Escalation Errors and the Sunk Cost Effect: An Explanation Based on Reputation and Information Asymmetries

Abstract

This paper is concerned with explaining a paradox of human behavior. Consider the following example. A department manager makes a large investment in new production equipment and, soon after, learns of different equipment that could perform the same operations at lower cost. Incremental analysis favors switching, but the manager refuses saying he does not want to waste the investment already made. Such real-world examples have been extensively documented and studied by social scientists (see Thaler [1980] and Staw [1981]). In these examples, the decision maker, having commited to a course of action, subsequently discovers new information that indicates that continuing the earlier commitment would likely result in worse consequences than switching. In spite of this he clings to and even escalates his earlier