Sunk Costs Are No Longer Costs

Summary： This article explores two crucial economic concepts: sunk costs and marginal costs. It highlights the difficulty in practicing the principle that "sunk costs are not costs," despite its simplicity. Using examples such as watching a bad movie, choosing a college major, and romantic relationships, the article illustrates how people often struggle to cut their losses. It emphasizes the importance of focusing on marginal costs and marginal benefits when making future decisions, illustrated through various scenarios. The article also discusses the implications of these concepts in industrial policy, using the example of choosing between 4G and 5G infrastructure, and concludes that sometimes adapting to past mistakes can be the most efficient decision.

Recently, I encountered two very important concepts: sunk costs and marginal costs. I have four insights to share.

1. "Sunk Costs" Are Easy to Understand but Hard to Practice

Where there are choices, there are costs; where there are no choices, there are no costs. When we can no longer make a choice, there is no cost. This is the meaning of "sunk costs are no longer costs." Many people understand this concept, but the real challenge is in decisively applying it in practice.

For example, when watching a movie, within the first 15 to 20 minutes, we can tell if it's good. The ticket is already bought, and the money spent. If the movie is bad, the best course of action is to leave immediately because the cost of the ticket is already sunk.

However, how many people actually get up and leave the cinema when they realize the movie is bad? It’s difficult to do.

Most college students realize within the first year or two whether their major is suitable for them, but how many decisively switch majors?

The same principle applies to romantic relationships. After about six months, most people can rationally judge whether the relationship is right for them. But how many people can decisively end the relationship? Many tend to drag it out.

So, while the concept "sunk costs are not costs" is easy to understand, it's hard to put into practice. Given that sunk costs are no longer costs, what should guide our actions?

2. Marginal Costs Determine Behavior Options

Another very important concept is marginal costs.

We should always focus on marginal costs and marginal benefits as our guide for future actions. Whenever we need to make a decision, we must ask a crucial question: how much more do we need to invest to achieve the expected return?

For example, if we have two plans, Plan A and Plan B. Plan A requires an investment of 100 to yield a return of 150. Plan B requires an investment of 100 to yield a return of 200.

If neither plan has started, which one is better? Plan B, of course.

If we have already invested 50 in both plans, continuing with Plan A means investing another 50 to get 150, while Plan B requires the same additional investment for 200. Plan B remains the better choice.

However, if we have already invested 90 in Plan A, needing only 10 more to get 150, while Plan B still requires the full 100 for 200, Plan A becomes more attractive due to its higher marginal return.

Thus, the comparison between Plan A and Plan B is not absolute. It depends on how much more we need to invest in each to achieve the return. The true guide for our decisions is the future return on investment from the current point in time.

3. Adapting to Mistakes Might Be More Efficient

The above numbers show that sometimes, even when we make a wrong decision initially, adapting to it might be the right choice.

A few years ago, I bought a laptop with my savings. I needed a lightweight laptop for assignments and gaming, so I chose a 1000 AUD entry-level laptop for its portability and cost-effectiveness. However, I didn't consider performance and expandability, and soon found it slow and lacking storage.

If I had spent 300 AUD more, I could have bought a laptop with better performance and more storage. But having made the wrong decision, I had to decide what to do next.

Sunk costs are no longer costs; the 1000 AUD was already spent. Continuing to use this laptop costs me almost nothing. To get a better one, I would need to spend 1300 AUD. Selling the current laptop would only get me 300 AUD. So, the marginal cost of getting a better laptop is 1000 AUD.

You see, at different decision points, the marginal cost changes. Initially, I needed only 300 AUD for better performance, but now, the marginal cost is 1000 AUD.

For me, this is too expensive. So, my choice was to continue using the entry-level laptop and spend 100 AUD on an external hard drive to expand storage. Though not ideal, it was a more economical decision since the mistake had already been made. This illustrates the importance of focusing on marginal costs and marginal benefits.

4. Applying Marginal Concepts in Industrial Policy

Let's apply this concept to industrial policy. For example, there are 4G and 5G wireless communication infrastructures. If starting from scratch, 5G is undoubtedly better than 4G. But if 4G is already established, should we introduce 5G? This becomes an economic issue worth considering.

Should we make do with 4G?

For instance, a 4G provider might threaten new 5G entrants by lowering service fees to a level where 5G can't make a profit, making users unwilling to switch.

From a neutral industrial policy perspective, should we support the 4G provider or the 5G entrant?

Here, we must use the concepts of marginal cost and marginal benefit. If 5G services do not offer a sufficiently high cost-benefit ratio, making do with cheaper 4G, which has a sunk cost of zero, might be more efficient.