What You Didn’t Learn in ECON 101 CAN Hurt You

Note: This post originally appeared on my Optimize Business Results blog on September 23, 2010. A few minor changes were made here.

What criteria do you use for decision-making? If the amount of resources (e.g., time, effort, money) is the sole criterion, you could be making the wrong choices. A concept from Economics 101 called “sunk costs” illustrates why you may need to re-consider your decision-making criteria.

The term sunk costs refers to resources you have expended that cannot be recovered or re-done. They are in the past and cannot be changed. Time is probably the best example of a sunk cost, as it cannot be recovered. Making a non-refundable payment on a product or paying for a service that’s been rendered are other examples.

The problem arises when people use sunk costs to justify or make decisions about current or future actions. The problem is magnified when the existing or proposed path does not serve them well. For example, when I was a professor, a student who found she disliked accounting after deciding to major in it stopped by my office to tell me how excited she was about the human resource courses she was taking. Given this discovery, it seemed logical that she would change majors, yet she decided not to do so. The rationale for her decision was that she already had taken most of her accounting classes, and she didn’t want that time and effort to go to “waste.” Sadly, by using sunk costs as her decision criterion, she continued to move ahead into a field she disliked rather than one she truly enjoyed.

Here are some other examples of poor decisions based on sunk costs. Do any of them resonate with you?

– Continuing to move forward with a project that is no longer aligned with the
organization’s goals because of the money spent on its development.

– Retaining an employee who is performing poorly because of the investment
made in his training.

– Sitting through a play you find boring because you’ve paid for the ticket.

– Deciding to keep your old car instead of buying another one because of the
money previously spent on repairs.

In each of the above examples, relying on sunk costs to decide whether to stay the course or go in another direction results in negative outcomes. I suggest two alternatives to relying on sunk costs as a decision-making criterion:

1. Resolve to cut your losses. That is, forget what you’ve already invested, and
make the decision based on other things (including costs) that you CAN
control or change and that will result in a better outcome. For example, walking
out of the play and using the time to do something that does appeal to you will
result in a much more pleasant evening.

2. Replace the sunk costs criterion with this one: ask yourself whether the current
or contemplated course of action will serve you or your organization well today
and in the future. The answer to THAT question is a much more effective guide
to action than using sunk costs. For example, retaining a program that was
expensive to develop but has not produced the desired outcome doesn’t serve
anyone well.

For those of you who never took ECON 101 or who didn’t pay attention during that course (because really, who believed any of these concepts would turn out to be useful?), you might be interested to know that there are other concepts that are just as important in “real life” as that of sunk costs. For example, comparative advantage comes to mind – i.e., the notion that by doing only the things we are really good at and delegating everything else to others who are good at doing those things, everyone comes out ahead. What other lessons from ECON 101 have you found useful? Let us know!

© 2012 Pat Lynch. All rights reserved.