Why Do Investors Remain Invested in Airline Business
In an earlier paper we had discussed why airlines do not make a decent return on their investment. In that paper with the help of core theory it was explained how the inherent instable nature of airline market made it impossible for airlines to post a healthy profit consistently over a period of time. The paper, however, did not answer the next logical question that if airline was such a profit challenged business then why the investors did not get out of it at the earliest. We attempt to do this in the present paper.
Economic theory is based on the assumption that human behaviour is rational and therefore any economic decision would be based on cause and effect rationality. In reality, however, humans do not always behave rationally while making their decision. Take the case of an investors who business interest in several industry including airline. Ever since he has invested in airlines he has found that the return from airline business has abysmal compared to his other businesses. As rational investor he aught to move his investment out airlines and put it one his other existing business to maximise his gains, but he does not do so. Traditional economics would label such behaviour as irrational.
Let us take another example, a non aviation one. A year ago during IPL 1 the match between Delhi Dare Devils and Kolkata Knight Riders was abandoned due to rain without a ball being bowled. Cricket matches often get abandoned due to rain therefore was nothing unusual in the present case. In fact it was a day of inclement weather, it had been raining incessantly since morning and well before it was time for the match to start it was fair knowledge that no play would be possible as the playground, which had no drainage system worth the name was sure to be water logged. Yet, 25000 spectators turned up at the ground several hours before the scheduled start and stayed on till the scheduled time for the match to end. Traditional theory would call the behaviour of the spectators as irrational. In a rational world the spectator who already knew that no play would be possible would have been better off in spending the time in some other pursuit that had the possibility of bringing positive return rather than drenching in the rain under the open sky of the uncovered stadium. But such was the behaviour of not one or two odd spectators, 25000 people behaved in this irrational manner. Clearly there must have been some logic behind this apparent illogical behaviour. To understand such behaviour we need to go beyond traditional economics; we need to look into the psychology of sunk cost.
Psychology of Sunk Cost
Psycho economics[1], which is also known as behavioural economics, is the youngest branch of economics. It came into prominence in the 1990s although work had been going on much earlier. It received the stamp of recognition when one of the pioneers Daniel Khaneman was awarded the Nobel Prize in Economics in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[2] Philosophy of sunk cost is one among the many new concepts that this branch of economics has developed to explain many issues that traditional theory has not been able to explain adequately. However, before describing the philosophy we need to know what is meant by sunk cost and it relevance in decision making.
What is Sunk Cost
Sunk cost is the cost already incurred which cannot be recovered regardless of future events.
In economics and business decision-making, sunk costs are costs that cannot be recovered once they have been incurred. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action, and prospective costs which are costs that will be incurred if an action is taken.
In traditional microeconomic theory, only variable costs are relevant to a decision. Traditional economics proposes that an economic actor does not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.
Behavioral economics proposes the opposite: that sunk costs greatly affect actors' decisions, because humans are inherently loss aversive and thus normally act irrationally when making economic decisions.
For example, when we have put effort into something, we are often reluctant to pull out because of the loss that we will make, even if continued refusal to jump ship will lead to even more loss. The potential dissonance of accepting that we made a mistake acts to keep us in blind hope. It is common for people who have invested in company shares to hold on tight to them as the market slumps, in the desperate hope that the shares will rise in price again.
The Sunk Cost Effect
Traditional economics predicts that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions, people routinely consider historic, nonrecoverable costs when making decisions about the future. This behaviour is called the sunk-cost effect.4 The sunk-cost effect is an escalation of commitment and has been defined as the "greater tendency to continue an endeavour once an investment in money, time or effect has been made."
