Sunk costs

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In economics and business decision-making, sunk costs are retrospective (past) costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective and prospective costs may be either fixed (that is, they are not dependent on the volume of economic activity, however measured) or variable (dependent on volume).

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment decision. Traditional economics proposes that an economic actor not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

Evidence from behavioral economics suggests this theory fails to predict real-world behavior. Sunk costs greatly affect actors' decisions, because many humans are loss-averse and thus normally act irrationally when making economic decisions.

Sunk costs should not affect the rational decision-maker's best choice. However, until a decision-maker irreversibly commits resources, the prospective cost is an avoidable future cost and is properly included in any decision-making processes. For example, if one is considering preordering movie tickets, but has not actually purchased them yet, the cost remains avoidable. If the price of the tickets rises to an amount that requires him to pay more than the value he places on them, he should figure the change in prospective cost into the decision-making and re-evaluate his decision.

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The sunk cost is distinct from economic loss. For example, when a car is purchased, it can subsequently be resold; however, it will probably not be resold for the original purchase price. The economic loss is the difference (including transaction costs). The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which is no longer relevant to decisions about the future; it may be used inconsistently in quantitative terms as the original cost or the expected economic loss. It may also be used as shorthand for an error in analysis due to the sunk cost fallacy, irrational decision-making or, most simply, as irrelevant data.

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