For consumers, there is nothing wrong with being on the lookout for a bargain. Saving money on one purchase makes another purchase possible. But we don’t want to get caught buying something we won’t use just because the deal is too good to pass up. For businesses, it is important to realize that everyone is interested in a good deal. Whether it is via sales or genuine low prices, the lure of a deal will attract customers. The parking lot at Costco, a warehouse-style retailer with a reputation for low prices, always has a large number of luxury automobiles. Even affluent consumers get a kick from transaction utility.
________________
* Perhaps surprisingly, the one group of people that come closest to thinking this way about opportunity costs is the poor. In their recent book Scarcity, Sendhil Mullainathan and Eldar Shafir (2013) report that, on this dimension, the poor come closer to behaving like Econs than those who are better off, simply because opportunity costs are highly salient for them. If a $100 windfall could pay the overdue utility bill or replace the kids’ shoes that are now too small, opportunity costs are front and center. However, this incessant fretting about opportunity costs takes a toll. Having to constantly worry about where the money is going to come from to pay the rent makes it hard to keep up with everything, and may contribute to some of the bad decisions made by the poor, such as taking out and rolling over payday loans.
† The median is the statistical term for middle. If all the prices are ranked from high to low, the median answer is the one with as many answers higher as lower.
‡ A recent study finds that when U.S. supermarkets were confronted with the challenge of a Walmart entering their home market, all suffered, but those who used a promotional pricing strategy (e.g., frequent sales) experienced significantly greater revenues and long-term viability than an everyday low price strategy (Ellickson, Misra, and Nair, 2012).
8
Sunk Costs
Vince paid $1,000 to an indoor tennis club that entitled him to play once a week for the indoor season. After two months he developed tennis elbow, which made playing painful. He continued to play in pain for three more months because he did not want to waste the membership fee. He only stopped playing when the pain became unbearable.
When an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone. Expressions such as “don’t cry over spilt milk” and “let bygones be bygones” are another way of putting economists’ advice to ignore sunk costs. But this is hard advice to follow, as the example from the List about driving to a basketball game in a blizzard, and the story of Vince and his tennis elbow, illustrate.
To make things clear, let’s stipulate that if a friend invited Vince to play tennis (for free) at another club, Vince would say no because of his painful elbow. In economics lingo that means the utility of playing tennis is negative. But having paid $1,000 he continues to play, seemingly making himself worse off every time he does so. Why would he do such a thing? That is the question I wanted to answer.
Over the years I collected dozens of examples of people paying attention to sunk costs. One involved a friend, Joyce, who was fighting with her six-year-old daughter Cindy about what she should wear to school. Cindy had decided that she no longer wanted to wear dresses, only pants or shorts. Joyce insisted that Cindy had to wear three dresses that had been purchased in preparation for the beginning of first grade. Shouts of “I bought those dresses, and you are going to wear them!” began many days, with Cindy replying that she would not go to school if she had to wear a dress. I am guessing that Joyce probably asked, unhelpfully, whether Cindy thought that money grows on trees.
I was brought in as a mediator, and explained the economic logic to Joyce. The money paid for the dresses was gone, and wearing the dresses would not get it back. As long as sticking to pants and shorts would not require any new clothing purchases, then insisting that Cindy wear the dresses would not help their financial situation. Joyce was thrilled to hear this news. She hated fighting with her daughter, but genuinely felt guilty about “wasting” the purchase of those three dresses. Having an economist tell her that ignoring sunk costs is perfectly rational, even required, was all she needed. Maya Bar-Hillel started calling me the world’s only clinical economist. (After her quilt purchase she became my first client.)
I may or may not have deserved that title, but I was hardly the only economist to recognize that Humans have trouble with this concept. In fact, the mistake is so common it has an official name—the sunk cost fallacy—and the fallacy is often mentioned in basic economics textbooks. But many people, even if they understand the concept in principle, can find it difficult to follow the advice to ignore sunk costs in practice.
Driving to the game in the blizzard, or playing tennis in pain, are mistakes no Econ would make. They rightly treat sunk costs as irrelevant. But for Humans, sunk costs linger and become another SIF, and not only for things like dinners and concerts. Many people believe that the United States continued its futile war in Vietnam because we had invested too much to quit. Barry Staw, a professor of organizational behavior, wrote a paper on what he called “escalation of commitment” and called the paper “Knee-Deep in the Big Muddy,” after an antiwar song by the folk singer Pete Seeger.* Every thousand lives lost and every billion dollars spent made it more difficult to declare defeat and move on, in Staw’s view. Some supposedly irrelevant factors can matter quite a lot.
Why do sunk costs matter? And why might people think that continuing a course of action—going to the game or concert, or continuing a futile war—is worth it? As we saw in the previous chapter, when you make a purchase at a price that does not produce any transaction utility (or disutility), you do not feel the purchase price as a loss. You have paid some money, and when you consume the product you will get the pleasure of the acquisition utility and the account will clear; your earlier cost is canceled out by your later gain. But what happens when you buy the ticket and then skip the event?
