Sunk Cost Fallacy, Self-control, and Contract Design

Abstract

This paper examines the sunk cost fallacy as a self-commitment device in mitigating self-control problems and analyzes its implications for contract design. The sunk cost fallacy can lead to over-consumption and escalation of commitment. We show that consumers anticipate the fallacy ex-ante, and can strategically use it to mitigate their self-control problem. Therefore, a firm's optimal pricing contract has to balance the demand for flexibility due to the sunk cost fallacy and the demand for commitment due to the self-control problem. We find that the optimal fixed fee for investment goods (e.g., gym attendance) has a U-shape relationship with the fallacy when the consumer has self-control problems: i.e., the optimal fixed fee first decreases and then increases with the sunk cost fallacy. We compare the optimal fixed-fee contract with a pay-per-use contract which does not induce the sunk cost effect. We also investigate two commonly-observed pricing schemes: a contract menu including a fixed fee and a pay-per-use fee, and a two-part tariff. Finally, we analyze the implications of different accounts of the sunk cost fallacy --- the regret-based and the memory-cue-based account, highlighting the importance of understanding the underlying psychological mechanisms of the fallacy for contract design.