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Sunk costs, seat belts, and why it is hard to stay competitive

Posted by Max Blumenthal | Aug 27, 2018 9:42:00 AM

Somewhere above the Atlantic Ocean, I took a break from writing this blog to watch The Black Panther (for a third time). There is a scene where T’Challa objects to his sister Shuri’s newly-developed technology because the technology that he was already using worked well enough for him. Shuri’s response was, “just because something works does not mean it cannot be improved.”

I’m going to label this concept of continued improvement despite successful functionality as “continuous innovation.”

While continuous innovation is a simple concept that clearly leads to gaining and maintaining a competitive advantage, few organizations actually pursue it.

As I mentioned in my last blog post, an organization is simply a group of people working toward a common goal. I am writing this blog to understand why we all can sometimes struggle with innovation.

I will begin by briefly describing how and why our interaction with sunk costs differs from economic models. Next, I will give a couple of examples of how it is difficult to break the status quo, even when it is incredibly simple to improve. I’ll wrap up by tying those together in a way that should help you and your organization think about how to maintain a competitive edge.

Sunk Costs

Nearly every economist agrees that sunk costs should have precisely zero effect on our decisions. The concept is straightforward: we make decisions based on maximizing the future value of a decision, regardless of what we decided in the past.

However, we often don’t handle sunk costs as predicted because emotions get in our way.

Freakonomics recently hosted Richard Thaler on their podcast to discuss behavioral economics. Thaler is often regarded as the “godfather of behavioral economics,” is a nobel laureate, and is most well known in pop culture for his appearance with Selena Gomez in The Big Short.

Richard Thaler

Thaler’s thesis is that economic models cannot account for human social factors, which is why we often DO account for sunk costs when making decisions. I highly encourage you to listen to the episode if you’d like to learn more about how human behavior affects decision-making.

Imagine a scenario in which you just convinced your boss to buy expensive new software to help you perform a task more efficiently. Three months later, you find a better solution that eliminates the task altogether! Would you tell your team that they should consider buying this improved technology? Maybe...

I’m not sure I would. I would worry that I’d look uninformed and that I lack confidence in my decisions. Beyond my feelings, I would of course consider the time and money that we had already invested. It could even hurt my ability to champion the next idea that I want to pursue. Nobody likes to admit that they made the wrong decision.

However, I believe that people are more trustworthy when they are able to admit that they were wrong or behind, especially when the outcome is that we can run more efficiently. That is one example of how I try to instill a culture of continuous innovation at Fincura.

Habitual inertia

Just because something works does not mean it cannot be improved.

The longer a process has been in place, the more resistant we are to change. Ironically, the fact that you haven’t changed the process is the best indication that there is room for improvement. The force required to change old habits/processes is greater than the force required for changing newer processes. I call this “habitual inertia.”

Two examples of habitual inertia come to mind: wearing seat belts and shooting free throws.

Seat Belts

In 1983, a law was passed that mandated the use of seat belts to prevent automotive deaths. The concept is simple: wearing a seat belt greatly improves your odds of walking away from an accident.

Get your belt on

The problem is that people had been in cars for over 70 years without seat belts. Using the concept of inertia, I would un-scientifically predict that people were slow to adopt seat belts, even though they require minimal work to use and have a drastic impact on life itself.  

It has been 35 years since the law was passed. We all know that it is far safer to be in a car with a seat belt, but how often do you ride in an Uber, taxi, or bus without buckling up? This is an example of habitual inertia.

Free Throws

Wilt Chamberlain is one of the greatest basketball players in history, but he was an abysmal free throw shooter. Over the course of his 15 years in the NBA, he only averaged 51% from the free throw line.

Wilt Chamberlain is most famous for his 100-point game in which he shot 87% (28/32) from the free throw line. This 70% boost in accuracy wasn’t a fluke...he shot all of his free throws in that game underhand. (Click the link or skip to 5:25 below)

Even after that success, Wilt reverted to shooting overhand because it’s the way that basketball was supposed to be.

One of the best free throw shooters in history is a little-known player named Rick Barry. Guess what? He shot his free throws underhand. Check out Malcolm Gladwell’s Revisionist History podcast episode titled "Big Man Can't Shoot" to learn more.

Habitual inertia: the longer a process has been in place, the more resistant we are to change.

Staying competitive

High frequency trading is a fantastic example of an industry with continuous innovation. The only way to win is increasing the speed to receive and process data. Trading firms invest billions of dollars to be fractions of milliseconds ahead of the competition.

Spread Networks built a $300M fiber optic cable between Chicago and New York with the purpose of decreasing the round-trip data transmission time by 0.004 seconds.

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Soon after completing the cable, the technology was already obsolete. Companies such as McKay Brothers and Tradeworx were able to shave an additional four milliseconds from the transmission time by using a microwave link through the air.

Firms that had already purchased access to the Spread Networks fiber optic line now faced a decision: continue reaping value from their initial investment in the fiber optic line (a sunk cost) or purchase access to the new microwave systems. In a world where you have to be first, firms flocked to the new microwave technology.

While high frequency trading is an extreme example of the need for continuous innovation, the principal still applies. I urge everyone in all levels of the organization to always look for ways to improve. Ignore decisions that happened in the past, look for processes that haven’t changed, and be aware of the challenges (and rewards) that come with change.

The best of the best strive to be better, sunk costs be damned!

Topics: perspectives, articles, technology

Written by Max Blumenthal

Co-Founder and CEO