The sunk-cost fallacy or the ‘escalation effect’ occurs when a decision-maker holds constant or increases her commitment to a particular choice despite marginal costs exceeding marginal benefits. In a nutshell, the effect implies causality between a decision-makers irreversible past choices and the current decisions they must make.
Microeconomics textbooks stress that one should not follow sunk costs. Plainly put – we shouldn’t cry over spilled milk, it’s not getting back in the glass. As intelligent decision-makers we should consider opportunity costs…but forget about the sunk ones! The usual recommendation of the economist is that honouring sunk costs can be expensive in terms of time, money and heartache!
Since the 1970’s researchers have tested to see whether or not decision-makers follow sunk costs and various psychological studies, in particular the works of Arkes and Blumer, found evidence to support the escalation effect. Sunk costs effects have been observed in various contexts such as in wars (Lipshitz 1995) and space exploration programs (Mitroff 1974).
In 1995 the first quantitative field test of a sunk cost effect was carried out by Staw and Hoang in a sporting context to extend sunk cost research from a behavioural perspective. Their results confirmed that more highly drafted individuals in the National Basketball League received additional playing time when controlling for on-field performance. Although later papers were to reconsider the author’s findings, Staw and Hoang found that when they created a standardised measure of performance, players at the top of the draft received more playing time. Even though a coach’s draft choice was playing poorly they were often following sunk costs and still choosing the player.
Why would individuals, firms or institutions ‘throw good after bad’? Arkes and Blumer described this effect in terms of judgement error, whereby individuals believe that by not following sunk costs they are invoking further losses or underutilising previous investment. Self-Justification theory also provides a wealth of explanations for the occurrence of a sunk cost effect; if an individual is personally responsible for previous investments they may follow sunk costs to maintain self-esteem.
Sport is perhaps one of the most interesting domains to test for this effect as cold calculated decision making is something one may not always associate with a chairperson or manager!