Sunk Costs

Definition of Sunk Costs

Companies in every industry have to spend money to make money. A company budget may
allow for investing money in employee salaries, inventory, office space or any other cost of
doing business. Once the company's money is spent, that money is considered a sunk cost.
Regardless of what money is spent on, sunk costs are dollars already spent and permanently
lost. Sunk costs cannot be refunded or recovered. For example, once rent is paid, that dollar
amount is no longer recoverable - it is 'sunk.'

A family group also has a budget that contains sunk costs. For example, if they put $30 worth
of gas in their car, they'll never get that money back. Their car has gas, but the cash is spent
and permanently lost; it is a sunk cost.

Decision-making in a company is naturally linked to budgeting and costs. It's a common

business tenet that sunk costs should never be considered a relevant factor in decision-making.
Using sunk costs as a factor in a decision is simply trying to justify past choices.

Examples of Sunk Costs

An example of obvious sunk costs can be found in

the construction industry. Let's say a construction
company has begun development of a new housing
sub-division. The lots and initial construction
materials have been purchased, and framing has
begun. A total of $4 million has been invested.

Suddenly, a crisis in the banking industry causes a recession, and subsequently the bottom falls
out of the housing market. The sub-division land is now worth much less than the construction
company paid for it. If the company abandons the project, it will take a $4 million loss. Some
company executives want to finish the houses and sell them to recover at least a portion of the
costs already spent - sunk costs. But it will cost an additional $6 million to complete the project.

One executive might say, 'We've already spent $4 million. We might as well finish the project.'
A more enlightened executive will say, 'It doesn't matter that we've already spent $4 million -
that's a sunk cost. We need to decide if investing in a housing development is a sound decision,
given the current housing and banking environment.' Making the decision without considering
the sunk costs will cause the executives to abandon the project and limit their losses to $4
million. The additional $6 million can be used for another project better suited to the current
business environment.
 Economies of Scope
The economies of scope concept is defined as the process of reducing the cost of resources and skills
for an individual business enterprise by spreading the use of these resources and skills over two or more
enterprises. As shown in below figure, the cost for an enterprise is cut in half if the resources are used
in two enterprises rather than just one. If the use of the resources is spread over three enterprises, the
cost per enterprise is reduced to a third.
Figure:
The cost for an enterprise is cut in half if the resources The economies of scope
are used in two enterprises rather than just one. If the
use of the resources is spread over three enterprises, the
cost per enterprise is reduced to a third.

Economies of Scope Examples

The cost of a combine can be spread over several crop

enterprises because, in many cases, the only thing
needed to harvest another crop is a different combine head. Another combine does not need to
be purchased for each additional crop enterprise. The same combine can be used to harvest
corn, soybeans, wheat, barley, oats, canola, sunflowers, etc. As a farmer, agronomic skills can
be used in the production of two or more crops. Being a seed dealer and a farmer means that
the knowledge gained about seed selection can be used both as a salesperson and a farmer. The
same can be said about farmers who sell crop insurance.

Collusion

What is Collusion?

Meet Eddie. Eddie is the owner of a large corporation that sells pizza. Eddie has always prided
himself on following the rules and regulations where his business is concerned. This all
changed one day when three other owners of pizza companies approached him. They wanted
Eddie to join them in a secret agreement to set the price for their pizzas in order to keep any
other firm from entering the market. What Eddie was involved in is known as collusion.
While you may be able to vaguely understand, the term based upon the example above, let's
further define collusion so that you have a better grip on what it means. Collusion is an
agreement between firms that usually compete against each other in efforts to set the prices for
their goods in order to gain an advantage. In doing so, the equilibrium of the market is disrupted
because supply and demand are no longer natural. When competitive firms work together,
they're able to increase profits via price increases, restriction of supply, and/or sharing insider
information. For example, firms may agree to limit the supply of their goods, making them
harder to find and purchase. In doing so, consumers are willing to pay a higher price because
of the limited amount available.

The Legal Issues Surrounding Collusion

So you may be wondering: is collusion an illegal practice? Well, this is a tricky question
because many factors can contribute to collusion. In short, collusion is generally thought of as
an illegal practice, but let's break it down a bit to understand why.

Collusion can involve price-fixing. Price fixing is an agreement between competitive firms on
the prices for goods. This can mean increasing or decreasing prices to gain an advantage. Price
fixing is an illegal practice. An example of price-fixing is when competitive firms get together
to set an agreed upon price for their product, like in our above example with Eddie. The firms
then agree not to deviate from that price.

Collusion may involve price leadership, otherwise known as parallel pricing. This occurs
when the leading firm in the market publishes their prices before the other firms in the market,
which then forces the other firms to match the price. When doing this, the leading firm
publishes prices that will benefit their firm and maximize their profits. This doesn't mean that
competitive firms will also see maximized profits. However, even if competitive firms won't
benefit from the leading firms' announced prices, they often utilize the same price for their
goods only to stay competitive. This type of collusion is generally thought of to be a legal
practice.
 Cartel

Imagine you are the owner of an oil field. Chances are, you want to make as much profit as
possible. Lower gas prices mean fewer profits, while higher prices mean greater profits. In an
effort to increase profits, you make a deal with a neighboring oil field to reduce the amount of
oil each of you produces each day. This partnership is known as a cartel.

