Unlike opportunity costs, which a firm must always consider when making production decisions, there are some costs that should never be taken into account when making such decisions.

In Chapter 6, we learned that some of a firm’s costs are fixed costs, payments to inputs that must be used no matter what the output quantity is, even if it is zero. Suppose you own a restaurant. Some of your fixed costs would be rent (if you have signed a lease), cookware, advertising expenses, and kitchen appliances such as refrigerators and ovens. If you go out of business, even though you produce nothing, you still must pay those fixed costs. Of course, you might be able to recover some of these costs if you could sell the cookware and the ovens, or sublet the building to someone else. These refundable types of fixed costs are sometimes said to be avoidable because the firm can take action so that it does not have to pay them if it stops operating.

Some fixed costs, however, are not avoidable. A fixed cost that you cannot avoid is called a sunk cost. Once a firm pays a sunk cost, it can never be recovered. For a restaurant, for example, money spent on advertising is a sunk cost. You spent the money, and there’s no getting it back. If you’ve signed a long-term rental agreement and cannot sublet the building, the rent is a sunk cost, too. You cannot recover it even by shutting down.

To sum up: If a fixed cost is avoidable, then it is not a sunk cost. If a firm cannot recover an expense even when shut down, then it is a sunk cost. The difference between sunk cost and avoidable fixed cost is crucial to the decisions a firm makes about how it will react if things begin to go south and the firm suffers a downturn in its business.

One part of a firm’s cost that is sunk is the difference between what the firm still owes on its fixed capital inputs (such as the equipment and cookware at your restaurant) and what the firm can resell this capital for. This difference should be relatively small for restaurant equipment, because most of it can be easily used by other restaurants.

But suppose your restaurant had a space theme, with every booth shaped like the inside of a spaceship, with tables that look like control panels. Such booths, tables, and other items (menus, staff uniforms/spacesuits, etc.) tied specifically to your space-themed restaurant are not of much use to other restaurants, unless you happen to get lucky and find that the Space Age Restaurant in Gila Bend, Arizona, is looking to expand. The cost of these booths and other space-themed equipment is likely to be sunk because you cannot recover it even if you shut down.

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As you can see from this last example, whether capital can be used by another firm is an important determinant of sunk costs. Capital that is not very useful outside of its original application is called specific capital. Expenditures on buildings or machines that are very specific to a firm’s operations are likely to be sunk, because the capital has little value in another use.

An important lesson about sunk costs is that once they are paid, they should not affect current and future production decisions. The reason is simple: Because they are lost no matter what action is chosen next, they cannot affect the relative costs and benefits of current and future production decisions.

For example, you’ve no doubt attended an event like a concert, sporting event, or movie where you got bored well before the end. Should you stay just because you paid for the ticket? No. Once you are at the event, the ticket price is sunk—it’s gone whether or not you decide to stay at the event. So, if you are asking yourself, “Should I stay or should I go?” (was it a Clash concert?), the ticket price shouldn’t affect your answer. Whether the ticket price was $1 or $1,000, that cost is sunk and cannot be recovered. The only thing that you should ask is whether you will have more fun staying for the second half of a bad movie or doing something else (going for a walk, taking a nap, or calling a friend). If the alternative would be more entertaining, then leave.

To put this in a production context, let’s go back to the restaurant example. You, as the owner, must decide between staying open for business or shutting down operations. Some of the restaurant’s costs are sunk costs, including nonavoidable fixed costs and the possible losses you would incur if you had to resell capital for less than you paid. These costs are not recoverable and must be paid whether the restaurant remains open or is shut down. In thinking about staying open for business, you know there will be some potential benefits (the money brought in from selling meals and drinks—your output), but there will also be definite costs (paying the waitstaff, purchasing ingredients, or turning on the heat or air conditioning). These benefits can be defined as the firm’s operating revenue, while these costs are called operating costs. If you decide to shut down, you don’t have to pay operating costs, but you also won’t reap any benefit (operating revenue) either.

If business falls off, then, how should you decide whether to stay open for business or close the doors? Generally, the restaurant should stay open if the value of staying open is greater than the value of shutting down. But here’s the important part: Sunk costs should not enter into this decision. You are going to lose your sunk costs whether you keep the restaurant open or not, so they are irrelevant to your decision about your restaurant’s future. The choice between staying open and shutting down depends only on whether the firm’s expected revenues are greater than its expected operating costs. If it costs more to stay open than you’ll bring in, you should close the restaurant. It doesn’t matter if you are facing $1 or $1 million of sunk costs.

The Sunk Cost Fallacy When faced with actual choices that involve sunk costs, people and firms sometimes have a difficult time ignoring sunk costs. They commit what economists call the sunk cost fallacy. The fallacy is that they act like sunk costs matter (when they should be ignoring them). In making economic, finance, and life decisions, you want to avoid falling victim to this fallacy, but it’s not hard to imagine scenarios where you might be tempted to do so.

How does it work? Suppose you are responsible for overseeing the construction of a new manufacturing facility for your company. Construction has gone on for 3 years and has cost $300 million so far (we’ll assume this entire expenditure is sunk—the factory is specialized enough so that you can’t sell it to another firm), and will need another 6 months and $50 million to complete. You then find out that a new and equally good production technology has just become available. Implementing this new technology would require an entirely different factory that will take only 6 months and $40 million to build. If you build this new factory, you can’t use any part of the factory you are currently building. What should you do?

You should stop the original project and start building the new factory. That’s because the $300 million (and the last 3 years) are sunk costs. They are lost whether you finish the first project or abandon it. The only comparison that should affect your decision, then, is between the relative benefits of finishing the first project and building an entirely new factory. Both will result in equally good production facilities in the same timeframe, but the new factory will cost only $40 million rather than the $50 million you would spend to complete the original factory. Thus, you should build the new factory. Despite this logic, many people would be reluctant to write off $300 million and 3 years of effort. The important point to realize is that the mere presence of this type of reluctance does not make it a good idea to give in to the temptation of the sunk cost fallacy.