Sunk Costs - YouTube

In this video, we're going to discuss the concept of sunk costs.

A sunk cost is 2 things: (1) it's a cost that has already been incurred, and that means

that you've already invested the money (you've already spent the money and it is gone).

(2) It can't be changed going forward.

You've invested the money.

You can't go back.

There's nothing that can be done.

For these 2 reasons, a sunk cost is irrelevant to decision making.

Why?

The money is gone.

It has already been spent.

It is already incurred, and we can't change it.

We can't do anything about it.

So it shouldn't be affecting our future decisions.

Let me just walk you through an example, and you'll see in a moment why this is the case.

Let's say as an example, you pay $10 for a movie ticket.

The movie that you wanted to see was sold out, so you pay $10 for some other movie that

you really don't want to see as much.

When you show up at the movie theatre, somebody offers you a free ticket to a movie that you

really want to see.

You would prefer to see this movie that you got the free ticket for.

Now if you start thinking, "Hey wait a minute, I've already paid $10 for this other movie.

I should probably see that."

Well, research has shown that a lot of people will actually go and see the movie that they've

already paid money for even though they think that they would like it less than the one

they are being offered a free ticket for.

And that's because, even though it is a sunk cost in that it has already been incurred

(we've already paid the $10.

It's lost.)

We can't change that.

People allow this to affect their decision making.

They have this idea of, "Well, I don't want to be losing money.

I don't want to waste $10 for nothing."

So even though they have these 2 options, and they know that they would like option

2 better than option 1 they will sometimes still choose option 1.

They are letting this sunk cost that should be irrelevant affect their decision making.

Now you might say, "Well, this is just going to the movies.

How is this important to the business world or to real life?"

Well sometimes what you'll have happen, let's say there's this firm that has invested $100

million in a project.

You've got this ongoing project and it looks like this project is not going to be a success.

There are problems.

It has just been a nightmare from the beginning, and they should just pull the plug.

But they are reluctant to pull the plug sometimes because they say, "Well, we've already invested

$100 million in this.

We should keep pushing forward."

Obviously, you don't want to just invest $100 million in something and have one problem

come up, and you say "Okay let's forget about the money."

But, if you come to believe that this is not going to be successful (or there's a very

good likelihood it's not going to be successful) and actually we should deploy our future money

elsewhere but, you continue along with this other project because you say, "Look, we've

already invested the $100 million."

Then what you are doing is you're allowing a sunk cost to affect your decision making,

and you shouldn't.

What happened here, to this $100 million dollars...that's gone.

What you should care about is the future.

How do we affect the firm positively going forward from here?

Because this is sunk, we're not getting that money back.

It's gone.

And whether we continue to throw money into this project isn't going to change the fact.

So we have to say, from this point going forward what's the best decision?

In doing so, we have to ignore sunk costs.

They are irrelevant, and we shouldn't allow them to affect our decision making going forward.