Beware Sunk Cost Thinking
I’m always on the lookout for pieces about decision making at work, or better still, great examples of decision traps at work. Richard Thaler writes about one of those traps called “escalation of commitment” in the New York Times when he describes a game that’s sometimes called a dollar auction. I’ve seen it done several ways but a common form is to auction off a $20 bill. It goes like this . . .
Bidding starts at $1 and goes up in $1 increments. The winner pays the [auctioneer] whatever the high bid was, and gets the $20. Here’s the catch: the second-highest bidder also has to pay, but gets nothing in return.
Typically, a few brave or stupid [bidders] — nearly always male — open the bidding but fairly quickly only two bidders remain and they discover they are in a war of attrition. The bidding slows when someone bids $20, but then resumes with neither wanting to “lose.” If the two students are particularly stubborn, prices can go over $50. [I have seen it go higher than that]
The dollar auction game was invented by a pioneer of game theory, Martin Shubik of Yale, and it illustrates the concept of “escalation of commitment.” Once people are trapped into playing, they have a hard time stopping. (Consider Vietnam.) The higher the bidding goes, and the more each bidder has invested, the harder it is to say “uncle.” The best advice you can give anyone invited to play this particular game is to decline.
Another version of this same trap is called “sunk cost thinking” which is exactly what it sounds like: You stay with an investment or keep doing something because you’ve already paid for it. It is one of the big reasons why the US is still prosecuting wars in Iraq and Afghanistan and why tax payers continue to pour billions of dollars into rescuing firms that should be shuttered.
I haven’t actually tried it (and probably won’t), but Thaler holds up yet another example of this decision trap at work. It’s a company called Swoopo, a self-described “entertainment shopping” company. It works like this . . .
Swoopo sells new merchandise using unusual auction formats. Let’s concentrate on one of them, the so-called penny auction.
Typically an item — say, a laptop that retails for $1,500, is offered for sale. The bidding starts at a penny, and goes up in one-cent increments, but it costs bidders 60 cents to make a bid. Each auction has a scheduled closing time, but as the deadline nears, that time is extended by 20 seconds whenever someone bids.
The site’s home page displays several attractive objects for sale with closing times fast approaching. It is mesmerizing.
One winning strategy might seem to be this: Bid at the last second, just before an auction is about to end. To “help” you do so, the site offers an automatic bidding program called a Bid Butler that allows you to make bids in the last 10 seconds. Alas, others can also use this automatic program, and you soon discover that just as the clock is ticking down and you’re about to make your big score, a bunch of other Bid Butlers get busy, the price jumps by a few cents, and the clock adds more time. Items can remain “in their final seconds” for days.
What makes this procedure so devilish is that while bidders are looking at what seem to be amazing bargains, the Web site is raking in the money. Because Swoopo collects 60 cents for each penny bid, its revenue is the selling price multiplied by 60. This means that if a computer you covet sells for $100, seemingly a bargain, Swoopo collects $6,000 in revenue, a very juicy profit.
Tags: DollarAuction, EscalationofCommitment, Vietnam, MartinShubik, Swoopo