Paying $100 for a ticket to a concert that you do not attend feels a lot like losing $100. To continue the financial accounting analogy, when you buy the ticket and then fail to use it you have to “recognize the loss” in the mental books you are keeping. Going to the event allows you to settle this account without taking a loss.
Similarly, the more you use something that you have paid for, the better you can feel about the transaction. Here is a thought experiment. You buy a pair of shoes, perhaps because they were on sale and, while still expensive, you could not pass up all that transaction utility. You proudly wear them to work one day and by noon your feet hurt. After letting your feet heal, you try the shoes again, just for an evening this time, but they still hurt. Two questions: Assuming that the shoes never get comfortable, how many more times will you try to wear these shoes before you give up? And, after you have stopped wearing them, how long will they sit in the back of your closet before you toss them or donate them to charity? If you are like most people, the answers depend on how much you paid for the shoes. The more you paid, the more pain you will bear before you stop wearing them, and the longer they will take up room in your closet.
The same behavior occurs with health clubs. If you buy a membership to a gym and fail to go, you will have to declare that purchase as a loss. In fact, some people buy a membership to help with self-control problems regarding exercise. If I want to go to the gym and will feel bad about wasting my membership fee, then the membership fee can help me overcome my inertia in two ways: the membership fee is haunting me, and there is no immediate monetary outlay when I do go. Marketing professors John Gourville and Dilip Soman conducted a clever study at a health club to demonstrate this point. This club bills its members twice a year. Gourville and Soman found that attendance at the club jumps the month after the bill arrives, then tails off over time until the next bill arrives. They called this phenomenon “payment depreciation,” meaning that the effects of sunk costs wear off over time.
A similar result w
as found by psychologist Hal Arkes, now at Ohio State University, who conducted a nice experiment with his graduate student Catherine Blumer. Students who were in line to buy season tickets to a campus theater company were randomly chosen to receive either a small or large discount on the purchase price. An important feature of the design of this experiment is that customers were already committed to make the purchase at full price before they got their discount, so experimenters could presume that the subjects who paid a discounted price valued the product as much as those who paid full price. Arkes and Blumer found that sunk costs did matter, but only for one semester. Those who paid full price went to more events in the fall semester, but by the spring attendance was the same across the three groups; apparently the students had gone to enough plays to feel they had gotten their money’s worth, or had just forgotten the original purchase altogether. So sunk costs matter, at least for a while, but may be forgotten eventually.
In some situations, sunk costs and opportunity costs can be intertwined. I had a chance to investigate a case like this with Princeton psychologist Eldar Shafir. We got to know one another when he was a postdoctoral fellow with Amos at Stanford in 1988–89. Eldar is among the small group of psychologists who can tolerate economists long enough to have collaborated with several, and has made important contributions to behavioral economics.
Our project began with a conversation at an airport when we discovered we were booked on the same flight. I had two coupons that allowed you to upgrade to first class if space was available. At that time, frequent fliers received some of these coupons for free, and could purchase additional ones for $35. I had already used one coupon to upgrade myself when I ran into Eldar and suggested that we try to get him an upgrade as well, so that we could sit together. They did have a seat, so I gave Eldar my remaining coupon as a gift. Eldar objected, insisted on reimbursing me, and asked how much the coupon had cost me. I told him that depended—some were free and some cost $35. So he asked me which kind of coupon I had used. “What difference does that make?” I asked. “I am now out of coupons and will have to buy more, so it makes no difference which kind of coupon I gave you.” “Nonsense!” he said. “If the coupon was free then I am paying you nothing, but if it cost you $35 then I insist on paying you that money.” We continued the discussion on the flight home and it led to an interesting paper.
Our question was: how long does the memory of a past purchase linger? Our paper was motivated by our upgrade coupon incident and by the List denizen Professor Rosett, who would drink old bottles of wine that he already owned but would neither buy more bottles nor sell some of the ones he owned. We ran a study using the subscribers to an annual newsletter on wine auction pricing called, naturally enough, Liquid Assets. The publication was written by Princeton economist Orley Ashenfelter,† a wine aficionado, and its subscribers were avid wine drinkers and buyers. As such, they were all well aware that there was (and still is) an active auction market for old bottles of wine. Orley agreed to include a survey from us with one of his newsletters. In return, we promised to share the results with his subscribers.
We asked:
Suppose you bought a case of good Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for about $75. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking the bottle? (The percentage of people choosing each option is shown in brackets.)
(a) $0. I already paid for it.
[30%]
(b) $20, what I paid for it.
[18%]
(c) $20 plus interest.
[7%]
(d) $75, what I could get if I sold the bottle.
