7.1 : Sunk and Opportunity Cost

Sunk costs are expenditures already made and cannot be recovered, irrespective of future choices. These costs are essentially "sunk" because they are irretrievable and should not influence future decision-making. On the contrary, opportunity costs denote the value of the best alternative forgone when a decision is taken.

For example, if a company invests in a failing project, the money already spent on it is considered a sunk cost. However, the opportunity cost of continuing with the project is the potential revenue or benefits that could have been obtained by investing in a different project or opportunity.

The sunk cost fallacy occurs when individuals or organizations base their decisions on past investments rather than considering present circumstances and future benefits, as people are reluctant to abandon previous investments, even when better alternatives are available. For instance, a business may continue to invest in a failing project because of the significant resources already dedicated to it, ignoring the opportunity to allocate future resources more effectively elsewhere.

Understanding the distinction between sunk and opportunity costs helps make rational decisions by focusing on future benefits rather than past investments.