What is a lost cost?
For any of us, the thought never crossed: “It cost me enough money, why spend more on it?” Decisions and choices in daily life often rely on expenses that have already been incurred and are no longer relevant when the new decision is made. In the world of economics, this phenomenon is known as ‘lost cost’. A lost cost or sunk cost is any expense incurred, such as money, time, physical labor, that is non-refundable and therefore no longer relevant to future decisions.
For example, a company invests NIS 10 million in developing a new product and the venture turns out to be unprofitable. The desired decision would be to stop the flow of funds to the project and internalize lessons. However, in reality, often the situation is different.
Lost cost in a political context
This economic thinking and error can also be identified in situations where money is not involved. George Ball, an American diplomat, understood the implications of American military intervention in Vietnam early. In a memorandum to President Lyndon B. Johnson in 1965, Ball warned that the U.S. military was not prepared for war in Vietnam. Ball added that since the beginning of the military operation in Vietnam, U.S. forces have suffered heavy losses that have led to a renewed feeding of increased order of battle in response, which has led to more casualties. All this, in order to avoid recognizing the loss. Ball called on President Johnson to withdraw the U.S. military from Vietnam because he believed national humiliation was preferable to a lengthy military operation that he believed would not be defeated. The commencement of military action and the initial mobilization of U.S. forces correspond to an initial non-refundable investment. Justifying the continuation of the operation as an attempt to save the initial attack that failed is analogous to lost attempts to save the initial investment. The Vietnam War lasted twenty years and claimed 55,000 American casualties and more than 2 million Vietnamese deaths.
Lost Cost in the Context of International Projects – “Even the Big Ones Make Mistakes”
On 21 January 1976, the first commercial supersonic flight of the Concorde took off from Heathrow Airport in London. The plane was intended to bring the forefront of aviation technology to the masses, at least to the affluent among them (the price of a two-way ticket increased at least 5 times as much as an equivalent ticket for a Boeing 747). In November 2003, after several crashes that claimed the lives of hundreds of passengers, it was decided to ground the Concorde permanently. Contrary to popular belief, technical failures were a catalyst and not the main reason for the decision to ground the aircraft. The source of the problem with the project was poor business planning. Some aspects that are still deadlocked in the development of new supersonic passenger aircraft were not considered when the initial draft of the Conread was proposed in the mid-1950s, and during its maiden flight in 1976.
Property damage caused by the Concorde supersonic boom led to a public outcry against supersonic flights over populated areas. A protest that succeeded in restricting Concorde to flights over the sea. Banning flights over land means exclusion from a huge lucrative market for domestic flights. The ordinary citizen who complained about broken windows courtesy of the supersonic boom was joined by the scientific community. The Concorde, which flew at higher altitudes than other passenger aircraft, caused more severe damage to the ozone layer. These problems joined other issues that were not addressed when planning the project. To design an aircraft that could withstand supersonic flight conditions, it had to be narrow and long. That is, the aircraft can accommodate a relatively small amount of passengers. The low passenger capacity (120 compared to 416 on the Boeing 747), high demand and the need to train dedicated crew for the aircraft caused ticket prices to rise hundreds of percent more than comparable tickets on jet aircraft. Another disadvantage that was not taken into account in the business model is the high fuel consumption of the aircraft. Fluctuations in fuel prices affected ticket prices more than other planes. Moreover, in order to justify the cost of tickets and guarantee its prestige, Air France placed a Concorde plane at New York Airport that stood on the ground solely as a backup in case of a malfunction in one of the planes. Short-term thinking and a fundamentally wrong business plan didn’t stop decision-makers from being dazzled by the aura created around Concorde and allowed a failing business to rack up losses for 27 years. Of course, with the advantage of hindsight, it is easier for us to judge actions committed in the past. However, the Concorde project, in its scale, can serve as an allegory for situations in life in which we pay in money, time, work or any other currency solely to justify an initial expense that turned out to be lost.
Lost cost in practical context
Lost cost is not limited to prime ministers and CEOs of multinational corporations. The source of this error is the behavioral mechanism with which people make choices at the basic level, and which is also reflected in decisions made in daily life.
A classic example that illustrates the consequences of not recognizing a decision as a lost cost is the ‘appearance scenario’. Let’s say in this scenario you purchased a ticket for 150 NIS to a performance by your favorite artist. On the morning of the performance, you wake up sick and are presented with two options: go to the concert or stay home and recover. If you choose to go to the concert despite the illness just because: “I already paid 150 NIS for the ticket…”, then you may not enjoy the performance at all. In this case, the cost of the performance (not necessarily in monetary terms) is greater than the benefit you will receive from it. Therefore, if the performance will not give you pleasure and the only reason to go is the non-refundable expense of NIS 150, it is better to acknowledge the financial loss and concentrate on recovery. The danger of biasing the lost cost is giving preference to external factors when making the decision solely because of the sense of commitment created at the time of the initial investment.
A situation that many people sometimes encounter is the situation in which we purchased a car, and soon car malfunctions begin, one after the other, with the cost of repairing them accumulating to a significant amount. When the car begins to break down, the thought arises that it might be better to replace it because purchasing it cost a large sum of money, and this sum is supplemented by the costs of repairs. In fact, the cost of purchasing a car is a lost cost and the correct way to make a decision in such a case is a thorough calculation of current and future forecasts of the cost of repairs, while receiving opinions from several garages, as opposed to the cost of buying a new car.
The lost cost bias is a behavioral fault that is often exploited in marketing strategies. In the U.S., some shopping centers are deliberately built at a great distance from residential areas to get visitors to purchase goods they don’t need, based on ‘lost cost’. Families invest time and effort in getting to those remote shopping centers (=non-refundable expense), and tend to spend more than they planned under the pretext of: “We’ve traveled so far so won’t we buy?” The appropriate way of thinking in such a case is: “We’ve traveled far, we’ve bought what we needed, we don’t really need to buy anything extra, it’s time to go home.” Even thinking along the lines of: “We didn’t find anything to buy, we made a mistake, we learned a lesson and we won’t repeat the mistake in the future,” is preferable to extravagant consumerism. Our inherent harmful habits are strong, but they can still be changed if we only turn the spotlight on them and become aware of them.
As shown, profit models in marketing companies are based on behavioral biases and human irrationality. The lost cost bias inspires a sense of commitment to investing. This is one of the reasons many businesses offer services on a subscription or prepaid basis. Annual subscriptions to newspapers and magazines are usually offered long-term, to awaken a sense of commitment that blinds our true desires, thereby motivating us to spend money on something we may have no interest in. Avoiding lost virtue does not mean that we must evade commitment. In many cases, commitment is good for us – investing in physical exercise, a healthy diet, a relationship, crafts, work, etc.
Being aware of fault allows us to understand what we really want. In this way, we can make decisions in the future that are right for us.
Behavioral biases will always exist, but curbing impulse-induced consumer behavior, as well as awareness of behavioral faults and causes will increase judicious thinking over impulsive thinking and reduce misguided economic decision-making. Working on changing habits takes a lot of effort, but keep in mind that habits, inherent as they may be, can be changed.
Correct economic behavior is achievable. It is even rational to think so, and not just as a slogan.
