A paper co-authored by Allan Chen, Professor and Marketing Department Chair, has just been accepted for publication by Management Science. Sunk Cost Bias and Time Inconsistency: A Strategic Analysis of Pricing Decisions.
Abstract: It is generally acknowledged that sunk cost bias leads to sub-optimal decisions such as escalation of commitment (Staw 1976). Some researchers, however, have suggested that sunk cost bias can be beneficial when consumers have self control problems (Nozick 1994; Walton 2002). In this paper, we explore the case when consumers with sunk-cost bias have time-inconsistent preferences and therefore suffer from self-control problems. We experimentally demonstrate that sunk costs can make subjects better off by inducing higher effort. We then develop an analytical model to explore the implications of sunk cost bias for firmâ€™s pricing strategy. We find that in the presence of sunk cost bias, higher prices can lead to higher experienced quality. We show that sunk cost bias can sometimes improve firmâ€™s profits, lead to lower prices and increase welfare. Our results suggest that when consumers use a product for multiple periods, pricing policies such as 0% financing which are often viewed as exploitative, can instead lead to lower total prices, higher profits and higher welfare.