Drowning in the sunk cost fallacy: Can economic models really predict human behaviour in an economy?

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Most economists like to think of themselves as rational decision-makers, yet everyone justifies questionable purchases from time to time. Despite inflation and rising travel costs, KLM reported a 5.4% increase in annual revenue in 2024. This growth hints at more than just efficient operations, it shows how deeply consumers, like myself, are influenced by behavioural traps like the sunk cost fallacy or loss aversion. Recently, my group of friends and I have been planning a budget-friendly weekend trip somewhere around Europe, which shattered my illusion of seeing myself as a relatively rational thinker. When talking about airline tickets, I confidently suggested flying with KLM, only to receive disapproving looks from my friends who were trying to find ways to make the trip cheap but still fun. 

Since moving to Amsterdam, I’ve always flown KLM for its convenient schedules. In fact, KLM’s revenues have soared post-pandemic, with 2024 seeing a revenue growth, suggesting many passengers like me are loyal despite cheaper options elsewhere. Today, 20 million members worldwide, myself included, proudly collect miles and KLM XP through their loyalty program. Nonetheless, for this trip, my usual airline preference wasn’t rational. My reasoning, and probably the reasoning of many of the 20 million members of the Flying Blue Air France–KLM loyalty program was as follows; since I have already flown with KLM so much, I don’t want to waste my past purchases and it's technically cheaper to add to the potential benefits by accumulating more miles and XP. This line of reasoning occurs without much deep thought. However, after getting a reality check of low-cost airline prices, one might realize that even economics students, trained in rational models, drown in the sunk cost fallacy. Consequently, this raises the question of whether economic theories are ultimately incapable of predicting human behaviour.

My past ticket purchases allowed me to gather a few thousand worthless KLM miles, clouding my judgment of a cost-minimizing decision. This is a textbook example of the sunk cost fallacy, which occurs when an individual makes economically irrational decisions by allowing their future choices to be based on unrecoverable costs from the past. The sunk cost fallacy often goes hand in hand with another behavioural economic phenomenon: loss aversion. This refers to the tendency for individuals to prefer avoiding losses rather than acquiring equivalent gains, as losses are perceived as more psychologically impactful. This concept was introduced in depth in Daniel Kahneman’s prospect theory. Kahneman later received a Nobel Prize for this alternative to rational choice theory. My dooming airline selection statement, subconsciously projected the fear of losing potential future perks if I don’t keep travelling with KLM, adding miles and XP to my account. This inconsequential experience provided me with a critical lens and made me realize how often we unknowingly fall victim to the sunk cost fallacy. 

After reflecting, and not wanting to admit to myself that I fell victim to such a novel concept, I considered everyday activities where one can encounter the sunk cost fallacy. Besides, travel, subscription models used by the likes of Netflix, Spotify, and many gyms, are a prime example of this fallacy. Many keep paying for their Netflix account or gym membership despite rarely using them, anticipating that their habits will change in the near future. From the company's perspective, this strategy helps balance costs and make many subscription models profitable, similar to Amazon Prime, which benefits from customers who continue paying despite using the service infrequently. 

TicketMaster uses behavioural tactics like virtual queues to exploit the sunk cost fallacy; the longer people wait, the more likely they are to justify paying surge prices. I have also fallen victim to this trap when purchasing Oasis concert tickets, and being forced to wait 7 hours in their virtual queue. 

Companies like Amazon and Spotify, which started relying on the sunk cost fallacy and loss aversion more in recent years, have reported an annual revenue growth in 2024 of 11% and 18.3%, respectively. Behavioural biases clearly shape consumer decisions, yet they didn’t play a major role in most of the first-year courses I have attended.

Establishing that even economists are susceptible to irrational decision making, begs another question: can economic theories truly predict behaviour in the real world? First-year economics courses introduce models that assume rational behaviour using novel concepts to simplify reality. However, ignoring behavioural biases in a broader context can lead to systematic consequences. These “basic theories” set the foundations for more advanced models, which attempt to include behavioural biases by relaxing (some of) the assumptions underlying the original frameworks. As mentioned previously, people in society don't always make rational decisions, just like during my airline ticket purchasing incident. I’m not in any position to disregard first-year bachelor and high school economic models, as they are indispensable in many instances, but their limitations shouldn’t be overlooked. I only aim to shed a bit of light on the fact that reliance on rationality alone is insufficient, a point that often lacks emphasis. John Maynard Keynes also questioned rationality within economics. He famously proposed the idea of ‘animal spirits’, which discredited rationality as a valid interpretation of economic behaviour. Keynes specifically expanded on individuals' investment decisions, which are often not driven by the highest returns or perfect information, but by emotions and societal behaviour. Investors often hesitate to sell a losing stock bought at a higher price, despite rational theory saying they should sell and cut their costs. 

