The Sunk-Cost-Fallacy Fallacy

This post is mostly economics, but I promise a small bit of undead action at the end.

As both an economist and a screenwriter, I loved the Planet Money podcast’s recent episode on “The Scariest Thing in Hollywood.”  The episode shows how, from the standpoint of return on investment (ROI), making super-low-budget movies can actually be superior to making big-budget blockbusters.

However, I think the episode has one misstep:  it commits what I call the “Sunk-Cost-Fallacy Fallacy” — that is, the error of using the Sunk-Cost Fallacy to condemn choices that are (or at least may be) perfectly rational.

Here’s the context.  The show follows the production of the movie “The Boy Next Door.”  (As an aside, this movie is best known to me and my wife as the movie that features a “first edition copy of the Iliad.”  Ponder that for a moment.)  The movie was directed by Rob Cohen on a tiny budget of $4.2 million.  When it was done, focus groups delivered “meh” responses.  But Cohen believed that just a little more money — $300,000 — could fix a couple of key scenes and turn the movie into a hit.  The film’s producer, Jason Blum, said no.  One of his rules for making low-budget movies with high ROI is “never ever break your budget,” and he stuck by that rule.  However, Cohen persuaded the film’s distributor, Universal, to throw in the extra $300K.  And ultimately, despite lousy critical reviews, “The Boy Next Door” grossed over $50 million worldwide.

The episode characterizes Cohen’s desire to use $300K to rescue the movie as a case of the Sunk-Cost Fallacy.  But that characterization, I suggest, is itself a fallacy.

The Sunk-Cost Fallacy is usually defined as “failing to ignore costs that have already been incurred and cannot be recovered.”  Such costs are gone no matter what you do, and thus they should be irrelevant to your present decisions.  Only present and future costs and benefits are relevant.  There are a couple of different ways that you can commit the Sunk-Cost Fallacy:

1. Because you have already invested (sunk) a bunch of money and resources into a project, you decide to spend more money to “bail out” your losses, i.e., to make benefits materialize that will justify the costs you’ve already incurred. This is the version of the fallacy that the episode’s producers are thinking of when they analyze Cohen’s decision.

2. Because you have already invested (sunk) a bunch of money and resources into a project, you continue to count those costs in the present for making present decisions. That is, you evaluate your decision looking at “all revenues” versus “all costs,” when you should be looking at “present/future revenues” versus “present/future costs.”  This is the version of the fallacy that actually occurs in the episode — not when Cohen wants to spend more money, but when Blum refuses to break the budget under any circumstances.

Think about it this way.  The $4.2 million budget is already gone.  So the relevant question is this:  How much will another $300K increase the movie’s revenues?  Let’s suppose that, without the extra $300K, the movie would have grossed $49.9 million.  The $300K infusion raises the take to $50 million.  In that case, the $300K is a bad investment because it reduces the net by $200K.

On the other hand, suppose that without the extra $300K, the movie will only gross $20 million, whereas with the extra $300K it will gross $50 million.  In that case, the $300K is an awesome investment because it increases the net by $29.7 million.

So there are really two possible errors here:  overestimating the added revenue, or underestimating it.  Now, it’s entirely possible that Cohen was engaged in some wishful thinking.  Maybe the movie would have grossed $50 million even without the “fixes” he had in mind.  But it’s certainly not fallacious to contemplate the possibility that some changes will generate added revenues that more than cover the added cost.  What is fallacious is assuming that can never happen, as Blum’s “never break the budget” rule suggests.

Now, Blum’s rule may have a good justification.  It may help him to resist wishful thinking that exaggerates the possible gains from added spending.  Following the rule ruthlessly might make it easier for him to say “no” to every director (like Cohen) who wants to spend a little more.  But the rule also has the downside of shutting down some potential improvements that lead to net gains.

Okay, I promised some undead action, so here goes.  In Chapter 2 of Economics of the Undead, “Human Girls and Vampire Boys, Part 2,” I discuss some of the reasons that a human girl might choose to stay with her vampire boyfriend despite some bad behavior on his part.  Included in those reasons is the value of certain relationship-specific investments she’s made in the relationship — value that will diminish or disappear if the relationship ends.  Now, this might sound like the Sunk-Cost Fallacy, but it’s not.  Here’s what I say in the chapter:

In considering the value of continuing a relationship versus walking away, you should be careful not to fall prey to the sunk cost fallacy. Sunk costs are costs that have already been incurred and cannot be recovered, and the fallacy is letting them influence your choices. For instance, suppose you’ve bought a nonrefundable ticket to see a concert (Vampire Weekend, naturally) on Sunday night—and then you get invited to a True Blood viewing party on the same night. In deciding what to do, the $100 you’ve already spent on the concert ticket is irrelevant, because you can’t get it back anyway; the only thing that matters is whether you would enjoy the concert or the party more. Likewise, the time and effort you’ve spent building a relationship are sunk costs. You’re never getting them back, no matter what you do. But what does matter is what your time and effort have bought you: the shared routines, memories, home, and so on, whose value will decrease or vanish if you break up. The value of these relationship-specific assets might, indeed, be enough to justify continuing your cross-the-grave romance.