SUNK COSTS & CONSUMER EXPLOITATION

Atul pays ₹5000 for a football class that he is supposed to attend thrice a week. After a few weeks, he realises that he has a ton of assignments and projects to complete, it would be economical to stop but he continues to play because he does not want to waste the membership fee. He only stops playing when his teachers make him do so.

When an amount of money, or even time for that matter has been spent and cannot be retrieved, it is said to be sunk, or lost. Economists advise one to ignore these “sunk” costs, but it is very hard advice to follow, and sometimes, even knowingly, economists themselves fall prey and find it hard to ignore sunk costs.

Take for example, in the scenario above, instead of having to pay ₹5000 every month, if Atul had been invited to play football by a friend, Atul would’ve declined doing so because of the excess of schoolwork he had, in other words, utility of football is negative. Only because he has paid a ₹5000 fee does he continue to play, even though it makes his situation worse.

Atul has already lost this ₹5000 and has no way of retrieving it, and him attending or not attending this class cannot change that. So why does he continue to go, even if he’s better off not going? This is known as the sunk cost fallacy and large firms exploit this.

“Once buyers have paid a hefty sum for your products, they can often be persuaded to kick in a little more for a truly stellar experience”

~ Greg Wise

This quote by Greg Wise sums up pretty well how sunk costs affect our decision making and how we are exploited because of this.

Essentially buyers tell themselves, “I’ve already spent this much so I may as well pay a little extra for a better experience”. This is particularly effective when the additional cost is significantly smaller than the initial expense.

For example, you go to a cafe to buy a coffee and you aren’t particularly hungry, but notice that there is an offer on cupcakes, having bought the coffee you think “I have already paid for this coffee, might as well buy the cupcake” this is you ignoring sunk costs, and coupled with the transactional utility* you receive, it can prove to be a deadly combination.

When buyers are rewarded or offered incentives to buy something, it becomes more tempting to buy again. More to the point, it becomes difficult to go elsewhere.

A classic example is that of a coffee stamp card where customers get their tenth coffee for free. Studies show people are significantly more likely to complete a ten-stamp once two spots are stamped than an eight-stamp card without any spots stamped. In both cases, customers only need eight stamps but it’s the former investment that drives them. With two spots stamped, people feel compelled to complete the card and get their reward. They will order coffee when they’d rather have tea and won’t waste their time buying coffee from anywhere else.

Here, even though customers aren’t necessarily losing anything by not buying coffee, the investment of buying two coffees makes them continuously buy coffee from the same place and therefore pay heed to sunk costs. A small incentive of a free coffee can sway customers into buying one’s product.

Sunk cost refers to costs that have already happened and cannot be recovered. It is clear, from the above examples, that our tendency to pay heed to sunk costs are exploited by businesses, and now hopefully, the next time you go out shopping and choose to buy a coffee, you don’t buy the cupcake that comes along!

* - Transactional utility is a term used to describe the happiness a consumer gets from the perceived value of the deal. 'Transactional utility' was developed by Richard Thaler and is said to be the difference between the actual price and your reference price – the price you expect to pay.