While adding ceteris paribus, all other things being equal, to models is useful for simplification, applying it too broadly can lead to serious consequences. A famous example when the ceteris paribus condition did not hold and rationality didn’t explain economic behaviour was the Great Depression in the 1930s. The then-classical economists believed in Say’s Law, that supply creates its own demand, and assumed that the surplus production, a remnant from World War I, would be balanced by consumption and investment. Economists were very confident that everything would correct itself naturally. The war had caused a capital shortage, preventing people from generating the necessary demand naturally. Therefore, classical theory failed, and the consequences of the Great Depression were devastating. These events increased the importance of government spending and moved economics a step forward. Paradigm shifts are common across disciplines, and even Keynes’ ideas have evolved over time. Despite the Great Depression showcasing the importance of cognitive biases, the 2008 crisis was also partially triggered by irrational behaviour. The overconfidence in the housing market, and loss aversion towards unprofitable securities further deepened the crisis. The limitations of classical economics are highlighted by these psychological factors. Robert Shiller, a Nobel laureate, published works on asset bubbles, further countering the efficient market hypothesis, looking deeply into irrational market behaviours, and further elaborating on Keynes’ ideas.

Cognitive biases start being more prevalent within established economic models. This has expanded the study of behavioural economics as its own respective field. Governments and businesses already incorporate behavioural economics to influence decision-making. Richard Thaler’s Nudge Theory, a Nobel Prize-winning idea, has influenced how governments implement policies and corporations form strategies. In 2012, the UK used Thaler’s nudge theory to make pension enrollment the default option, significantly boosting participation by leveraging loss aversion. This simple change to the system capitalized on cognitive biases like loss aversion, as many citizens were reluctant to sign out of the programs for fear of losing the savings or benefits they had already accumulated. 

Recognizing the wide range of implications of behavioural biases in relation to economics, it might be rational to respond. While most people studying economics already understand that rationality cannot always be assumed, and understand the shortcomings of simple graphs, the general public doesn't. Not acknowledging irrational behaviour can not only have implications in academia, but also financial markets and consumer welfare. The heavy reliance on the ceteris paribus assumption should be emphasized more directly, especially as social media and global interconnectedness have given a platform to pseudo-economists who advocate for policy decisions based on oversimplified, rationality-dependent high school economics. If the awareness of behavioural biases in education of economics improves, the general public can make better economic decisions, acknowledging when they are being baited into an irrational trap. 

Returning to the initial food for thought, the KLM loyalty program and subscription models that benefit from the sunk cost fallacy require modern policy. It has become clear that implementing consumer protection laws could help individuals avoid falling into these corporate traps. Forcing businesses that rely on subscriptions to put into effect automatic cancellations after months of inactivity could save irrationally spent money. Clearer pricing strategies would also empower users to make informed decisions rather than being manipulated by perceived scarcity, such as in Ticketmaster queues. Interestingly, Ticketmaster introduced surge pricing in late 2022, just as governments were lifting lockdown measures and live events were returning. This pricing strategy, which heavily relies on behavioural biases, contributed to a remarkable 36.24% increase in revenue between 2022 and 2023. To prevent such exploitation of consumers, these platforms could also be required to provide greater transparency about key details like actively displaying the actual monetary value of the miles, so consumers, including me, recognize the options and avoid being misled by the sunk cost fallacy. 

At the end of the day, economics is about people, and people aren’t always rational. While irrationality is inevitable, there are steps we can take to try to avoid it. Economics as a field has been evolving for decades, and emphasizing the existence of cognitive biases in models and theories seems rational in this non-rational world. The sunk-cost fallacy is very prevalent, with many major corporations using it as a profit maximization strategy. Despite not having a lasting effect on my life, it made me realise that the world is far less rational than our economics courses suggest. Economic models, even the ones assuming rationality remain essential, but should be considered with caution, striking a balance between simplicity and realism. As Bob Dylan said, "you better start swimmin’ or you’ll sink like a stone", and economists and policy makers must start swimming, embracing cognitive biases, or risk drowning in the very sunk cost fallacy they overlook.