A cartel is a collaboration between two or more companies who attempt to manipulate the
prices of goods or services. The cartel forms because the companies are hoping to work together
to control the market. We often see a cartel develop when there are a small number of
companies who offer the product and each company often owns a large share of the good, such
as with oil or gold. Through this collaboration, the companies who form the cartel are able to
control prices by taking various measures to drive up the cost of goods or services.

There are two primary types of cartels that are formed - private and public.

Private Versus Public

Private cartels are those formed between member companies. In a private cartel, the members
are interested in increasing their own benefits. Think of the example above where you wanted
to make more profits so you made a deal with a neighboring oil field - this would be a private
cartel.

Private cartels are often considered a violation of laws known as antitrust laws. Antitrust laws
are regulations put in place by governments to increase the fairness of trading and production
of goods or services. When private cartels are developed, they often violate these legal
stipulations.

Public cartels are often encouraged by governments and are not subject to antitrust laws. These
cartels are often formed in an effort to help the producers of the product or service and the
global population. For example, instead of private cartels being developed, the major countries
have joined the Organization of Petroleum Exporting Countries, better known as OPEC.
This organization assists in controlling the amount of oil that is produced in an effort to stabilize
oil prices.

Economic Influence

Let's say you and your neighboring oil field ignore the legal implications of a private cartel and
develop an agreement between yourselves and another oil field. While the increase in profits
will certainly have significant economic benefits for you and your company, it will likely harm
consumers.
 Price Discrimination

This involves charging a different price to different groups of people for the same good. For
example: student discounts, off peak fares cheaper than peak fares.

Different Types of Price Discrimination

1. First Degree Price Discrimination

This involves charging consumers the maximum price that they are willing to pay. There will
be no consumer surplus.

2. Second Degree Price Discrimination

This involves charging different prices depending upon the quantity consumed.

E.g. after 10 minutes phone calls become cheaper.

3. Third Degree Price Discrimination

This involves charging different prices to different groups of people. E.g. students, OAPs and
peak travelers etc.

More on third degree price discrimination

Conditions Necessary for Price Discrimination

1. The firm must operate in imperfect competition, it must be a price maker with a
downwardly sloping demand curve.
2. The firm must be able to separate markets and prevent resale. E.g. stopping an adults
using a childs ticket.
3. Different consumer groups must have elasticities of demand. E.g. students with low
income will be more price elastic.

To maximize profits a firm sets output and price where MR=MC. If there are 2 sub markets
with different elasticities of demand. The firm will increase profits by setting different prices
depending upon the slope of the demand curve.

Therefore for a group like adults, PED is inelastic the price will be higher
For groups like students prices will be lower because there demand is elastic
Profit Maximization under Price Discrimination

Profit is maximized where MR=MC. Because

demand is more inelastic in market (A) it leads to
a higher price being set. In market (B) demand is
price elastic, so profit maximizing price is lower.

Advantages of Price Discrimination

1. Firms will be able to increase revenue.

This will enable some firms to stay in business who otherwise would have made a
loss. For example price discrimination is important for train companies who offer
different prices for peak and off peak.
2. Increased revenues can be used for research and development which benefit
consumers
3. Some consumers will benefit from lower fares. E.G. old people benefit from lower
train companies, old people are more likely to be poor.

Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are likely to be
allocative inefficient because P > MC.
2. Decline in consumer surplus.
3. Those who pay higher prices may not be the poorest. E.g. adults could be
unemployed, OAPs well off.
4. There may be administration costs in separating the markets.
5. Profits from price discrimination could be used to finance predatory pricing.

Importance of Marginal Cost in Price Discrimination

In markets where the marginal cost of an extra passenger is very low. E.G. a bus traveler the
firm has an incentive to use price discrimination to sell all the tickets. This is why sometimes
prices for airlines can be very low just before their date. Once the company is due to fly the
MC of an extra passenger will be very low. Therefore this justifies selling the remaining tickets
at a low price.
Examples of price discrimination

1. Student discounts on trains

2. Discounts for buying train tickets in advance
3. Discounts for travelling at off peak time
4. Lower unit cost price for buying high quantity.

Price Leadership

Another form of collusion is price leadership. In this form of coordinated behavior of

oligopolies one firm sets the price and the others follow it because it is advantageous to them
or because they prefer to avoid uncertainty about their competitors reactions even if this
implies departure of the followers from their profit-maximizing position.

Price leadership is widespread in the business world. It may be practiced either by explicit
agreement or informally. In nearly all cases price leadership is tacit since open collusive
agreements are illegal in most countries.

Price leadership is more widespread than cartels, because it allows the members complete
freedom regarding their product and selling activities and thus is more acceptable to the
followers than a complete cartel, which requires the surrendering of all freedom of action to
the central agency. If the product is homogeneous and the firms are highly concentrated in a
location the price will be identical. However, if the product is differentiated prices will differ,
but the direction of their change will be the same, while the same price differentials will broadly
be kept.

