In my previous blog on sunk costs, I used the example of auctioning a $1 bill. I received some e-mails on this topic requesting clarification. Here is a quick clarification and analysis.
The goal is to auction a $1 bill to the highest bidder. Bidding can start in increments of 10 cents with an initial price of 10 cents. A $1 bill at 10 cents is quite a lucrative deal. However, this is an auction with a slight twist, which is announced at the start of the game. The twist is that the second highest bidder too will have to pay the amount of his or her second highest bid to the auctioneer, when the bidding ends. Of course, the second highest bidder does not win the $1 bill but he or she still has to pay up.
Generally, several people join the bid and the bid pretty quickly moves up to 90 cents. This is when most the people drop out of the auction and only the highest and the second highest bidders are left in the game. At this point the second highest bidder, lets call her Ashley, realizes that she will end up losing her 80 cents unless she bids at $1, which she thinks is still a better alternative than losing 80 cents. This is an easy decision for Ashley and she raises her bid to $1. Now the other party, lets call him Hank, follows the same logic as Ashley and realizes that for him it is still better to raise his bid to $1.10 instead of losing 90 cents. Again an easy decision for Hank. Now Ashley is about to lose her $1 but if she wins the next bid at $1.20, her loss will be only 20 cents. Ashley raises her bid to $1.20. Please note that competitiveness is playing no part here. These two individuals are trying to be as rational as possible to minimize their total loss. When the bid reaches $2 for a $1 bill, Hank, who is now the second highest bidder reasons that if he bids $2.10, his loss will be only $1.10 otherwise he will be losing $1.90. This can continue for a long time until one of them realizes ridiculousness of the situation.
What is the problem here? The problem is that Ashley and Hank are calculating their loss based on sunk costs. However, loss or gain should be calculated on future costs or gains only. Once we exclude sunk costs or costs incurred in the past, the quality of decision improves substantially. When the bid amount reaches $1, no one will be willing to bid on it, since sunk costs are no longer a factor in decision making. Therefore, Ashley or Hank will just pay up 90 cents to exit the game. In fact, the people who think through and realize that this game is based on escalation of commitment won't play the game. Another solution to this game is that if the first person bids $1 on a $1 bill, there won't be any second highest bidder and the game will end.
In business such situations are quite common. For example, a project that never seems to end. Past investments or past efforts in such cases should be given no consideration, when a decision about future has to be made. Analysis should be based on incremental costs and gains.
The goal is to auction a $1 bill to the highest bidder. Bidding can start in increments of 10 cents with an initial price of 10 cents. A $1 bill at 10 cents is quite a lucrative deal. However, this is an auction with a slight twist, which is announced at the start of the game. The twist is that the second highest bidder too will have to pay the amount of his or her second highest bid to the auctioneer, when the bidding ends. Of course, the second highest bidder does not win the $1 bill but he or she still has to pay up.
Generally, several people join the bid and the bid pretty quickly moves up to 90 cents. This is when most the people drop out of the auction and only the highest and the second highest bidders are left in the game. At this point the second highest bidder, lets call her Ashley, realizes that she will end up losing her 80 cents unless she bids at $1, which she thinks is still a better alternative than losing 80 cents. This is an easy decision for Ashley and she raises her bid to $1. Now the other party, lets call him Hank, follows the same logic as Ashley and realizes that for him it is still better to raise his bid to $1.10 instead of losing 90 cents. Again an easy decision for Hank. Now Ashley is about to lose her $1 but if she wins the next bid at $1.20, her loss will be only 20 cents. Ashley raises her bid to $1.20. Please note that competitiveness is playing no part here. These two individuals are trying to be as rational as possible to minimize their total loss. When the bid reaches $2 for a $1 bill, Hank, who is now the second highest bidder reasons that if he bids $2.10, his loss will be only $1.10 otherwise he will be losing $1.90. This can continue for a long time until one of them realizes ridiculousness of the situation.
What is the problem here? The problem is that Ashley and Hank are calculating their loss based on sunk costs. However, loss or gain should be calculated on future costs or gains only. Once we exclude sunk costs or costs incurred in the past, the quality of decision improves substantially. When the bid amount reaches $1, no one will be willing to bid on it, since sunk costs are no longer a factor in decision making. Therefore, Ashley or Hank will just pay up 90 cents to exit the game. In fact, the people who think through and realize that this game is based on escalation of commitment won't play the game. Another solution to this game is that if the first person bids $1 on a $1 bill, there won't be any second highest bidder and the game will end.
In business such situations are quite common. For example, a project that never seems to end. Past investments or past efforts in such cases should be given no consideration, when a decision about future has to be made. Analysis should be based on incremental costs and gains.
