How real people decide: rules of thumb and sunk costs

Imagine you need new headphones, and a shopping site lists 400 pairs. Reading every review and comparing every price would take days. So you look at a few well-rated pairs under 50 dollars and buy the first one that seems fine.

Many economic models assume a buyer who knows every option and weighs them all perfectly. That’s a useful simplification. But real people have limited time, information and attention.

Herbert Simon called this situation bounded rationality: people try to choose well, but within limits on what they know and can work out. He won the Nobel prize in economics in 1978 for his research on how organisations make decisions.

Simon noticed that people often set a standard, such as “well rated and under 50 dollars”, and take the first option that meets it. He called this satisficing: settling for good enough instead of hunting for the best.

Searching has a cost. An hour spent comparing headphones is an hour you can’t spend on anything else. The next best use of that hour is the opportunity cost of searching. This is where a rule of thumb helps: a simple shortcut for deciding, such as “buy the best-rated one I can afford”. Using one is often the smart choice, not a lazy one.

A rule of thumb works best when the choice is small, you make it often, and a mistake costs little. Slow down when the choice is big, rare or hard to undo, like a two-year phone contract.

In 1962, Britain and France signed a treaty to build Concorde, a supersonic (faster than sound) passenger jet. Its costs soon rose far above the first estimates, and nobody could be sure it would ever pay its way. The governments kept paying. One argument was that the money already spent shouldn’t be wasted. But quitting wasn’t free either. In 1969, the British government’s top lawyer warned that France could sue if Britain pulled out. That was a real cost of stopping, and it does count.

Letting a sunk cost push you to carry on is called the sunk-cost fallacy (a fallacy is a mistake in reasoning). When people, firms or governments keep pouring money into a plan whose future costs beat its future benefits, that’s called escalation of commitment.

The bridge was worth finishing, even though its 5 million of benefits will never cover the 15 million it cost in all. The concert and the adverts weren’t worth what they’d still cost. Each time, the money already spent was gone, so only what was still to come could decide.