I was listening to a recent episode of Planet Money that discussed the sunk cost fallacy (or sunk cost bias). The episode reminded of something I’ve long thought: one bias, taken out of context, might in-fact help solve another bias (which itself seems to be problematic when viewed in isolation).
Let me start by describing the two biases. First, the sunk cost bias. I remember well a moment in college when I realized this economics thing might be for me. I was skiing with a group of friends, one of whom was worn out by lunchtime, announcing they were heading back to hotel. Another friend, encouraging the deserter to stay, said something along the lines of: “Common, these lift tickets are expensive. You’ve got to keep going to get your money’s worth.” I remarked we should stop pestering the deserter: the lift ticket was a sunk cost.
Nothing, at this point, would refund the cost of the lift-ticket. So, the decision was not whether to buy a lift ticket or not (that cost was sunk), but, rather, the decision was which course of action, now at lunch, would make the individual happier: A) continue skiing or B) rest in the hotel room. I was pleased that I seemed to convince my friends this was the right way to think about it. Lessons to avoid the sunk cost fallacy (or bias) are probably taught in virtually every ECON 101 class, and yet, it seems to be a bias to which we all routinely fall prey.
Consider a second, seemingly unrelated bias: present bias (or time-inconsistent preferences). It isn’t irrational to care about the present more than the future. But, it is problematic if the rate at which we discount the future changes depending on when we are asked. Consider a simple example. Which would you prefer: A) $100 today or B) 101 tomorrow? Now, a second question. Which would you prefer: C) $100 one year from now or D) $101 one year and one day from now?
It is common for people to choose A over B (“give me the quick $100 bucks now!”) and then D over C (“I’ve already waited a year, what’s one more day to get a dollar?”). There is a problem with that choice pattern. Choice of A over B implies a person is unwilling to wait a day for a dollar but choice of D over C implies the opposite: a willingness to wait a day for a dollar. When people exhibit these sorts of time inconsistent preferences, they tend to want to start a diet tomorrow. But, when tomorrow becomes today, they’re no longer willing to start the diet, and again plan to do it … tomorrow.
These two biases, the sunk cost fallacy and time-inconsistent preferences, are widely discussed in economic research, but rarely together. However, it strikes me that, at least in some circumstances, the sunk cost fallacy can help solve time-inconsistent preferences.
Consider a gym membership. If I exhibit time-inconsistent preferences, I won’t work out as much as I should. I will always imagine my future self being more disciplined and exercise-ready than my present-self ever will be. Yet, many of us pay large up-front gym membership fees. One economics study suggests people significantly over-pay for gym memberships and concludes we’d be financially better off choosing a “pay as you go” plan. But, what if paying a large-up front fee induces the sunk cost fallacy? “I’d better go to the gym to ‘get my money’s worth’”? If so, fretting over our sunk costs would lead us to exercise more than we might otherwise, helping offset the problem of time-inconsistent preferences, which, in isolation, would tend to lead us to exercise less than we otherwise might.
A commonly suggested solution for time-inconsistent preferences is to create commitment contracts. Commitment contracts occur when my present self undertakes actions (or commitments) to bind my future self, or at least makes it more costly for my future self to reverse course. An example is a Christmas Club savings account, a savings account where withdrawals are only allowed (without penalty) around the Holiday season. If people were perfectly rational, a Christmas Club account would be unnecessary; we’d just use our “regular” savings accounts that have more flexibility and, in all likelihood, pays higher interest rates. Yet, some people choose to use Christmas Club savings accounts as a type of commitment device (I’m binding my future self to not spend the money till the Holidays).
It strikes me that the psychological feelings we have around sunk costs act as a sort of commitment device. Although ECON 101 tells us to ignore sunk costs, the fact that we often fret over them suggests that, at least in certain circumstances, they may be binding us to a course of action our previous self wanted us to pursue.