Thursday, April 24, 2014

A Lesson in Ignoring Sunk Costs

From the NY Times:
Oregon Considers Handing Troubled Insurance Exchange to U.S.
This is almost certainly the correct call, but something that human nature has a hard time doing.  Behavioral economists know that sunk costs (those that are non-recoverable) can have large psychic effects even when the rational decision maker should ignore them.  Glad there is some rationality in the Cover Oregon camp finally.

Update: Because I have been asked - a typical sunk cost behavioral response story would be something like this:  Suppose you buy a season long Sno-Park permit for $25 because you estimate that you'll use it more than 6 times and thus it is more cost efficient than the $4 daily permit.  Then on the last skiing day of the season you are trying to decide whether to go skiing on the mountain one more time or hike on the coast. All else equal you would prefer the coast on that day, but you think that since you have only used the Sno-Park permit a few times you "want to get your money's worth out of it" and decide to go skiing instead.   Economically speaking you have made a mistake - the $25 is gone and non-recoverable so there is no reason to take it into account.  Emotionally, however, we have a hard time ignoring such expenditures and often act on them.  I do it too.

This doesn't mean economic theory is wrong, just that we don't specify the utility function correctly.  If I care about not making mistakes (like buying a season Sno-Park), I might actually maximize my utility by not ignoring the cost.

But organizations are not individuals and in the case of Cover Oregon there is no place for sentimentality.  This has to be a purely rational decision.

1 comment:

Fred Thompson said...

It helps that the camp itself has been turned over. Everyone who was invested in Cover Oregon is gone. Alex wasn't even in Oregon last November.