Friday, 13 September 2013

Apples and the sunk cost fallacy

   It is apple season for another year. The trees in the village where I live are packed full of tasty, fresh, organic apples. And, most of them are going to be left to fall to the ground and rot! Which I think is a great waste. I also think it is a great example of the sunk cost fallacy in action.
    Here's the issue: Consider someone called Mark who goes out to the supermarket and buys some apples. He will almost certainly eat those apples and go out of his way to not waste them. Mark, however, ignores the apples growing in his garden and does not think twice about letting them go to waste. Why does Mark save the apples he bought and not the apples  growing in his garden?
    You might say it is a difference in quality; but, the apples in my garden are easily as tasty as those in my local supermarket. You might say it is the difficulty of harvesting the apples; but, it takes seconds for me to harvest 20 apples from my garden. The difference, therefore, must be psychological. That is where the sunk cost fallacy comes in.
     A sunk cost is a cost that cannot be recovered. Given that it cannot be recovered it should not influence future choice. When Mark walks out of the supermarket (and throws away the receipt) the money he paid to buy the apples is a sunk cost. As such, the amount of money he paid for the apples should not influence whether or not he eats the apples.  We see, however, that it does: He is more likely to eat an apple he has bought than one growing in his garden. This looks like the sunk cost fallacy: Mark lets sunk costs influence his choice.
    Richard Thaler in his classic paper on mental accounting gives a slightly different example. In this case Mark has bought some expensive shoes that do not fit. The more expensive they are the more likely Mark will continue to try and wear them and the longer he will keep them in his cupboard. Note the subtle difference between these examples. In the shoe example the emphasis is on how Mark 'over-values' the shoes he has paid a large sunk cost for. In the apple example the emphasis is on how Mark 'under-values' the apples that he has got for free.
      The classic take on the sunk cost fallacy is that it is about mental accounting (see the paper by Richard Thaler). While buying this interpretation, I also think the fallacy is partly caused by people confusing the price they paid for something with the value it has for them. Mark, for instance, should focus on how much he values an apple and how much he values the shoes. For example, he might value a fresh apple at $2 and shoes that do not fit at $0. Instead, he will focus on how much he paid for the apple or shoes. If he got the apple for free he think it cannot be worth much, if he paid $1 for the apple it seems more valuable, and if he paid $300 for the shoes then they must be worth saving.
      The lesson, therefore, is to ignore how much something cost when deciding whether or not to use it. And, just because something is for free does not mean it is not valuable. So, let's get making some apple pie. 

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