Caring About Sunk Costs: A Behavioral Solution to Hold-up Problems with Small Stakes

Abstract:     
Economics students need to be taught that opportunity costs are important for optimal decisionmaking but that sunk costs are not. Why should this be? Presumably these students have been making optimal decisions all their lives, and the concepts should be easy for them. We show that caring about sunk costs can help agents achieve efficient investments in a simple team production environment. Further, the solution we propose is uniquely efficient if the environment is sufficiently complex. Hence, in addition to explaining contract form and ownership (Williamson (1975) and Hart (1995)), studies of the holdup problem may also provide insights into observed behavior in day to day bilateral bargaining problems.

JEL Classifications: C78

Working Paper Series