The art of Emotional Decisions (Sunk Cost Evaluation) Can we avoid emotions which lead us to irrational decisions?

Distinct from an Economic Loss Sunk Cost A cost that has been incurred and cannot be reversed Example: A worn-out piece of furniture you bought several years ago is a sunk cost because the cost of buying it cannot be changed A sunk cost is not a precise quantity, but an economic decision Decisions should be relevant , not irrational! The original cost is no longer relevant since what you paid in the past is already spent What you paid should not affect your future decisions Regardless of the resale value Regardless of the price paid If you can derive more value in selling a car than not, you should sell it Distinct from an Economic Loss When you purchase a car, it can be resold; but not at the original price.

Make Rational Decisions Sunk costs are not considered when making a decision You buy a movie ticket – you can choose between two results since you already paid for the ticket: Watch a movie you do not want to see Use the time to do something more fun (“opportunity cost”) But you bought the ticket already! Therefore, if you regret it… Base your decision upon on whether you want to see the movie, regardless of the price What would be your decision if the movie was free? Economists suggest the second option … Why? You suffer only one way (spent money), Option 1 involves suffering in two ways (spent money and wasted time)

In Business, We Cut Our Losses Short Example: You spend $20 million on building a power plant which currently has no value because it is incomplete (it has no sale or recovery is feasible) Your choices: Complete the plant for an additional $10 million Abandon construction and build a different facility built for $5 million The correct choice: Option 2 It is more “rational”, even though it represents a total loss on the original expenditure If you choose Option 1, Your decision is inefficient (irrational) because you are misallocating resources by depending on information that is not relevant to the decision being made If decision-makers are (economically) irrational or have the wrong incentives, the completion of the project is chosen Can leads to continued construction and cost overruns The original sum is sunk (i.e. spent – you are not getting it back)

Characterizing Sunk Costs Overly optimistic probability bias – The evaluation that your investment is “reaping” dividends is increased Knox & Inkster: People who commit themselves reduce “post-decisional dissonance” by believing more than ever they had a winner 141 people wagering on horses, 72 had just placed a $2.00 bet; 69 people about to place a $2.00 bet . Rate their decision 7 point scale Finding: People finished betting: 4.81 – Good chance People about to bet : 3.48 – Fair chance Feeling of personal responsibility (Sunk Cost Fallacy) You feel obligated to go to the movie despite not wanting to, because doing otherwise would be wasting money (Point of No Return) If you go, you miss the opportunity cost of an alternative use of time

Loss Aversion and the Sunk Cost Fallacy Loss Aversion is “Irrational“ Behavior (Sunk Cost Fallacy): Many people have strong misgivings about "wasting" resources because they feel it is inefficient But this misallocates resources (in our case money) by depending on irrelevant information to the decision being made By deliberately incurring sunk costs beyond the point of no return, you can continue or get into investments that otherwise you would not have Have you noticed that you see very few partially built bridges… Why? Because once started, we feel the costs are too high to stop or start over

Sunk Cost Dilemma But this leads us to a dilemma… If sunk costs are not considered when decisions are made … Can several good decisions lead to a very big bad one? Note: Do not confuse this with the sunk cost fallacy, where a misconception of sunk costs can lead to bad decisions Decisions are considered using open (not sunk) costs, and each is beneficial (e.g., Rubik’s Cube, solitaire, etc. Just like a train: Once on the track, it is very difficult to change its direction Consider a project when decisions are made – whether to start the project at first and then to continue Each time a decision is made, the strategy of going ahead is dominant, i.e. it has the highest payoff and always is positive Therefore, the decision to not proceed becomes more and more unlikely In the end, the overall payoff of the project is negative Can be explained using Game Theory and is why projects run into crisis

The Prisoner’s Dilemma (Game Theory) A non-zero-sum game where players "cooperate with” or “betray” each other Question: Will two prisoners cooperate to minimize total loss of liberty or will one, trusting the other to cooperate, betray him to go free? Prisoner B Stays Silent Betrays Prisoner A Stays Silent Each prisoner serves six months A serves ten years; B goes free Prisoner A Betrays A goes free; B serves ten years A and B serve five years each Prisoner’s only concern is to maximize his/her own payoff, without concern for the other No matter what the other player does, one player will always gain a greater benefit by betraying Therefore, the rational player will betray the other. Rational Choice: The two betray each other even though it is in each player's interest to cooperate – the individual reward would be greater if they betray