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The Journal of Law, Economics, and Organization V19 I1
© 2003 Oxford University Press

Original Article

Caring About Sunk Costs: A Behavioral Solution to Holdup Problems with Small Stakes

Lorne Carmichael and W. Bentley MacLeod

Queen's University
University of Southern California

Abstract

Economics students need to be taught that opportunity costs are important for optimal decision making 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. Furthermore, the solution we propose is uniquely efficient if the environment is sufficiently complex. Hence, in addition to explaining contract form and ownership (Williamson, 1975; Hart, 1995), studies of the holdup problem may also provide insights into observed behavior in day-today bilateral bargaining problems.


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