sunk+costs

Sunk Cost Melody Duncan

Definition In economics and business decision-making sunk cost are costs that have already been incurred and which cannot be recovered to any significant degree according to [|www.economics.com]. In layman terms, it states that what is done cannot be undone. Sunk cost could also be described as investment costs incurred before a certain activity takes place which cannot be recovered by the possible sale of the asset they produced. Some examples of sunk cost include a worn out piece of equipment bought several years ago, advertising and research and development. Sunk costs are also referred to as “stranded cost”. It is argued that sunk costs are not figured in to rational decision-making process, because the price paid should be irrelevant. Economists often claim that a rational actor should not let sunk costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own merits. Most people even after making a bad decision will continue to stick with it because we are emotional AND rational. The best bet would be to move on and accept the loss, but as humans most people do not.

Characteristics of Sunk Cost include an overly optimistic probability bias and requisite of personal responsibility. Overly optimistic probability bias simply states that after the cost has been incurred, a person’s evaluation of the investment reaping dividends is increased. The requisite of personal responsibility means that sunk cost are felt more by individuals who feel personally responsible for making the investment.

The Sunk Cost Fallacy or “throwing good money after bad” is also considered “loss aversion”. One example of this would be if you bought concert tickets for a friend and yourself. The friend couldn’t go, therefore you didn’t really want to either. You go anyway because you don’t want to feel like you wasted the money it cost to buy the tickets. You feel an obligation to go, as if you passed the point of no return. Therefore the misconception of Sunk cost has lead to bad decision-making

Business Application Sunk cost can be a barrier to entry. If potential entrants would have to incur similar costs, which would not be recoverable if the entry failed, they may be scared off. Sunk costs can also represent barriers to exit for a firm because a firm that has incurred in high sunk costs will have difficulties in deciding to exit the market even if it sees good opportunities outside. Also a firm that is deciding whether to enter into a certain business will have to consider with a particular attention the sunk costs and the risk that during the operations period they might not be recovered.

Questions (Correct answer in bold) 1. Sunk cost can be recuperated? True or **False**

2. Which of the following is not considered a sunk cost? a. Research & Development b. Equipment investment d. Advertising
 * c.** **Future Profit**

3. Sunk cost fallacy is also known as which of the following? a. Prisoner’s Dilemma b. Predatory Pricing c. Rivals cost d. **Loss aversion**

4. Sunk costs should not be taken into account when making rational decisions?
 * True** of False

5. Which of the following is a characteristic of sunk cost? b. The limiting of pricing c. To advertise or not to advertise d. Business competition
 * a.** **Requisite of personal responsibility**

[|www.investopedia.com/terms/s/sunkcost.asp] [|www.economics.com] http://en.wikipedia.org/wiki/Sunk_cost http://www.economicswebinstitute.org/glossary/costs.htm [|www.evangelicaloutpost.com/archives/004041.html]