1. ignore hidden costs; or
2. take account of sunk costs.
The NY Jets football team are trying to avoid the second mistake in trying to decide what to do with their quarterback. Mark Sanchez has
...played poorly for two seasons in a row, and has now thrown more interceptions in his career than touchdowns. But the Jets have invested an enormous amount of energy and money in Sanchez, and, assuming that no one will trade for him, they are contracted to pay him $8.25 million next year, whether he plays or not.In the Jets case, the relevant costs of keeping Sanchez or trading him should ignore the guaranteed salary and look at the alternatives. It could be the profit they could earn by keeping Sanchez, despite his poor performance, are bigger than the cost of keeping him--the profit of the alternative. The league is short on good free agent quarterbacks and the draft looks thin, so keeping him might be the right decision.
However, there are well documented psychological tendencies that might bias the Jets into keeping him regardless of whether it is the right decision.
Hal Arkes, a psychologist at Ohio State University who has spent much of his career studying the subject, explains, “Abandoning a project that you’ve invested a lot in feels like you’ve wasted everything, and waste is something we’re told to avoid.” This means that we often end up sticking with something when we’d be better off cutting our losses—sitting through a bad movie, say, just because we’ve paid for the ticket. In business and government, the effect pushes people to throw good money after bad. The quintessential case of this is the Concorde. There was never a convincing business case for the supersonic airliner, and there were numerous attempts to kill it. But those attempts all failed, in large part because of the billions that had already been spent.Moreover the bias intensifies, the more you have invested:
The most intriguing aspect of sunk costs, as Arkes and others have documented, is that greater investment in a project increases people’s belief that it will succeed. That may help explain what happened last March, when the Jets gave Sanchez a contract extension that guaranteed his salary through 2013. Since Sanchez was already signed for two more years, and was coming off a mediocre season, the extension seemed peculiar to outside observers. But the Jets argued, and doubtless believed, that it was a smart way of locking up a young player. It was a classic case of what psychologists call the “escalation of commitment.” Since the Jets had bet big on Sanchez, it seemed reasonable to place an even bigger bet on his future.