I’ve invested too much to back out now.

Is this thought a mistake, or not?

Costs

Every action incurs a cost. The cost is whatever you lose by taking the action. In some cases a cost can be recovered, and in other cases a cost is unrecoverable or sunk.

In economics it’s said that there’s no such thing as a free lunch. This is because, even if food is provided to you without payment, accepting it incurs an opportunity cost. You lose the option to eat a different meal or to do something different with that time.

Since every decision is an exclusion of all alternatives at that moment, every decision carries an opportunity cost.

Opportunity costs can’t be recovered in general. Time spent is always a sunk cost.

Recoverable and sunk costs

Sometimes costs can be recovered, for example through a refund. Naturally, the more recoverable a cost is the less risk there is in taking that action.

Costs and benefits aren’t always transferred at the same time. While either can happen first, a very common situation is investing resources with hopes for a future benefit. This could be making a literal investment, placing a bet, working in order to receive a paycheck later, remodeling a room of your house, hiking up a mountain to watch the sunrise, and so on.

Notably, in some of these cases the benefit is virtually certain, and in others the amount of benefit can vary or there might be none at all. Additionally, sometimes projects can incur unexpected costs partway through. For example, an accident during remodeling could require the unplanned reconstruction of a wall.

Projects and activities can often be abandoned without incurring additional cost, but any sunk costs are lost at that point providing no benefit. The cost-benefit analysis of abandoning something partway through can be counterintuitive.

The sunk cost fallacy

A common error in reasoning is to think about such a situation in the following way:

“If I abandon my progress now, I will have gotten nothing out of the costs I expended. If I continue, there is still some chance of receiving benefits. Therefore, it is better to continue, even if it costs even more.”

This often arises in gambling. A gambler who is down $100 and a gambler who is down $10,000 are equally likely to win or lose; the expected value of making a $1 bet is the same for them. Logically, all else being equal, the gambler out $10k should be more incentivized to stop, because they probably can’t afford to lose any more money while the gambler out $100 might be able to afford to lose more money.

However, the gambler who is down by more money is often more psychologically motivated to continue gambling. This is partly accounted for by the gambler’s fallacy, thinking that a run of losses make a win more likely, and partly by the sunk cost fallacy.

Quitting realizes losses, which can feel like incurring losses. As long as you keep gambling, the amount you’re up or down by is in flux, and can potentially go very high. So even when quitting is the economically rational thing to do, it can feel like you’re giving up costs which are actually already sunk.

When quitting isn’t rational

A phenomenon I have observed a handful of times is people thinking the sunk cost fallacy applies to any situation with unrecoverable costs. This is not true.

Whether continuing despite sunk costs is fallacious depends on whether the activity can be easily resumed or not. Quitting carries the opportunity cost of having to start over if you want to pursue the activity in the future.

Gambling, the usual exemplar of the sunk cost fallacy, has no progress over time that is lost upon quitting. On the other hand, if you run a functioning business that is in the red, abandoning it incurs the additional opportunity cost of having to build a functioning business all over again, which is a massive cost. As a result, it is usually rational to continue operating a business in the red until it is evident that it will never be able to be profitable.

In situations where progress will be lost, it’s not as simple as the sunk cost fallacy. It’s a little confusing because the fallacy can come into play, but it doesn’t always. It depends on whether the prospective expected losses exceed the expected opportunity cost. This can be very difficult to determine, as they are based on judgments of the probabilities of uncertain future events.

Takeaway

Reasoning about costs and probabilities can be very unintuitive. Informal fallacies do a good job of summarizing common errors, but they aren’t equally applicable to every situation. Situations that look similar on the surface, like those involving unrecoverable costs, can have other factors that have to be considered. In particular, opportunity cost is something many people forget about, since it is not an explicit cost.

When it comes to the sunk cost fallacy, it applies when quitting carries little to no opportunity cost. If there is significant opportunity cost, then the cost-benefit analysis becomes much more complex. The sunk cost fallacy can still apply if potential losses greatly outweigh the opportunity cost, but it often doesn’t. The failure to perceive when quitting would be rational can be due to misestimation of costs or probabilities rather than fallacious reasoning.

So when someone is continuing with something that isn’t going well, that they have invested a lot in, it’s not necessarily because of the sunk cost fallacy, and it’s not necessarily irrational.

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Photo by Pavel Danilyuk