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Essays on decision making and the sunk cost phenomenon

University of British Columbia

This dissertation consists of three separate essays, each dealing with a different aspect of the sunk cost phenomenon. The first essay proposes a multiattribute utility model of the sunk cost phenomenon. We argue that this phenomenon, the tendency toward over-investment in losing courses of action, is the result of tensions between economic and psychological factors such as cognitive dissonance. We formalize this tension by decomposing the investor's total utility into its economic and psychological components, and develop a two-attribute utility model which describes sunk cost behavior. We establish the interaction between the economic and psychological factors, which determines the form of the resulting model, both for decisions under certainty and under uncertainty. The model helps reconcile past explanations of sunk cost behavior, and also generates new predictions. We explore the behavioral ramifications of the model, and introduce formal concepts that are useful in characterizing the presence and intensity of a sunk cost effect. The model is then extended beyond the sunk cost problem, to more general allocation situations involving multiple projects or mental accounts. The second essay examines some of the strategic implications of the sunk cost phenomenon in sequential allocation decisions. Drawing from psychology and behavioral decision theory, we first present a typology of possible causes for this tendency. We then present a generic two-period allocation model of the phenomenon within a utility-maximization framework, and derive some comparative statics results - thus showing that the sunk cost phenomenon can be accommodated within formal micro-economic models. The model is used to formalize many of the possible causes of the phenomenon. We then move on to the analysis of some implications of this behavior in strategic situations. A strategic game analysis is used to derive the optimal allocations as a function of sunk cost behavior. We establish when this behavior can be used as a successful precommitment strategy by the sunk cost player, and when it is exploitable by an opponent. Numerous strategic applications of our game-theoretic approach are discussed. The third essay addresses key questions surrounding the financial implications of sunk cost behavior by using data on actual decisions made by firms, and the stock market reaction to these decisions. Specifically, using field evidence we test for the presence of a systematic sunk cost phenomenon in allocation decisions made by publicly traded firms, as recognized by the stock market and reflected in the prices of these firms' shares. We use a financial event study methodology to determine whether share prices reflect the stock market's belief that managers display a sunk cost effect, and use these results to infer the magnitude of the financial implications or "cost" of managers' sunk cost behavior to these firms.

Text

2011-02-03

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http://hdl.handle.net/2429/31079

Business Administration

University of British Columbia

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