Welcome to Finance and Fury. Many of you would have seen the news over the last few weeks about Victoria cancelling the commonwealth games plans due to financial constraints.

  1. Is this the right decision when viewed through an economic lens – looking at the concept of a sunk cost – which is something which can be applied in our own every day lives when making financial decisions
    1. So in this episode we will be exploring sunk and prospective costs – using the Commonwealth Games as an example – and how to make better financial decisions

Looking at the commonwealth games – international multi-sport event Think of it as a lite version of the Olympics – with participation amongst Commonwealth Nations

  1. 56 nations in total – Australia is a major competitor – and has a history of hosting the games – being a 12-day sporting event every four years
    1. Victoria was slated to hold the next event – to be held in 2026
      1. The last event held in Australia was in 2018 at the Gold Coast – this event cost$1.2 billion – and last year this was hosted in Birmingham at a cost of $1.8 billion
    2. Victoria when putting a bid in for the games estimated that this would costs between $1.9 bn to $2.6 bn – but this has blown out – hence the cancellation of them hosting the games
    3. What went wrong – The full story still hasn’t come out, but it seems the government didn’t do its homework
      1. The estimated operational cost jumped from $1.3 billion to $1.9 billion
      2. the capital expense of building athlete villages and constructing new and improving existing sports venues went from $1.3 billion to $2.6 billion.
  • the original financial estimate didn’t include costs for additional services, primarily transport and police, increasing the costs by a further $500 million
  1. The reason for costing blow outs is that this was planned to be a regional games – across five regional centres instead of Melbourne – this required additional infrastructure and costs to not only cover transportation, but build and upgrade sporting locations to hold the events – the intent was to stimulate the regional economies after being locked down for the better part of a year, but at what cost?
    1. I have done episode in the past on the Olympics and white elephant projects, so do listen to these if you want further information on this question
  2. But the Victorian government didn’t think so – but it will still likely cost them $1bn for nothing – so was this the correct decision? A sunk cost of $1bn is better than paying $7bn
  1. What is a sunk cost versus prospective costs –
    1. In economic decision making, a sunk cost is a cost that has already been incurred and cannot be recovered – think of this as the $1bn for Victoria
    2. On the other end, there are prospective costs – which are future costs that may be avoided if action is taken – which would be the $7bn
  2. Costs don’t always have to be monetary – Concept of utility – which can help to explain that not all costs and benefits are monetarily based – some are simply satisfactions and time
    1. A cost may be the time you have or will spent on an endeavour – or it could be a satisfaction that you will get out of an endeavour
    2. Under economic theory – only prospective (future) costs (be it money, time, energy) are relevant to a rational decision – when weighed against your utility
      1. So a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future
      2. Even though in theory, a sunk cost should no longer be relevant to future rational decision-making, people in their everyday life often take previous expenditures into account when making future decisions
    3. At any moment in time, the best thing to do depends only on current alternatives – when taking into account the opportunity cost – what else could be done to yield the similar outcome that may be cheaper
      1. As the only things that should matter are the future consequences – the past should be irrelevant – as any costs incurred prior to making the decision have already been incurred no matter what decision is made.
      2. people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions.
    4. Examples – Say that you are building a home, and you pay a non-refundable deposit of $10,000 and sign the contract – but then the builder increases the costs to you by $100,000 in a variation – the $10k is the sunk cost and the $100,000 is your prospective costs
      1. What should you do? What are the alternatives – ignore the $10k – do you pay the $100k or is there another builder that has a guaranteed price that is lower than the total build costs
    5. Under theory – this is the notion of “separability”. Separability requires agents to take decisions by comparing the available options in eventualities that can still occur, uninfluenced by how the current situation was reached or by eventualities that are precluded by that history.

This concept does not always play out with real-world behaviour

  1. When looking at real world behaviours – sunk costs often influence people’s decisions – sometimes in the opposite direction – as the past money spent can justifying further expenditures
    1. People tend to demonstrate a greater tendency to continue an endeavour once money, effort, or time has been made
    2. This is the sunk cost fallacy – through instead of cutting your losses, you simply make more
      1. This can happen even in failing relationships because people believe that they have already invested too much in the relationship to leave
      2. This can happen with certain investments as well – like an investment property – over capitalising for little benefit
    3. A person’s behaviour is also influenced by their current emotions – experiments have shown that negative emotions can have a greater influence into falling into the sunk cost fallacy – sunk cost fallacy will have a greater impact on people under high load conditions and people’s psychological state and external environment are under stress
  2. Beyond individuals – Governments are probably worse when making rational decisions around a sunk cost – as it isn’t their money being spent on prospective costs – and there is a public perception to also account for – the PR around pulling out of a project that the government has committed to can sink political careers – so it is in politicians own interest to overspend on projects – ignoring sunk costs
    1. The term “Concorde fallacy” was used from the fact that the British and French governments continued to fund the joint development of the Concorde supersonic airplane even after it became apparent that there was no longer an economic case for the aircraft – even the British government privately regarded the project as a commercial disaster that should never have been started – but it couldn’t pull out due to a combination of public perception and contracts with the manufactures
    2. Based around this – I was a little surprised that the Victorian government pulled out of the games
    3. Abandonment of the over expenditure was likely the more rational decision, even though it represents a total loss of the original expenditure—the original sum invested is a sunk cost
      1. If decision-makers are irrational or have the “wrong” (different) incentives, the completion of the project may be chosen.
      2. Often politicians have more of an incentive to avoid the appearance of a total loss – in this instance, to save face and given that it isn’t their own limited resources being spent – the sunk cost effect is reversed

How to reduce your chances of falling into the sunk cost fallacy is by is knowing about the specific psychological factors underlying the sunk cost effect:

  1. Loss aversion – whereby the price paid becomes a benchmark for the value – whereas the price paid should be irrelevant.
    1. This comes back to people having misgivings about “wasting” money – called loss aversion – obviously this can contribute to the sunk cost effect.
  2. Framing effects – a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations – in this case a loss or as a gain.
    1. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented – a sunk cost is a negative frame, as the money is seen as a loss – so people can take on additional risks, through spending more when the better decision is to walk away
  3. An overoptimistic probability bias, whereby after an spending funds on a project or making an investment the positive evaluation of your action is increased
    1. This can occur for anything – with the positive feeling and anticipated benefit from spending or investing funds, or even gambling – people who were about to place a bet rated the chance with a “fair chance of winning” whereas people who have already place a bet say they have a “good chance of winning”.
  4. The feeling of personal responsibility and also simply the desire not to appear wasteful – One reason why people may wish to throw good money after bad is that to stop investing would constitute an admission that the prior money was wasted
    1. Say you buy a ticket to a movie – if the movie is awful and you are 20 mins in – and have something better to do with your time, do you leave or stay?
    2. You might have spent $40 on the tickets, but say you could do something else, that could provide additional utility to you, rather than wasting another hour plus of your time –
    3. If something else is better to do, then you should ignore the $40 already spent – ignore the feeling that leaving would waste these funds
    4. To help override this – recognising the opportunity cost of the alternative use of time can help make a rational decision

So in summary: Victorian government did probably make the correct decision –

  1. Cutting their losses rather than making a large additional expense, getting the state more and more in debt with little long term economic benefit to show for it
  2. In your own life, the sunk cost fallacy can also be a problem – so it is something to watch out for
  3. Remember the psychological factors that can influence this, such as loss aversion, framing effects, probability bias and not wanting to be wasteful

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