We all know there is no use crying over spilled milk, but when it is our own milk we do so anyway. In love, war, and even business, it can be hard to know when to walk away from a bad situation.
In economics, however, it has long been a key principle that decision makers must ignore “sunk costs.” Once money is spent on something that cannot be recovered or resold, that expenditure becomes irrelevant to future decisions about achieving the best profit possible.
For two centuries, the assumption that humans are rational formed the bedrock of economic theory. The approach to any problem was “Humans are rational satisfaction-maximizers. What would such a person do in this case?”
This explained some things well, predicting exactly what farmers do when the wheat price goes up or what consumers do when ground beef is on sale. It failed in other areas.
Stockbrokers have long noted that people are more willing to sell a stock that has gone up – even if it is expected to go up more – than they are to sell a stock that has gone down and that probably will not recover. This isn’t rational, but it is common behavior.
In the last decade, a cohort of young economists has worked with psychologists to explain such apparent anomalies. It is an approach of “people do this, let’s figure out why” rather than “people are rational, so here is what they would do.”
Research shows that the psychological pain of acknowledging mistakes that led to a loss is much greater than the satisfaction that comes from decisions that produced an equal gain. It is a part of human nature.
But some conclusions of conventional theory stand. A firm will be more profitable if its managers ignore past unrecoverable expenditures and focus only on the expected cost and income from future alternatives.
The same is true in other aspects of life. The spilt-milk adage has been true for centuries. Dear Abby’s classic question, “Are you better off with him or without him?” is another way of saying, “Ignore sunk costs and weigh marginal costs and benefits going forward.”
People who are able to ignore such “sunk costs” generally make more money or lead happier lives than those who cannot. They find that admitting failure and moving forward gives them “a new freedom and a new happiness,” to use a phrase from the 12-Step movement.
Others cannot let go of the past. Some respond instead by “doubling down,” trying the failed action one more time in the hope it will succeed. Every year some farmer or elevator operator enters a bad futures contract position. Not accepting the loss, they increase their bet and their risk exposure. Eventually everything blows up and they go spectacularly broke.
Big traders do it too. Last fall, hedge fund Amaranth Advisors lost $3 billion on natural gas. In 1995, Nick Leeson, a 28-year-old trader, broke the venerable Barings Bank with $1.4 billion in such losses. Similarly, copper trader Yasuo Hamanaka dropped $2.6 billion for Sumitomo and San Diego treasurer Robert Citron lost $1.4 billion in vain attempts to reverse losing positions.
If difficulty in ignoring sunk costs is innate in the human psyche, how can we minimize its harmful effects?
Financial institutions can implement internal control systems to ensure that no one trader’s impulses break the company. The same is true for pension plans and co-op elevators.
In personal affairs, roommates can tell the lovelorn sophomore, “Look, she is just not that into you.” Friends and shelter volunteers can advise the battered wife, “Don’t go back, he’s never going to change.”
It is harder in defense policy. During World War I, generals continued to throw soldiers into meat-grinder battles long after the futility of doing so was clear. In 1942, after the United States invaded North Africa, Hitler could have withdrawn an intact Africa Corps. Instead he doubled down and lost a quarter-million men, and repeated the mistake at Stalingrad.
The French made mistakes in Indo-China and repeated them in Algeria. Only Charles De Gaulle, a leader of unparalleled stature, could take the painful decision to let Algeria go its own way.
We face a similar situation in Iraq. People of good will who all love our country obviously can come to different conclusions about the expected benefits and the expected costs of staying the course, doubling down or withdrawing.
Some say, “If we pull out now, more than 3,000 of our people will have died in vain.” The other side replies, “If the final result is going to be the same, sacrificing 500 more in a vain cause would be tragic.”
Economists cannot resolve these conflicting points of view. However, we can point to evidence that innate human impulses in such situations often produce mistakes.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.