What are sunk costs?

Sunk costs are expenses that have already been incurred and cannot be recovered. This concept is essential in the field of economics and decision-making because it emphasizes that past costs should not influence current or future financial decisions. When evaluating options for moving forward, it's important to focus on relevant costs—those that will be affected by a decision—rather than costs that cannot be altered by any choice made now.

For example, if a company has spent money on research and development for a project that ultimately fails, that expenditure is a sunk cost. The company should not take this cost into account when deciding whether to continue investing in that project or to pursue a different direction, as the money spent cannot be retrieved regardless of future actions. This principle helps businesses and individuals make more rational choices, avoiding the "sunk cost fallacy," where past investments unduly sway current decisions. Understanding sunk costs allows rational economic agents to focus on potential future costs and benefits instead.