In an earlier paper we had discussed why airlines do not make a decent return on their investment. In that paper with the help of core theory it was explained how the inherent unstable nature of airline market made it impossible for airlines to post a healthy profit consistently over a period of time. The paper, however, did not answer the next logical question that if airline was such a profit challenged business then why the investors did not get out of it at the earliest. We attempt to do this in the present paper.
Economic theory is based on the assumption that human behaviour is rational and therefore any economic decision would be based on cause and effect rationality. In reality, however, humans do not always behave rationally while making their decision. Take the case of an investors who business interest in several industry including airline. Ever since he has invested in airlines he has found that the return from airline business has abysmal compared to his other businesses. As rational investor he aught to move his investment out airlines and put it one his other existing business to maximise his gains, but he does not do so. Traditional economics would label such behaviour as irrational.
Let us take another example, a non aviation one. A year ago during IPL 1 the match between Delhi Dare Devils and Kolkata Knight Riders was abandoned due to rain without a ball being bowled. Cricket matches often get abandoned due to rain therefore was nothing unusual in the present case. In fact it was a day of inclement weather, it had been raining incessantly since morning and well before it was time for the match to start it was fair knowledge that no play would be possible as the playground, which had no drainage system worth the name was sure to be water logged. Yet, 25000 spectators turned up at the ground several hours before the scheduled start and stayed on till the scheduled time for the match to end. Traditional theory would call the behaviour of the spectators as irrational. In a rational world the spectator who already knew that no play would be possible would have been better off in spending the time in some other pursuit that had the possibility of bringing positive return rather than drenching in the rain under the open sky of the uncovered stadium. But such was the behaviour of not one or two odd spectators, 25000 people behaved in this irrational manner. Clearly there must have been some logic behind this apparent illogical behaviour. To understand such behaviour we need to go beyond traditional economics; we need to look into the psychology of sunk cost.
Psychology of Sunk Cost
Psycho economics[1], which is also known as behavioural economics, is the youngest branch of economics. It came into prominence in the 1990s although work had been going on much earlier. It received the stamp of recognition when one of the pioneers Daniel Khaneman was awarded the Nobel Prize in Economics in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[2] Philosophy of sunk cost is one among the many new concepts that this branch of economics has developed to explain many issues that traditional theory has not been able to explain adequately. However, before describing the philosophy we need to know what is meant by sunk cost and it relevance in decision making.
What is Sunk Cost
Sunk cost is the cost already incurred which cannot be recovered regardless of future events.
In economics and business decision-making, sunk costs are costs that cannot be recovered once they have been incurred. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action, and prospective costs which are costs that will be incurred if an action is taken.
In traditional microeconomic theory, only variable costs are relevant to a decision. Traditional economics proposes that an economic actor does not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.
Behavioral economics proposes the opposite: that sunk costs greatly affect actors' decisions, because humans are inherently loss aversive and thus normally act irrationally when making economic decisions.
For example, when we have put effort into something, we are often reluctant to pull out because of the loss that we will make, even if continued refusal to jump ship will lead to even more loss. The potential dissonance of accepting that we made a mistake acts to keep us in blind hope. It is common for people who have invested in company shares to hold on tight to them as the market slumps, in the desperate hope that the shares will rise in price again.
The Sunk Cost Effect
Traditional economics predicts that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions, people routinely consider historic, nonrecoverable costs when making decisions about the future. This behaviour is called the sunk-cost effect.4 The sunk-cost effect is an escalation of commitment and has been defined as the "greater tendency to continue an endeavour once an investment in money, time or effect has been made."
