Tuesday, August 24, 2010

Sunk-cost fallacy in real estate

In the post below this one, we show that the housing market can have excess supply.  This post shows that it is due to the reluctance of homeowners to sell at a loss, a version of the sunk cost fallacy.

Two homeowners, with identical houses, will list the houses at different prices, depending on what they paid for the house because of what psychologists call "loss aversion." Unfortunately for these loss-averse sellers, buyers don't suffer from similar delusions,
Properties listed above the market price just sat there. In the Boston market over all, sellers listed their properties for an average of 35 percent above the expected sale price, and less than 30 percent of the properties sold in fewer than 180 days. In other words, much of the market went into a deep freeze as many people held out for market prices that no one would reasonably pay.

Note that this reluctance is similar to the  reluctance of businesses to pull the plug.

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  2. Bah, I meant "sunk costs fallacy." Thats what I get for writing responses to blog posts at 4:24 AM.

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  17. Sunk costs can be defined as “the costs and benefits you consider that do not vary with the consequences of your decision “ (Frobe); “a cost that has already been incurred and thus cannot be recovered; it differs from future costs that a business may face and are excluded from future business decisions, because the cost will be the same regardless of the outcome of a decision” (Investopedia) or “Irreversible investments represent sunk costs and traditional “[e]conomic analysis provides a clear-cut recommendation to the manager facing the sunk cost problem. ... The amounts invested in the past are sunk costs; neither they nor their amortization are relevant to today’s decisions. Those who violate this rule are said to be ‘throwing good money after bad,’ leading to the popular label of the sunk cost fallacy” (Parayre).

    In layman’s terms, sunk costs is one’s resources – whether it be moolah or time – that you have already spent on a project that is gone and will not be able to recoup. This is why many economists advise you not to factor these costs into future costs. It is human nature to want to get back lost money; but one should consider relevant facts instead. I compare it to going to a casino and losing a small windfall. Sure, you COULD keep gambling in the hopes of recouping your money, but you probably won’t.

    But there is a growing school of theory called real options theory that questions this assumption and states that maybe sunk costs should be considered in future financial planning. One reason why is they believe this is because it is rational to persist and endure some amount of losses if there is some possibility that industry profitability may improve. If conditions improve, firms who decided to exit may regret the decision due to the cost to re-enter (Dixit). Another reason is that they feel that most of the research out there about the sunk cost fallacy is based off of case studies and if there is an effect, it was found to be small and erratic (O’brien & Folta).


    Parayre, R. (1995), ‘The strategic implications of sunk costs: A behavioral perspective,’ Journal of Economic Behavior and Organization, 28, 417–442
    www.investopedia.com
    Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2016). The One Lesson of Business. In Managerial Economics: a Problem Solving Approach (4th ed., pp. 18-26). Boston, MA: Cengage Learning.
    Dixit, A. (1992), ‘Investment and hysteresis,’ Journal of Economic Perspectives, 6, 107–132.
    O'brien, J., & Folta, T. (2009). Sunk costs, uncertainty and market exit: A real options perspective. Industrial and Corporate Change, 18(5), 807-833. doi:10.1093/icc/dtp014

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