Living Economics

Unsinkable Sunk Cost
Health club usage patterns clearly show that members are emotionally attached to sunk cost even though most economists think that rational incremental decisions should only compare marginal benefit with marginal cost.

Imagine that you have just brewed a pot of coffee for yourself. After drinking two cups you feel satisfied and do not desire any more, yet there is still some coffee left in the pot. Would you drink more coffee just so that what you have already bought and brewed does not go to waste? If so, then in the eyes of classical economics, you have committed the error of considering sunk costs.

Various studies have indicated that you would not be alone. Diners at a buffet pizza restaurant consumed less pizza if their charge was refunded before eating than if they had to pay for the meal themselves. Even though the marginal cost of eating more is zero in both cases, the desire to get their money's worth affects the amount consumed. Likewise, respondents in a survey were more likely to give away a pair of uncomfortable, yet fine and expensive shoes, if they had received the shoes as a gift. If they had purchased the shoes with their own money, however, they were more willing to put up with the discomfort (Frank 287).

According to classical economic theory, this type of behavior is irrational. A rational choice would consider only the marginal benefit vs marginal cost of one choice or the other. The unrecoverable cost prior to making an incremental decision should never be a factor in that decision.

While die-hard economists are busy bemoaning the irrationality of typical consumers, new research is coming up with suggestions for businesses to take advantage of this irrational behavior. Harvard marketing professor John Gourville studied usage patterns at several health clubs. He found that members used the club more at the beginning of their payment period and less at the end. Yearly payment members exercised often in January and little in December. Likewise, quarterly payment members exercised primarily during the beginning of each quarter. His conclusion is that the members felt driven to justify their fee by using the health club, a feeling that decreases over time (Wessel).

Further study by economists Stefano DellaVigna and Ulrike Malmendier found that monthly payment members were much more likely to continue using a health club after their first year. These members were still exercising at the end of the year, when the yearly members had stopped attending. By paying each month, they were reminding themselves to attend often, making the club more useful to them. Hence they were more willing to sign up again at the end of the year (Wessel).

The obvious suggestion for health clubs is that promoting the monthly payment option will result in more repeat business. Ironically, the attachment to sunk cost on the part of health members is better for both them and the health clubs. This phenomenon, among others, shows that humans cannot always be trusted to follow rational choice theory. Businesses must consider the actual behavior of customers, rational or irrational, to beef up their bottom line.

Note:
  1. DellaVigna, Stefano and Ulrike Malmendier. "Overestimating Self-Control: Evidence from the Health Club Industry." 26 Nov. 2003. 15 June 2004.
  2. DellaVigna, Stefano and Ulrike Malmendier. "Overestimating Self-Control: Evidence from the Health Club Industry." 26 Nov. 2003. 15 June 2004.
  3. Frank, Robert H. Microeconomics and Behavior. Second Edition. New York: McGraw-Hill, Inc., 1994.
  4. Frank, Robert H. Microeconomics and Behavior. Second Edition. New York: McGraw-Hill, Inc., 1994.
  5. Gourville, John and Dilip Soman. "Pricing and the Psychology of Consumption." Harvard Business Review, Vol. 80, No. 9, September 2002.
  6. Gourville, John and Dilip Soman. "Pricing and the Psychology of Consumption." Harvard Business Review, Vol. 80, No. 9, September 2002.
  7. Thaler, Richard. "Toward a Positive Theory of Consumer Choice." Journal of Economic Behavior and Organization, 1, 1980.
  8. Thaler, Richard. "Toward a Positive Theory of Consumer Choice." Journal of Economic Behavior and Organization, 1, 1980.
  9. Wessel, David. "Forget Prices and Get People to Use the Stuff." Wall Street Journal. 6/3/04.
  10. Wessel, David. "Forget Prices and Get People to Use the Stuff." Wall Street Journal. 6/3/04.
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