Sometimes even economists get mixed up about the sunk cost fallacy

In an interesting article in The Conversation this week, Aaron Nicholas (Deakin University) wrote:

Have you ever encountered a subpar hotel breakfast while on holiday? You don’t really like the food choices on offer, but since you already paid for the meal as part of your booking, you force yourself to eat something anyway rather than go down the road to a cafe.

Economists and social scientists argue that such behaviour can happen due to the “sunk cost fallacy” – an inability to ignore costs that have already been spent and can’t be recovered. In the hotel breakfast example, the sunk cost is the price you paid for the hotel package: at the time of deciding where to eat breakfast, such costs are unrecoverable and should therefore be ignored.

The problem is, the example of the subpar hotel breakfast doesn't necessarily illustrate the sunk cost fallacy at all. At least, just because some people choose the subpar hotel breakfast, it doesn't mean that those people have fallen victim to the sunk cost fallacy.

To see why, let's first consider what a purely rational decision-maker might do. A purely rational decision-maker considers only the costs and benefits of each of the alternatives available to them. As Nicholas notes, sunk costs are unrecoverable and therefore ignored. In the case of the subpar hotel breakfast, the benefits of the hotel breakfast are low, but the costs are effectively zero (since it has already been paid for). The benefits are greater than the costs. However, going down the road to a cafe has greater benefits (better food), but also comes with greater costs (the time and effort to get to the cafe, plus the monetary cost of the breakfast). It's not certain that the net benefit (benefits minus costs) would be greater for the cafe breakfast than for the hotel breakfast, even for a purely rational decision-maker. So, just because someone chooses the subpar hotel breakfast, it doesn't mean that they have fallen victim to the sunk cost fallacy.

Now consider a quasi-rational decision-maker. Quasi-rational decision-makers are loss averse (they value losses greater than monetarily-equivalent gains), and engage in mental accounting. Mental accounting suggests that we keep 'mental accounts' associated with different activities. Quasi-rational decision-makers put all of the costs and benefits associated with the activity into that mental account, and when they stop that activity, they close the mental account associated with it. And since they are loss averse, they are reluctant to close an account where the costs are greater than the benefits. In the case of the hotel breakfast, the mental account for breakfast has the cost of the breakfast in it (even though it is a sunk cost), so a quasi-rational decision-maker is more likely to stay for the subpar hotel breakfast than a purely rational decision-maker, because the quasi-rational decision-maker wants benefits (however modest) to offset the cost of the breakfast before they close the breakfast mental account. It is mental accounting (and loss aversion) that makes quasi-rational decision-makers susceptible to the sunk cost fallacy.

Taken altogether, this suggests that quasi-rational decision-makers are more likely to stay for the subpar hotel breakfast. It does not mean that staying for the subpar hotel breakfast means that a decision-maker is quasi-rational (and falling victim to the sunk cost fallacy), since a purely rational decision-maker could decide on the subpar hotel breakfast as their better option, even ignoring the sunk cost.

The other examples that Nicholas uses are better. The best examples of the sunk cost fallacy involve decision-makers continuing an activity they have started, even though the remaining costs will outweigh the remaining benefits. The sunk cost fallacy (arising from mental accounting and loss aversion) keeps us in unpromising projects for too long, as well as unhappy relationships, and bad jobs. 

Most real-world decision-makers are susceptible to the sunk cost fallacy. That's why it's sometimes more notable when we see decision-makers not falling victim to it (see here and here, for example). However, when economists explain sunk costs and the sunk cost fallacy, we need to make sure that we are using examples that unambiguously illustrate the problem.