Of mice and men

When considering a decision about whether to do something or not, we are thinking about the future. For example, say that we are managing a firm that has an ongoing project and we are considering whether to persist with the project or to stop the project and divert the resources to an alternative project. In this case, we should only be considering the future. Costs (and benefits) that have already occurred and that cannot be recovered are sunk costs. They should not affect our decision-making. And yet, so often they do.

Richard Thaler, the 2017 Nobel Prize winner whose work is neatly summarised in his book Misbehaving: The Making of Behavioral Economics (which I reviewed here), says that the sunk cost fallacy arises because of a combination of loss aversion and mental accounting.

In general, people are loss averse because we value losses more than we value equivalent gains. Gaining $10 makes us happier, but losing $10 makes us unhappier to a greater extent than gaining $10 makes us happier. So, we generally try to avoid losses.

Mental accounting suggests that we keep 'mental accounts' associated with different activities. We put all of the costs and benefits associated with the activity into that mental account, and when we stop that activity, we close the mental account associated with it. But if the mental account has more costs in it than benefits, it is a loss. And because we are loss averse, we try to avoid closing the account.

So, you can see why a manager might be reluctant to stop a project that is incomplete, even if (and maybe especially if) it has cost a lot so far. Sunk costs may not affect the decision-making of a purely rational decision-maker, but for someone who is quasi-rational (and therefore affected by loss aversion and mental accounting), the sunk costs are relevant to their decision.

Now, it seems that humans are not the only creatures subject to the sunk cost fallacy. New research, reported in the New York Times last week, suggests that mice have the same problem:

This “sunk cost fallacy,” as economists call it, is one of many ways that humans allow emotions to affect their choices, sometimes to their own detriment. But the tendency to factor past investments into decision-making is apparently not limited to Homo sapiens.

In a study published on Thursday in the journal Science, investigators at the University of Minnesota reported that mice and rats were just as likely as humans to be influenced by sunk costs.

The more time they invested in waiting for a reward — in the case of the rodents, flavored pellets; in the case of the humans, entertaining videos — the less likely they were to quit the pursuit before the delay ended.

“Whatever is going on in the humans is also going on in the nonhuman animals,” said A. David Redish, a professor of neuroscience at the University of Minnesota and an author of the study. 

So take heart. You may not be purely rational but, in the animal kingdom, you're not alone.

[HT: Marginal Revolution]