[20%]
(e) –$55. I get to drink a bottle that is worth $75 that I only paid $20 for so I save money by drinking this bottle.
[25%]
When we included option (e), which we found greatly amusing, we were not sure anyone would select it. We wondered whether there were really people who are so sophisticated in their use of mental accounting that they can consider the drinking of an expensive bottle of wine as an act that saves them money. But many people took that option seriously, and over half of the respondents said that drinking the bottle was either free or saved them money. Of course, the correct answer according to economic theory is $75, since the opportunity cost of drinking the wine is selling it at that price. All Econs would pick that answer, and in this case, so did the many economists who completed the survey. Indeed, most of the people who gave this answer were economists. I know this because the answers were not anonymous. We held a lottery among those who replied, with a bottle of Bordeaux as the prize, and to be eligible to win the prize respondents had to supply their name and address.‡
There is a small modification to this question that gets most people to respond like economists. Instead of asking people about drinking a bottle, we asked subjects how it would feel if they had dropped and broken the bottle. A majority said they felt that dropping the bottle costs them $75, what they could get for selling it.
The return address for the surveys was nondescript, so respondents did not know that either Eldar or I was involved. Many volunteered explanations for their answers. One, a retired engineer, wrote: “I understand that, emotion aside, replacement cost is relevant for economic decisions. However, my ideal feeling will be if my ’89 and ’90 futures increase enough in value to sell half for my total cost and drink the balance with only pleasure in mind, not money.”
You see what he is saying? If the wine doubles in value and he sells half, then he can drink the rest as “free.” Brilliant! This ploy will make each bottle he drinks render considerable transaction utility. Another letter came from well-known University of Chicago accounting professor Roman Weil. Roman, who became a friend when I became his colleague at Chicago, comes as close to being an Econ as anyone I have encountered.
“You left out the right answer. I feel the loss is $75 less the transaction costs of selling it (which are about $15). So, I think of the bottle as costing about $60. Since I do have plenty of wine in lifetime inventory, net realizable value is correct. If I did not have sufficient lifetime inventory, I’d use replacement cost, $75 plus commission, plus shipping—about $90. Also, you don’t have the tax treatment of gain correctly. I get to enjoy tax free the capital gain. At a tax rate of 40% . . .”
But back to the survey, in which more than half the respondents are saying that drinking a $75 bottle of wine either costs them nothing or saves them money. The response raises another question: if when they drink the bottle they think it is free, what are they thinking when they buy a bottle? The next year we went back to Orley’s readers with a new questionnaire. This time we asked:
Suppose you buy a case of Bordeaux futures at $400 a case. The wine will retail at about $500 a case when it is shipped. You do not intend to start drinking this wine for a decade. At the time that you acquire this wine which statement more accurately captures your feelings? Indicate your response by circling a number on each of the scales provided.
(a) I feel like I just spent $400, much as I would feel if I spent $400 on a weekend getaway.
1 ---- 2 ---- 3 ---- 4 ---- 5
Strongly
Strongly
Mean: 3.31
Agree
Disagree
(b) I feel like I made a $400 investment which I will gradually consume after a period of years.
1 ---- 2 ---- 3 ---- 4 ---- 5
Strongly
Strongly
Mean: 1.94
Agree
Disagree
(c) I feel like I just saved $100, the difference between what the futures cost and what the wine will sell for when delivered.
1 ---- 2 ---- 3 ---- 4 ---- 5
Strongly
Strongly
Mean: 2.88
Agree
Disagree
The most popular answer reveals that when buying wine to lay away for ten years before drinking, peopl
e think of the expenditure as an investment. The second choice was that they were saving money. Calling it spending came in dead last.
Although economic theory does not stipulate which of these answers is appropriate, when the answers are combined with the results of the earlier survey we clearly see some inconsistent thinking going on. It can’t be right that acquiring the wine is just an “investment” and the later consumption of the wine either costs nothing or saves money. Surely the support of an expensive wine drinking habit must involve spending money at some point! Eldar and I published a paper on this, with a title that fully summarizes the findings: “Invest Now, Drink Later, Spend Never.”
Notice that this way of thinking is very good for the fine wine industry, since it eliminates the spending part of consumption, a good trick if you can pull it off. Vacation time-share properties make similar use of this way of thinking. Typically, the prospective vacationer “invests” a sum of money, say $10,000, which entitles her to spend a week at the property in perpetuity, or at least until the property falls down or the company goes bankrupt. The mental accounting works this way. The original payment is an investment (not a purchase), the annual “maintenance fee” is a nuisance, but future vacations at the property are “free.” Whether such an investment makes sense for a family will depend, in part, on how painful it is for them to spend money on vacations. But such investments should be seen for what they are: a way to disguise the cost of taking a vacation.
Misbehaving: The Making of Behavioral Economics Page 8