Friday, August 14, 2009

The Sunk Cost Fallacy

Penny auction critics say these auctions exploit the sunk cost fallacy, ie "throwing good money after bad." I don't know if the average user experiences the pitfalls of sunk cost (irrational) psychology, but Zorro2612 certainly did in this recent auction over at Swoopo. This user spent $108 on bids and $155.40 on this iPod Nano worth $199 retail. Swoopo gives users a hand by automatically calculating their savings on an auction (retail price - (bids +cost)). Too bad this calculator only goes to $0 because you can have negative savings, they're called losses. Zorro2612 had savings of $199-$155.4-$108 = -$64.4. Didn't exactly slash a bargain now did we Zorro?

Here is what I bet Zorro was thinking:

Aye corrumba, i've already spent $100 on this auction, now I have to win it no matter what. If I back-off now, I'll have wasted that $100.

The problem with thinking about sunk costs this way is that it leads to irrational decision making. Having "sunk" $100 worth of bids into an auction does not make you more likely to win, therefore Zorro would have been best off to walk away after his total money spent on bids + cost of the item passed the retail price of the iPod. However, he did not do that, and in this case did end up winning the auction. Note that the outcome he received ie paying $263.4 for an iPod (including bids) is a better outcome than walking away at say $90 in bids and then buying the iPod at the street price of $199. However, when he made the decision to "go for it, all or nothing," there was no way of knowing he would be the winner. There very well could have been only one competitor on that auction who's strategy was also "go for it, all or nothing," and who got nothing. Zorro could have easily been out $200 with no iPod, instead of out $90 with no iPod as in the hypothetical situation I construct here.

To maximize value in all things; cars; houses; investments; penny auctions, users need to ignore sunk costs. As many critics point out, this seems especially hard to do in penny auctions, institutional investors (who I'll assume to be more sophisticated, but perhaps undeserving of the distinction) are known to be more likely to sell portfolio holdings that have appreciated in value by a certain amount to "take some profit," then they are to sell holdings that have declined in value by a similar amount, which they should do to minimize downside risk if the same standard of logic is to be applied evenly. This comes from a field called behavioral finance, which I find to have much in common with penny auctions, and is part of what initially drew and continues to hold my interest in these types of auctions.

1 comment:

  1. Swoopo also auctions of bids. Hence, you assume that he paid $108 in bids, but he may have purchased the bids at a substantial discount. 50 bids recent sold for $3.62. It is likely that his cost of bidding was below $43.60 and he earned positive profits.