cannot be recouped. Therefore, it should be ignored and should have no effect on your decision whether or not to repair your car and keep it. From a rational viewpoint, the real cost at this time of repairing and keeping your car is $1500, not $1750. So the correct decision is to repair your car and keep it rather than spend $1600 on a new car.
In this example, the $250 that has already been spent and cannot be recovered is what economists call a sunk cost. Sunk costs should be ignored in making decisions about future actions because they have no influence on their actual costs and benefits. It’s like the old saying, “There’s no use crying over spilled milk”: once something can’t be recovered, it is irrelevant in making decisions about what to do in the future.
A sunk cost is a cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in decisions about future actions.
Another example of sunk cost is the time spent waiting. Imagine getting all your textbooks from the bookstore at the beginning of a term. You have already waited in the line for 30 minutes. Should you continue waiting or come back earlier tomorrow? In making your decision, you should not factor in the 30 minutes you already spent in the line because you cannot recoup the time: that half hour is a sunk cost. If you expect it will take another 20 minutes to check out, but your total wait time tomorrow will be less than 20 minutes, then you should leave the line and abandon the sunk cost.
It is often psychologically hard to ignore sunk costs. And if, in fact, you haven’t yet incurred the costs, then you should take them into consideration. That is, if you had known at the beginning that it would cost $1750 to repair your car, then the right choice at that time would have been to buy a new car for $1600. But once you have already paid the $250 for brake pads, you should no longer include it in your decision making about your next actions. It may be hard to accept that “bygones are bygones,” but it is the right way to make a decision.
A BILLION HERE, A BILLION THERE
If there is any industry that exemplifies the principle that sunk costs don’t matter, it has to be the biotech industry. Biotech firms use cutting-edge bioengineering techniques to combat disease. But according to Arthur Levinson, chief executive of Genentech, one of the largest and most successful biotech firms, biotechnology has been “one of the biggest money-losing industries in the history of mankind.” He estimates that the industry has lost nearly $100 billion since 1976 (yes, that’s “billion”). Of 286 publicly held American biotech firms, only 28 were profitable in 2012, and Canadian biotech firms do not fair any better. The industry proudly speaks about the amount of capital raised, revenue earned, research and development expenditures, new patents filed, and their great potential in the future, but is generally silent about the lack of profitability of many of its members.
However, this is not a tale of incompetence because the problem lies in the nature of the science. It takes about seven to eight years, on average, to develop and bring a new drug to the market. Moreover, there is a huge failure rate along the way, as only one in five drugs tested on humans ever makes it to market.
The company Xoma is a case in point: it has suffered setbacks on several drugs addressing diseases as varied as acne and complications from organ transplants. Since 1981, it has never earned a profit on one of its own drugs and has burned through more than $780 million dollars. Why does Xoma keep going? And, more importantly, why are investors willing to keep providing it with more money? It’s because Xoma possesses a very promising technology and because shrewd investors understand the principle of sunk costs.
Quick Review
Sunk costs should be ignored in decisions regarding future actions. Because they have already been incurred and are nonrecoverable, they have no effect on future costs and benefits.
Check Your Understanding 9-3
CHECK YOUR UNDERSTANDING 9-3
Question 9.6
You have decided to go into the ice-cream business and have bought a used ice-cream truck for $8000. Now you are reconsidering. What is your sunk cost in each of the following scenarios?
The truck cannot be resold.
The truck can be resold, but only at a 50% discount.
An ice-cream vendor who wants to expand his business is willing to purchase the truck from you at full price.
Your sunk cost is $8000 because none of the $8000 spent on the truck is recoverable.
Your sunk cost is $4000 because 50% of the $8000 spent on the truck is recoverable.
Your sunk cost is $0 because you can fully recover the cost of buying the truck by selling it to another ice-cream vendor.
Question 9.7
You have gone through two years of medical school but are suddenly wondering whether you wouldn’t be happier as a musician. Which of the following statements are potentially valid arguments and which are not?
“I can’t give up now, after all the time and money I’ve put in.”
“If I had thought about it from the beginning, I never would have gone to med school, so I should give it up now.”
“I wasted two years, but never mind—let’s start from here.”
“My parents would kill me if I stopped now.” (Hint: We’re discussing your decision-making ability, not your parents’.)
This is an invalid argument because the time and money already spent are a sunk cost at this point.
This is also an invalid argument because what you should have done two years ago is irrelevant to what you should do now.
This is a valid argument because it recognizes that sunk costs are irrelevant to what you should do now.
This is a valid argument given that you are concerned about disappointing your parents. But your parents’ views are irrational because they do not recognize that the time already spent is a sunk cost.