Short Notes: Sunk costs
Posted by Ripon Abu Hasnat on Tuesday, May 27, 2014 | 0 comments
Sunk
costs are costs which, once committed, cannot be recovered. Sunk costs arise because some activities
require specialized assets that cannot readily be diverted to other uses. Second-hand markets for such assets are
therefore limited. Sunk costs are always fixed costs, but not all fixed costs
are sunk.
Examples
of sunk costs are investments in equipment which can only produce a specific
product, the development of products for specific customers, advertising
expenditures and R&D expenditures.
In general, these are firm-specific assets.
The
absence of sunk costs is critical for the existence of contestable markets. When sunk costs are present, firms face a
barrier to exit. Free and costless exit
is necessary for contestability. Sunk
costs also lead to barriers to entry. Their existence increases an incumbents’
commitment to the market and may signal a willingness to respond aggressively
to entry.
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