Economists Do It With Models

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This Year’s Economist Valentinegram…

February 14th, 2014 · 5 Comments
Behavioral Econ

Via a Twitter friend:

It’s funny because it’s true, and I’ve been trying to explain this to people for years. (In related news, economists don’t have a reputation for being particularly romantic.) In case you’re not familiar, sunk costs are costs that you’ve already paid and can’t recover- i.e. you can’t get your money back. Rationally, sunk costs shouldn’t factor into decision making because they are, since they’ve already been incurred, present in every possible outcome and therefore can’t affect the relative appeal of different options. For a Valentine’s themed illustration, consider the following: you purchase a box of chocolates, only to find that all of the chocolates are of the gross coconut-filled variety (seriously, who likes those?)- do you continue to eat the chocolate because, gosh darn it, you paid for it and you’re going to get your money’s worth, or do you chuck the heart-shaped box into the nearest trash can ASAP, saving yourself both empty calories and the pain of choking down substandard goodies? If you’re rational, you’d choose the latter option (or at least find that one person who is apparently keeping the coconut-filled Valentine’s chocolate industry alive and given them a nice gift), since “getting your money’s worth” is only going to make you less happy.

In practice, people are not always good at ignoring sunk costs, even though it would be reasonable to do so. Some empirical evidence:

  • People report being less likely to purchase a replacement movie ticket than the original ticket, even though the two decisions are nearly identical (unless one is so cash constrained that the wealth difference between the two choices actually becomes a limiting factor). Sometimes people try to justify their choice by saying “Why would I pay twice to see the movie?” and I counter with “Why would you pay once to not see the movie?”
  • People are less likely to attend concert events when they are randomly given a discount on their season tickets after they’ve decided to purchase the tickets.
  • People often report being “pot committed”> in poker, when, rationally, whether the money in the pot is your or someone else’s should have no bearing on whether you raise or fold.
  • If people were good at ignoring sunk costs, the phrase “throwing good money after bad” would have never been invented.

If you’re curious, you can see more fun with sunk costs in Richard Thaler’s “Mental Accounting Matters.” Thaler even gives a potential explanation for why people tend to ignore sunk costs- in his mental accounting framework, people only explicitly evaluate transactions that are exceptions to the ordinary, so they fail to notice that, for example, they would be paying to not go to the movie and instead only focus on the potential of paying twice to go to the movie. Therefore, it’s not hard to see how ignoring sunk costs could lead to faulty reasoning along the lines of “well, I’ve put so much into this relationship already, I basically have to see this through.” (Like I said, we’re a romantic bunch.)

Isn’t it nice that you can get a valentine and a life lesson in one? I have to admit, however, that this is my favorite nerdy valentine thus far:

Or, if you prefer your valentines to be of the “real” sciences form instead, check these out. Personally, I’m giving this one to my students:

Tags: Behavioral Econ

5 responses so far ↓

  • 1 Evan // Feb 14, 2014 at 5:00 pm

    I think you’ve misrepresented pot commitment slightly. Sure it doesn’t matter whose chips are in the pot. But the mechanics in poker always ensures that if you have put in x chips there will be at least 2x chips in the pot when you next have to make a decision. The size of the pot clearly does, and should, affect your decision making.

    I think most good, experienced poker players think of pot commitment as being related to the size of the pot, rather than the number of chips you personally have committed.

  • 2 Allan // Feb 14, 2014 at 7:04 pm

    Agree with Evan that there’s a misrepresentation of pot commitment in poker.

    I’m curious, would you consider a one-off club membership joining fee to be a sunk cost? Say I also had to pay a monthly fee on top of that to continue to use the facilities. Wouldn’t I be more likely to want to use the club and keep paying the monthly fee because I had already paid that joining fee? So there are barriers to entry and if I increase the cost of barriers to entry, I’m less likely to exit, everything else constant. So I’d disagree with your statement that sunk costs “shouldn’t factor into decision making.” Have I misrepresented something?

  • 3 Philip // Feb 14, 2014 at 7:35 pm

    Agreed with Evan and Allan, and to be fair to Jodie, the leading Urban Dictionary definition is too much of a summary to be reliable in this case. Pot commitment at its most useful really pertains to planning your first decision in light of your second decision — if you know that the pot’s so big relative to your stack after your raise first-in that you’ll have to call any reraise, then for various reasons you usually want to shove your entire stack in yourself (in no-limit games). If you don’t do this, and instead wait until the pot is giving you odds you have to call, then you’ve not really planned well. You shrug, say, “Well, I’m pot-committed,” and call off because you have to given the odds.

    But that’s not really the sunk cost fallacy. Good poker authors do recognize the sunk cost fallacy under different names, and warn us against it.

  • 4 Mike // Feb 15, 2014 at 1:47 pm

    Economist not being romantic? What would Russ Roberts say? http://www.amazon.com/gp/aw/d/0262681358

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