Crying Over Spilt Milk: Sunk Costs, Fairness Norms and the Hold-up Problem

Abstract

This article explores a possible connection between two behavioural anomalies in economics, the observed responsiveness of individual decision makers to sunk costs, and the apparent failure of backward induction to predict outcomes in experimental bargaining games. In particular, we show that under some conditions, a ‘sunk cost sensitive’ fairness norm can evolve in such environments. Under this norm, a fair distribution allows all parties to recoup whatever each has invested in their relationship before the net surplus is then divided into equal shares. The establishment of such a norm would have important consequences for the hold-up problem, which we characterize in terms of ultimatum bargaining in the presence of an outside option. We then conclude with a brief discussion of the possible labour market implications of our results.