Sunk Costs

Definition

Sunk costs refer to costs that have already been incurred and cannot be recovered, regardless of future actions or decisions. These costs are irrelevant for future decision-making as they do not depend on the choice being considered.

5 Must Know Facts For Your Next Test

1. Sunk costs are not considered in economic decision-making because they are irrelevant to the choice at hand, as they have already been incurred and cannot be recovered.
2. Ignoring sunk costs and focusing on future, relevant costs is a key principle of rational decision-making, as it ensures that decisions are based on the best use of resources going forward.
3. Sunk costs can create a bias known as the 'sunk cost fallacy,' where individuals or firms continue to invest in a project or decision because of the money already spent, even if it is no longer the best course of action.
4. Sunk costs are important in the context of short-run and long-run costs, as they influence a firm's entry and exit decisions in the long run.
5. Monopolies can use sunk costs as a barrier to entry, discouraging potential competitors from entering the market due to the high upfront investment required.

Review Questions

• Explain how sunk costs relate to the concepts of explicit and implicit costs, and accounting and economic profit.
  • Sunk costs are distinct from explicit and implicit costs in that they are costs that have already been incurred and cannot be recovered, regardless of future actions. Unlike explicit costs, which are the actual out-of-pocket expenses, or implicit costs, which are the opportunity costs of using a firm's own resources, sunk costs are irrelevant for decision-making. This is because sunk costs do not depend on the choice being considered and have already been paid, so they should not influence a firm's decisions. Additionally, sunk costs are not included in the calculation of accounting profit, which only considers explicit costs, but they are relevant for economic profit, which takes into account all costs, including implicit costs.
• Describe how sunk costs influence a firm's decision-making in the short run and long run.
  • In the short run, when a firm's capital equipment and other fixed inputs are already in place, sunk costs are irrelevant for the firm's production decisions. The firm should focus on maximizing its profits by producing the quantity that equates marginal revenue and marginal cost, without considering the sunk costs it has already incurred. However, in the long run, when the firm is considering whether to enter or exit a market, sunk costs become more relevant. High sunk costs, such as the cost of building a manufacturing plant or developing a new product, can act as a barrier to entry, discouraging potential competitors from entering the market. Conversely, sunk costs can also influence a firm's decision to exit the market, as it may be willing to continue operating as long as it can cover its variable costs, even if it cannot recover its sunk costs.
• Analyze how a monopoly can use sunk costs as a barrier to entry to maintain its market position.
  • Monopolies can leverage sunk costs as a barrier to entry to discourage potential competitors from entering the market. By requiring a significant upfront investment, such as the construction of a large-scale manufacturing facility or the development of a complex technology, a monopoly can create a high barrier to entry. Potential competitors may be deterred from entering the market, as they would have to incur these substantial sunk costs, which they may not be able to recover if they fail to successfully compete with the established monopoly. This allows the monopoly to maintain its market position and pricing power, as new firms are less likely to enter the market and challenge the monopoly's dominance. The presence of these sunk costs, which are irreversible investments, can thus serve as an effective deterrent to potential competitors, further entrenching the monopoly's market power.

Related terms

Explicit Costs: Explicit costs are the actual, out-of-pocket expenses incurred in the production of goods or services, such as wages, rent, and raw materials.

Implicit Costs: Implicit costs are the opportunity costs associated with using a firm's own resources, such as the value of the owner's time or the use of owned equipment, rather than purchasing them from the market.

Accounting Profit: Accounting profit is the difference between a firm's total revenue and its explicit costs, representing the amount of money the firm has left after paying its bills.