The economic analysis underlying corporate decision making: what economists do when confronted with business realities—and how they might improve

Business Economics, July, 2004 by Hugh Schwartz

RECOMMENDATION 3. Although the small cadre of economists in large corporations cannot be expected to become familiar enough with the detail of operations to be personally aware of the location and significance of most slack, economists should help devise a system for monitoring the dimensions of the phenomenon and for dealing with it.

Sunk Costs

Nearly half of the economists indicated that their company was involved from time to time in a "sunk cost fallacy," and they conceded that it was eliminated only gradually. (One observed that it was harder to get out of a bad investment than into a good one.) The economists stated that they generally argued against giving consideration to sunk costs but conceded that they did not always do so. A few claimed that some of their reticence to do so was attributable to factors such as a company policy of loyalty to long-standing employees. Behavioral economists generally cite psychological factors such as a tendency to recognize losses only on the actual sale or suspension of the activity in question--a status quo effect--in the words of some.

Two economists placed the responsibility for paying attention to sunk costs on the accounting standards set by the FASB, but two others maintained that some of the accounting standards were so obviously wrong-minded that their companies kept two sets of books and made decisions on the basis of data other than accepted accounting norms (placing more reliance on cash-flow considerations, for example). A few firms wrestled with activity-based accounting in an effort to assign sunk costs more accurately, but no economists were a part of those efforts. Nor did they seek to become part of them, two insisting that the known approaches to activity-based accounting did not assign costs in truly economic terms.

RECOMMENDATION 4. Business economists should always speak out against tendencies to resort to the sunk cost fallacy and some should take an active role in developing systems of activity-based accounting in order to unify accounting and economic criteria.

Changes in Tastes and Perceptions

Despite problems of handling sunk costs, several economists stated that decision-making in their companies was more analytical than several years before, and two in enterprises for which bidding is important maintained that the infamous winner's curse was becoming less common. (3) Even so, one of the economists most involved in the microeconomic analysis of his firm maintained that learning had become more difficult in the period since 9/11, given what he characterized as the ensuing chaos in the markets in general and in his company's industry in particular. He acknowledged, though, the increased importance of psychological factors, which he conceded he had less ability to analyze, such as changes in taste and the ability to perceive data accurately.

RECOMMENDATION 5. Business economists should take steps to improve their understanding, not only of statistical techniques, but of data perception. (4)