Photo: Tony Webster via Flickr (CC BY 2.0) (https://flic.kr/p/LvJVD1)
In economics, a “sunk cost” is one “incurred in the past which is irretrievable and which is therefore irrelevant to any future decision-making.”
A brewer, for example, might print up a pile of labels with his or her branding on it and buy a load of brewing equipment. The labels are a sunk cost because, if he or she decides to liquidate the business, they cannot be sold while the brewing equipment isn’t a sunk cost because it can be sold to another brewer.
If “sunk costs” are, then, “irretrievable,” why does it follow that they are “therefore irrelevant to any future decision-making”?
As one of my old textbooks explains:
Suppose that a firm paid $30,000 for a piece of land that it can resell for only $20,000. Also suppose that it uses the lad itself and the current value of the land to the firm is only $19,000. Should the firm use the land or sell it? As any child can tell the firm, there’s no point crying over spilt milk. The firm should ignore how much it paid for the land in making its decision. As the value of the land to the firm, $19,000, is less than the opportunity cost of the land, $20,000, the firm can make more by selling the land.
As another old textbook puts it:
One of the most important lessons of economics is that you should look at the marginal costs and marginal benefits of decisions and ignore past or sunk costs. We might put this as follows:
Let bygones be bygones. Don’t look backward. Don’t cry over spilt milk or moan about yesterday’s losses. Make a hard-headed calculation of the extra costs you’ll incur by any decision, and weigh these against its extra advantages. Make a decision based on marginal costs and marginal benefits.
Indeed, the notion that sunk costs should influence investment decisions — that we have spent so much we have no choice but to spend more — is known as the “sunk cost fallacy.” This should be borne in mind when discussing the Blue Line extension project.
This is estimated to cost $3.6 billion, a figure which has increased by 61% in just two years. Its “two most vital backers,” the Star Tribune reported recently, “Hennepin County, which is providing the lion’s share of the project’s funding, and the Metropolitan Council, which would operate the line — are publicly battling over how to cover a $224 million local funding shortfall that must be resolved before project sponsors can apply for a $752 million federal grant.” The Metropolitan Council says that roughly $290 million has been spent on planning and design so far.
A recent op ed in the Star Tribune titled “We’ve come too far to let the Blue Line extension fall apart now” argues that we should plough on. We haven’t, in fact, come anywhere at all yet; construction isn’t due to begin for another year. And, as we’ve seen, in the question of whether we spend that $224 million or the other $3.1 billion beyond that, it doesn’t matter how much we have spent or how far we have come, all that matters is whether the money we are proposing to spend is worth it.