In their seminal paper[3] Hal R. Arkes and Catherine Blumer explain the concept of sunk cost philosophy with the example of a contest winner of a radio programme who has been rewarded with a ticket to a football game. Since he does not want to go to the game alone he persuades a friend to purchase a ticket. When they are about to leave for the game a terrible blizzard begins and the contest winner does not want to go. His friend insists on going to the match since he did not, ‘want to waste the money that he has already paid for the ticket.’ According to traditional theory the friend is not behaving rationally; he should go to the game only if the pleasure of watching the game is more than the agony of sitting in blinding snowstorm. After all the price of the ticket has already been paid for by the friend and his decision to go or not to go will not bring the money back to him, that money is gone; it is a sunk cost. Past investments that are irrecoverable should not be allowed to influence present decision. But, as 25000 spectators at the cricket ground on a rainy night demonstrated, people do.[4]
Something similar happens in the airline business. Individual and companies invest in airlines for a variety of reasons; since this paper is about why people remain invested and not why they invest in airline business we will not discuss the issue in too much detail. In terms of behavioural economics the broad reasons for investing in airlines can be summed as
- It will not happen to me: This is a syndrome that we are familiar with. Individuals routinely assume that ordinary misfortunes like road accidents, a loss in business, attack of an epidemic and so on will not happen to them. The confidence comes from two sources, first, about which one is generally unaware, is the statistical probability of such events occurring are extremely low and therefore for most part misfortunes do not strike a person too often. The second, about which the individual is well aware off, is an inherent belief in themselves that they are smarter than the rest. So, billionaires, otherwise familiar with the apocryphal story about the shortest way of becoming a millionaire is to start an airline does precisely that viz. invests in airline business. They carry with them the self-belief that they would be able to run the business much better than others ahead of them have been able to.
- Prior experience: It is generally true that those investing in airlines have some prior experience, say, as a pilot, a tour operator or travel agent, experience of running airlines etc. This provides them a confidence that they can do better than others.
- Glamour: Traditionally flying has enjoyed a very high glamour quotient primarily because it is a task that human beings can never perform. Another factor that earns respect for those manoeuvring a flying machine is the high risk factor. Mankind has always accorded great value to those who dare to put their life at risk to achieve the improbable. Airline business basks in the reflected glory of this glamour. In the pecking order of the Chamber of Commerce the owner of an airline enjoys a higher ranking than the owner of a hosiery firm though the business of the later may be earning higher profit.
After a point of time investors having made their investment confront situations that we have discussed in the earlier part of the paper. After facing several years of low profitability or outright losses when it seems that it would be best to get out of the business they walk into the fallacy of sunk cost. Having spent so much money and time on an investment it appears to the investors that all their efforts would go to waste if they wind up the airline. Their dilemma can be explained with the aid of the following diagram that contains prospect theory’s[5] value function. The function defines the relationship between objectively defined gains and losses and subjectively defined value a person places on such gains and losses.
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Another feature of sunk cost that is pertinent to airline business is the certainty effect. Time and again data analysis has established that (a) airlines finance follow a cyclic pattern, a period of losses is always followed by a period of profit; and (b) over a long period of time airlines are profitable. These two factors guide to create an impression in the mind of the investor that it is most certain that investment in airlines will earn a profit; and this leads to certainty effect. The certainty effect manifests in two ways. First, absolutely certain gains are greatly overvalued.[6] Second certain losses are greatly undervalued.[7] In other words certainty magnifies both positive and negative values that makes quitting even more difficult.
One reason why investors find sure loss so aversive and avoiding the sunk cost effect could be the perennial human reluctance to admit mistake. For a Chairman to announce before the Board that it was a mistake to have invested in airlines is more difficult than to keep investing and create an impression in the mind of the shareholders that the prior act of investment was a sensible one.
But not all investors remain invested some do walk out, like Air Sahahra did. Does their behaviour contradict the theory of sunk cost? It does not; sunk cost has two important dimensions size and time dimension. Our discussion so far mostly dealt with the first aspect. To earn a return on the investment an investor has to go through a period of waiting. How long is the investor ready to wait is the crucial factor that decides whether or not the investor would be entrapped by sunk cost. The longer the wait, greater the chances of entrapment.
