Sunk Cost Effect, Self-Control, and Contract Design

Abstract

This article examines the role of the sunk cost effect as a commitment device in mitigating the self-control problem and analyzes its implications for optimal contract design. Consumers may anticipate the effect ex ante and strategically use it to mitigate their self-control problems. Although the sunk cost effect may lead to a loss of consumption flexibility in the event of high consumption costs, it can serve as a commitment device to enforce self-control. A firm's optimal policy should balance the consumer's demand for flexibility in consumption with the demand for commitment. Under a simple fixed-fee contract, sunk costs have a nonmonotonic effect on profits for investment goods; that is, profits first decrease and then increase with the sunk cost effect. The firm can use a two-part tariff or a refundable fixed-fee contract to mitigate the sunk cost effect. This article also compares the implications of alternative psychological mechanisms underlying the sunk cost effect (regret-based vs. memory-cue-based) for contract design.