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Sunk and Opportunity Costs in Valuation and Bidding

Phillips, Owen R.
Battalio, R. C.
Kogut, C. A.
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.
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