Mnemonomics: The Sunk Cost Fallacy as a Memory Kludge

Abstract

We study a sequential investment model and offer a theory of the sunk cost fallacy as an optimal response to limited memory. As new information arrives, a decision-maker may not remember all the reasons he began a project. The initial sunk cost gives additional information about future net profits and should inform subsequent decisions. We show that in different environments, this can generate two forms of sunk cost bias. The Concorde effect makes the investor more eager to complete projects when sunk costs are high and the pro-rata effect makes the investor less eager. The relative magnitude of these effects determines the overall direction of the sunk cost bias. In a controlled experiment we had subjects play a simple version of the model. In a baseline treatment with no memory constraints subjects exhibit the pro-rata bias. When we induce memory constraints the effect reverses and the subjects exhibit the Concorde bias.

Sunk Cost Fallacy in Driving the World’s Costliest Cars

“…Such "escalation of commitment" has been interpreted as being made to rationalize the decision maker's earlier choice (Staw 1976, Staw and Hoang 1995, Staw et al 1997. However, the same increase in investment could also be interpreted as the rational outcome of the decision maker's moral hazard, building of reputation (Kanodia et al 1989, Camerer andWeber 1999), investment in a real option (Friedman et al 2007, McAfee et al 2010, or a memory shortcut (Baliga and Ely 2011). For instance, Camerer and Weber (1999) reanalyzed the Staw and Hoang (1995) data on escalation of commitment in the deployment of NBA basketball players.…”

Trading Places: An Experimental Comparison of Reallocation Mechanisms for Priority Queuing

“…We add to this literature that endowment effects may be weak in environments where customers' positions are not protected by default, like in the server-initiated auction. The sunk-cost effect has also been documented extensively in the empirical literature (e.g., Arkes and Blumer, 1985;Phillips et al, 1991;Offerman and Potters, 2005;Friedman et al, 2007;Baliga and Ely, 2011). This paper is the first to study the sunkcost effect by manipulating waiting costs for queued customers.…”

“…Baliga and Ely (2011) note that the sunk-cost effect can result in a willingness-to-pay that is higher or lower than standard theory predicts. They argue that the sunk-cost effect is rational if decision-makers are assumed to have limited memory.…”

“…In the customer-initiated auction customers might perceive time spent in the queue as the price of obtaining position rights, while in the server-initiated auction customers cannot obtain these rights. Following Baliga and Ely (2011), time spent in the queue might lead to the Concorde effect in the customerinitiated auction and in the server-initiated auction it might lead to pro-rate effect. Both effects would be deviations from standard economic theory.…”

“…8 See the seminal paper by Arkes and Blumer (1985). Phillips et al (1991), Offerman and Potters (2006), Friedman et al (2007), and Baliga and Ely (2011) present further experimental evidence on the sunk-cost bias.…”