In addition to time dimension Heath adds one more factor that he calls ‘mental budgeting’ that allows an investor to avoid entrapment. According to Heath investors set a mental limit for their expenditures, and when their expenditures exceed the limit they quit investing.[8]
Waiting for a bus would be good example to illustrate the above point. The alternative to the wait is either taking an auto or a taxi. However, it has been a common experience that longer the wait gets less willing one tends to get go for the alternative. The situation is equivalent to sunk cost – time spent in waiting for the bus is sunk cost; reluctance to hire an auto or taxi is willingness to invest more on waiting. The decision to wait and invest further may be prompted by the knowledge that longer the more certain it becomes to earn a profit. In the process, though the size of investment, that is, the sunk cost (both in time and money) gets so big that it becomes impossible for the investor to get out.
Conclusion
Airline business has several peculiarities some of which defy logic in terms of traditional economic theory. It is well established that the industry gives a very poor return to its investors, the cycle of loss making years are usually prolong and the profits made during the profit cycle only marginally make up the losses of the earlier periods. Even then the industry continues to attract investment and what is even more intriguing the investors who have invested in the industry feel shy of moving their investment where higher profit can be earned. Conventional economic logic does not provide any plausible explanation for this behaviour of the investor and describes it as irrational. Psycho economics or Behavioural economics provides an alternative explanation in terms of psychology of sunk cost. Their proposition can be summed up as follows:
“Gone too far to retract”: Having invested in an endeavour over a period of time the investor feels that it would be unwise to invest out because in that case all the money that has been put into the business so far would go waste. It would be better to stay on as future may bring in better returns and it might be possible to turn things around.
Kingfisher Airways, Jetairways, Air India, Goair are prime example of this sunk cost syndrome. Although the respective owners are well aware that if they put the same money in some of their alternative business then that would bring in better profit and yet they continue to invest in their respective airlines even when return on additional investment is not worthwhile all because they “have already invested too much to leave” and they “owe it to their shareholders” to “show them some result”.
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[1] Behavioural economics and behavioural finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.
The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioural models typically integrate insights from psychology with neo-classical economic theory. Behavioural Finance has become the theoretical basis for technical analysis.
Behavioural analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest.
[2] "Nobel Laureates 2002"; Nobelprize.org
[3] The Psychology of Sunk Cost, Hal R. Arkes and Catherine Blumer; Organisational Behaviour and Human Decision Process, 1985, 35, 124-140, reproduced in Judgement and Decision Making, Terry Connolly, Hal R. Arkes, Kenneth R. Hammond, p 97-113, accessed at http://books.google.com/books?id=Uo34qW1wi_YC&printsec=frontcover&source=gbs_navlinks_s. Various dates.
[4] Nearly six months after that IPL match I was talking to a group of friend of my daughter when the discussion turned to that match and I commented that how foolish it was for all those people to turn up for the match when the whole of Delhi knew that no match would be possible. At this one of her friend remarked that he was one among the ‘foolish’ people. Whereupon I asked why did he have to go, his reply was, “But Uncle, I had saved my pocket money to buy the ticket.”
[5] Daniel Kahneman, professor at Princeton University’s Department of Psychology, and Amos Tversky developed prospect theory in 1979 as a psychologically realistic alternative to expected utility theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g. in financial decisions. Starting from empirical evidence, the theory describes how individuals evaluate potential losses and gains.
Prospect theory contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains.
[6] By this we mean that the value of certain gains is higher than what would be expected given an analysis of a person’s values of gains having a probability less than 1.0.
[7] That is, the value is more negative than what would be expected given an analysis of a person’s values of losses having a probability less than 1.0.
[8] Chip Heath, Escalation and De-escalation of Commitment in Response to Sunk Cost: The Role Budgeting in Mental Accounting, Organisational Behaviour and Human Decision Processes 62, 38-54
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