In their seminal paper[3] Hal R. Arkes and Catherine Blumer explain the concept of sunk cost philosophy with the example of a contest winner of a radio programme who has been rewarded with a ticket to a football game. Since he does not want to go to the game alone he persuades a friend to purchase a ticket. When they are about to leave for the game a terrible blizzard begins and the contest winner does not want to go. His friend insists on going to the match since he did not, ‘want to waste the money that he has already paid for the ticket.’ According to traditional theory the friend is not behaving rationally; he should go to the game only if the pleasure of watching the game is more than the agony of sitting in blinding snowstorm. After all the price of the ticket has already been paid for by the friend and his decision to go or not to go will not bring the money back to him, that money is gone; it is a sunk cost. Past investments that are irrecoverable should not be allowed to influence present decision. But, as 25000 spectators at the cricket ground on a rainy night demonstrated, people do.[4]
Something similar happens in the airline business. Individual and companies invest in airlines for a variety of reasons; since this paper is about why people remain invested and not why they invest in airline business we will not discuss the issue in too much detail. In terms of behavioural economics the broad reasons for investing in airlines can be summed as
(a) It will not happen to me: This is a syndrome that we are familiar with. Individuals routinely assume that ordinary misfortunes like road accidents, a loss in business, attack of an epidemic and so on will not happen to them. The confidence comes from two sources, first, about which one is generally unaware, is the statistical probability of such events occurring are extremely low and therefore for most part misfortunes do not strike a person too often. The second, about which the individual is well aware off, is an inherent belief in themselves that they are smarter than the rest. So, billionaires, otherwise familiar with the apocryphal story about the shortest way of becoming a millionaire is to start an airline does precisely that viz. invests in airline business. They carry with them the self-belief that they would be able to run the business much better than others ahead of them have been able to.
(b) Prior experience: It is generally true that those investing in airlines have some prior experience, say, as a pilot, a tour operator or travel agent, experience of running airlines etc. This provides them a confidence that they can do better than others.
(c) Glamour: Traditionally flying has enjoyed a very high glamour quotient primarily because it is a task that human beings can never perform. Another factor that earns respect for those manoeuvring a flying machine is the high risk factor. Mankind has always accorded great value to those who dare to put their life at risk to achieve the improbable. Airline business basks in the reflected glory of this glamour. In the pecking order of the Chamber of Commerce the owner of an airline enjoys a higher ranking than the owner of a hosiery firm though the business of the later may be earning higher profit.
After a point of time investors having made their investment confront situations that we have discussed in the earlier part of the paper. After facing several years of low profitability or outright losses when it seems that it would be best to get out of the business they walk into the fallacy of sunk cost. Having spent so much money and time on an investment it appears to the investors that all their efforts would go to waste if they wind up the airline. Their dilemma can be explained with the aid of the following diagram that contains prospect theory’s[5] value function. The function defines the relationship between objectively defined gains and losses and subjectivelyThe field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioural models typically integrate insights from psychology with neo-classical economic theory. Behavioural Finance has become the theoretical basis for technical analysis.
Behavioural analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest.
[2] "Nobel Laureates 2002"; Nobelprize.org
[3] The Psychology of Sunk Cost, Hal R. Arkes and Catherine Blumer; Organisational Behaviour and Human Decision Process, 1985, 35, 124-140, reproduced in Judgement and Decision Making, Terry Connolly, Hal R. Arkes, Kenneth R. Hammond, p 97-113, accessed at http://books.google.com/books?id=Uo34qW1wi_YC&printsec=frontcover&source=gbs_navlinks_s. Various dates.
[4] Nearly six months after that IPL match I was talking to a group of friend of my daughter when the discussion turned to that match and I commented that how foolish it was for all those people to turn up for the match when the whole of Delhi knew that no match would be possible. At this one of her friend remarked that he was one among the ‘foolish’ people. Whereupon I asked why did he have to go, his reply was, “But Uncle, I had saved my pocket money to buy the ticket.”
[5] Daniel Kahneman, professor at Princeton University’s Department of Psychology, and Amos Tversky developed prospect theory in 1979 as a psychologically realistic alternative to expected utility theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g. in financial decisions. Starting from empirical evidence, the theory describes how individuals evaluate potential losses and gains.
Prospect theory contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains.
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