Sunk and Opportunity Costs in Valuation and Bidding

Studies have shown that when individuals make decisions they often do not ignore sunk costs. Richard Thaler [19] and Arkes and Blumer [1] show in their experiments that commitment to an endeavor is strengthened after sunk costs are paid. Generally, such behavior is explained by Kahneman and Tversky’s [11] prospect theory, in which individuals edit and evaluate choices using different mental rules. They model individual behavior with a value function that acts as a filter, weighing potential losses differently than potential gains. In this filter utility is defined on gains and losses, not the final wealth outcome. People dislike a loss so much that in an uncertain environment the prospect (perceived value) of a loss is not offset by the prospect of an equivalent gain. But after a loss is incurred, for example through the payment of a sunk cost, further investment is easier to make in order to obtain a gain. The value function is convex for losses and concave for gains.