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IAI Actuarial Core Principles · Business Economics · Relationship between economics and business

A bank branch in Chennai spent Rs 8 lakh on a software licence that cannot be refunded or resold. It now considers whether to keep using the software or switch to a rival system. In rational decision making, how should the Rs 8 lakh be treated?

The Rs 8 lakh is a sunk cost: it cannot be recovered whichever option is chosen, so a rational decision maker ignores it and compares only the future costs and benefits that differ between continuing and switching systems.

  1. AAs an opportunity cost of switching
  2. BAs a sunk cost that is ignored in the decisionCorrect
  3. CAs a marginal cost of continued use
  4. DAs a variable cost that rises with output
  5. As a benefit forgone by switching

Explanation

The licence fee is unrecoverable whichever option is chosen, so it is a sunk cost. Rational decisions compare only future costs and benefits that differ between alternatives. Treating it as relevant leads to the sunk cost fallacy.

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