Sunk cost
A cost is what a firm, an individual or society pays to produce or consume goods and services, it is the consumption of resources such as labour time, capital, materials, fuels, etc. In economics, all resources are valued at their opportunity cost, which is the value of the alternative use of the resources. Costs are defined in a variety of ways and under a variety of assumptions that affect their value. The opposite of a cost is a benefit and often both are considered together, for example, net cost is the difference between gross costs and benefits.[2]
A sunk cost is a cost that has been paid and it cannot be recovered, it is a fixed cost that is unavoidable. If the firm stops producing and wants to sublet their space to another firm they might be restricted by their contract from doing so and in which case, the firm will incur the rental cost that cannot be offset by production.[3] Firms must consider this when entering into contracts which might restrict their flexibility in the future.
If an asset cannot be sold or re-purposed easily then it will become a sunk cost. These assets are called specific capital, this is capital which cannot be easily transferred. If a pipeline company goes out of business and had a stockpile of specialty 0.75 m diameter pipe that was designed for a project which fell through, the firm will try to sell the stockpile. If the standard pipe is 1 m diameter and all the fixtures are made to fit the standard diameter, then the specialty pipe will become a sunk cost because it is specific to a use and cannot be bought by other companies and easily installed into standard size projects.
Sunk Cost Fallacy
This is the mistake of allowing sunk costs to affect the decision of whether or not to carry on a business when faced with a potential exit from the market. Regardless of any action taken, sunk costs are lost no matter what. Therefore any decision made after they are lost should be made without sunk costs in mind.[4]
Suppose a natural gas provider is 3 years into a 4 year construction project of a new plant. 3 years in, the construction has cost $20 million and needs $13 million more to be completed. Since the beginning of construction, steam turbine technology and the overall efficiency of natural gas plant design has greatly improved and the firm can build a new plant for $11 million and can be constructed in one year. The firm should stop construction of the current plant and begin construction on the new plant (assuming the current plant cannot be sold or re-purposed). This seems like a huge loss but because the new plant design is more efficient, the company can maximize their profit, save overall cost as the new plant is $2 million less than what is required to finish the current one, and the construction time is the same as the current plant. The $20 million spent on the original plant is gone no matter what course of action the firm takes. If the firm decides to build the new plant they will end up with a new, more efficient plant, they will be under budget by $2 million despite having to build two plants and will be able to recoup the capital costs of the construction quicker with the new plant.
See Also
References
- ↑ Pixabay [[Online, Available: https://pixabay.com/en/pressure-water-line-tube-pipeline-509871/.
- ↑ A. Verbruggen, W. Moomaw and J. Nyboer. Glossary of terms used in the: Special Report on Renewable Energy Sources and Climate Change Mitigation (SRREN). [Onlince], Available: http://www.ipcc.ch/publications_and_data/publications_and_data_glossary.shtml [May.29, 2016]
- ↑ The Economist. “Sunk Costs.” [Online], Available: http://www.economist.com/economics-a-to-z/s#node-21529345[May. 29, 2016].
- ↑ A. Goolsbee, S. Levitt and C. Syverson. ‘’Microeconomics’’. New York: Worth Publishers, 2013, pp. 267.