Abstract
This paper examines some of the strategic implications of the sunk cost phenomenon in sequential allocation decisions. Drawing from psychology and behavioral decision theory, we first present a taxonomy of possible causes for the ‘sunk cost effect’, the tendency of many managers to throw good money after bad. We then present the analysis of some implications of this behavior in strategic situations. A two-period strategic game is developed and analyzed to derive optimal allocations as a function of one player's sunk cost behavior. We establish when this behavior can be used as a successful precommitment strategy by the sunk cost player, and when it is exploitable by an opponent. Welfare implications are also explored. The sunk cost effect constitutes a form of strategic preference manipulation, in which a credible preference change can be induced to provide a strategic advantage to one of the players.
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