Last Friday I decided enough was enough, I wanted an Xbox. The problem was that I could not justify throwing down $250 for an Xbox and a couple of games, so I came up with a plan: Blockbuster recently introduced a new program where you can trade in your used DVDs for store credit that can be used on anything. So I took in about 35 titles and got myself enough credit to buy a new Xbox and used copies of Halo 2 and Fable (roughly $240).

Some of my friends thought this was quite clever, but some asked me why I would trade in over $700 in movies for $250 worth of stuff?

The reason why is Sunk Costs, a concept I first learned in an accounting class in university:

In economics and in business decision-making, sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. Sunk costs are sometimes contrasted with incremental costs, which are the costs that will change due to the proposed course of action. In microeconomic theory, only incremental costs are relevant to a decision. If we let sunk costs influence our decisions, we will not be assessing a proposal exclusively on its own merits.

Source: http://en.wikipedia.org/wiki/Sunk_cost

If you have watched The Lion King you may remember the scene where old Rafiki whacks Simba on the head and when confronted about it says ‘It doesn’t matter, it’s in the past!’ This sums up Sunk Costs nicely: what you paid for an item in the past has nothing to do with the present, you will never get the price you originally paid on a car, TV, DVD, or heavy loader.

You have probably encountered Sunk Costs in your business interactions: I often go into pawn shops and see items like 4 year old Pentium II computers selling for $400, shaking my head because new computers can now be bought for less. Why are they charging so much? Because they paid a lot for the item. This is called the Sunk Cost Fallacy: the tendency to fear loss and allow the fear of loss to influence their business decisions. Here are some examples:

1) A man holding stock does not sell when things go really badly because he put so much into it. Rather than realize that he should get out while the getting is good, he holds the stock because he is past the point of no return.

2) Someone tries to sell his car/house for a lot more than can reasonably be expected because he paid so much for it and put so much into it.

3) Wikipedia gives the example of someone who buys a ticket to a bad movie. If they do not walk out and find a better use of their time simply because they have spent the money and MUST watch the movie, they have a sunk cost fallacy.

So in my case, I did not look at how much I had collectively spent on the DVDs I traded in, I concerned myself more with how much value they represent to me now. In this case, the movies were the ones that I had only watched once or twice since buying them (it takes a while to realize that if you don’t watch it more than four times you might as well rent it). So, these movies were not worth an awful lot to me at the moment, but traded in they would be worth a very desirable Xbox and games.

The bottom line is that you need to remember that money you have spent in the past is in the past, and cannot be recovered. If an opportunity comes along, you need to evaluate it on its merits and not on the past.

This entry was posted on Wednesday, June 1st, 2005 and is filed under Financial Management. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.