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.
