Final answer:
Sunk costs refer to irreversible past expenditures. The sunk cost fallacy occurs when individuals or firms let these costs influence further investment decisions, often leading to irrational behavior. One should focus on future potential rather than past costs.
Step-by-step explanation:
Sunk costs are past expenditures that cannot be recovered. Firms and individuals often struggle with sunk costs due to an emotional attachment to their investments. This leads to the sunk cost fallacy, where they continue pouring resources into a failing venture instead of making rational decisions based on future potential.
For instance, firms may hesitate to discontinue a product that's performing poorly simply because they've invested heavily in its development and launch, which is a mistake as these are sunk costs. The key lesson is to focus on the marginal costs and benefits of current and future options, disregarding the sunk costs.