Economics 101: What is Sunk Cost

The start of a new series!  We teach you about finance, but we want to teach you some economics too so you can apply what you learn to decisions you make. We first met David Stein on our Better Know a Millionaire series.  You loved him so much we brought him back! He joins us today answer the question what is sunk cost. Do you know what a sunk cost is? Even if you don’t, you’ve probably fallen victim to sunk cost fallacy at some point. Today we’ll explain what sunk costs are so you can avoid them. Abandon A Sinking Ship A sunk cost is a past cost that you can’t recover. The sunk cost fallacy is convincing you that you can’t give up because of all the time and money you’ve already spent. Here’s an example; you’ve spent $10,000 repairing your car over three years. That $10,000 is the sunk cost. Then the engine blows. What do you do? If you replace the engine, that’s, even more, money spent on a car that is unreliable and needs to be replaced. Good money after bad. But if you junk the car, you’ve wasted thousands of dollars. That’s the sunk cost fallacy. What should you do? There are two answers; one is the correct one. What kind of answer you get depends on the type of economist you ask. Old School Economists Traditional economists theorize in a bubble. They believe that people only allow future costs, not past ones, to affect decisions. To say nothing of experience, emotion, or psychology. A traditional economist uses hard numbers to create the ideal model of what a human should consider and decide when making an economic decision. They expect that human beings will always act rationally. Ha! I don’t know what kind of human being these economists are meeting, but I’ve never met a similar one. If you ask this kind of economist what you should do with the car, they’ll tell you to get rid of it. You lost the money; it’s over, and you have to focus on the future. The lost money should not influence your decision. The economist would tell you to sell the car and buy a new one. Your Caveman Brain But human be