Sunk Cost Fallacy, Self-control, and Contract Design

49 Pages Posted: 9 Aug 2021

See all articles by Xing Zhang

Xing Zhang

Sungkyunkwan University

Ganesh Iyer

University of California, Berkeley - Marketing Group

Xiaoyan Xu

Southwestern University of Finance and Economics (SWUFE)

Juin-Kuan Chong

National University of Singapore (NUS) - NUS Business School

Date Written: August 3, 2021

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.

Keywords: Sunk cost fallacy, Self-control, Pricing, Contract design, Behavioral economics

JEL Classification: D11, D91, L11

Suggested Citation

Zhang, Xing and Iyer, Ganesh and Xu, Xiaoyan and Chong, Juin-Kuan, Sunk Cost Fallacy, Self-control, and Contract Design (August 3, 2021). Available at SSRN: https://ssrn.com/abstract=3898439 or http://dx.doi.org/10.2139/ssrn.3898439

Xing Zhang (Contact Author)

Sungkyunkwan University ( email )

53 Myeongnyun-dong 3-ga Jongno-ju
Guro-gu
Seoul, 110-745
Korea, Republic of (South Korea)

Ganesh Iyer

University of California, Berkeley - Marketing Group ( email )

Haas School of Business
Berkeley, CA 94720
United States

Xiaoyan Xu

Southwestern University of Finance and Economics (SWUFE) ( email )

55 Guanghuacun St,
Chengdu, Sichuan 610074
China

Juin-Kuan Chong

National University of Singapore (NUS) - NUS Business School ( email )

1 Business Link
Singapore, 117592
Singapore

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
50
Abstract Views
387
PlumX Metrics