There are various forms of price leadership.

The most common types of leadership are:

(a) Price leadership by a low-cost firm.

(b) Price leadership by a large (dominant) firm.

(c) Barometric price leadership.

These are the form of price leadership examined by the traditional theory of leadership as
developed by Fellner and others. The characteristic of the traditional price leader is that he sets
his price on marginality rules, that is, at the level defined by the intersection of his MC and MR
curves. For the leader the behavioral rule is MC = MR. The other firms are price-takers who
will not normally maximize their profit by adopting the price of the leader. If they do, it will
be by accident rather than by their own independent decision.
ADVERTISEMENTS:

A. The Model of the Low-cost Price Leader:

We will illustrate this model with an example of duopoly. It is

assumed that there are two firms which produce a homogeneous
product at different costs, which clearly must be sold at the same
price. The firms may have equal markets (or they may come to an
agreement to share the market equally) as in figure , or they may have
Fig: Low-cost price leader
unequal markets (or agree to share the market with unequal shares), firms with equal market
as in figure 10.8. The important condition for this model is that the shares

firms have unequal costs.

The firm with the lowest cost will charge a lower price (PA) and this
price will be followed by the high-cost firm, although at this price
firm B (the follower) does not maximize its profits. The follower
would obtain a higher profit by producing a lower output (XBe) and
selling it at a higher price (PB). However, it prefers to follow the
leader, sacrificing some of its profits in order to avoid a price war,
which would eliminate it if price fell sufficiently low as not to cover Fig: Low-cost price leader
firms with equal market
its LAC. It should be stressed that for the leader to maximize his profit
price must be retained at the level PA and he should sell XA. This implies that the follower must
supply a quantity (0XB in figure 10.8, or OX1 = OX2 in figure ) sufficient to maintain the price
set by the leader.

ADVERTISEMENTS:

Although the price- leadership model stresses the fact that the leader sets the price and the
follower adopts it, it is clear that the firms must also enter a share-of-the-market agreement,
formally or informally, otherwise the follower could adopt the price of the leader but produce
a lower quantity than the level required to maintain the price (set by the leader) in the market,
and thus push (indirectly, by not producing enough output) the leader to a non-profit-
maximizing position.

In this respect the price follower is not completely passive he may be coerced to adopt the
leaders price, but, unless tied by a quota-share agreement (formal or informal) he can push the
leader to a non-maximizing position.
B. The model of the Dominant-firm Price Leader:

In this model it is assumed that there is a large dominant firm which

has a considerable share of the total market, and some smaller firms,
each of them having a small market share. The market demand (DD
in figure) is assumed known to the dominant firm.

It is also assumed that the dominant leader knows the MC curves of the smaller firms, which
he can add horizontally and find the total supply by the small firms at each price; or at best that
he has a fair estimate, from past experience, of the likely total output from this source at various
prices. With this knowledge the leader can obtain his own demand curve as follows.

At each price the larger firm will be able to supply the section of the total market not supplied
by the smaller firms. That is, at each price the demand for the product of the leader will be the
difference between total D (at that price) and the total S1. For example, at price P1 the demand
for the product of the leader will be zero, because the total quantity demanded (D1) is supplied
by the smaller firms.

As price falls below P1 the demand for the leaders product increases. At P2 the total demand
is D2; the part P2 A is supplied by the small firms and the remaining AD2 is supplied by the
leader. At P3 total demand is D3 and the total quantity is supplied by the leader since at that
price the small firms do not supply any quantity. Below P3 the market demand coincides with
the leaders demand curve.

Having derived his demand curve (dL in figure 10.10) and given his
MC curve, the dominant firm will set the price P at which his MR =
MC and his output is 0x. At price P the total market demand is PC,
and the part PB is supplied by the small firms followers while quantity
BC = 0x is supplied by the leader.

The dominant firm leader maximizes his profit by equating his MC to

his MR, while the smaller firms are price-takers, and may or may not
maximize their profit, depending on their cost structure. It is assumed
that the small firms cannot sell more (at each price) than the quantity
denoted by S1. However, if the leader is to maximize his profit, he must make sure that the
small firms will not only follow his price, but that they will also produce the right quantity (PB,
at price P). Thus, if there is no tight sharing-the- market agreement, the small firms may
produce less output than PB and thus force the leader to a non-maximizing position.

C. Barometric Price Leadership:

In this model it is formally or informally agreed that all firms will follow (exactly or
approximately) the changes of the price of a firm which is considered to have a good knowledge
of the prevailing conditions in the market and can forecast better than the others the future
developments in the market. In short, the firm chosen as the leader is considered as a barometer,
reflecting the changes in economic environment.

The barometric firm may be neither a low-cost nor a large firm. Usually it is a firm which from
past behavior has established the reputation of a good forecaster of economic changes. A firm
belonging to another industry may also be chosen as the barometric leader. For example, a firm
in the steel industry may be agreed as the (barometric) leader for price changes in the motor-
car industry. Barometric price leadership may be established for various reasons.

Firstly, rivalry between several large firms in an industry may make it impossible to accept one
among them as the leader. Secondly, followers avoid the continuous recalculation of costs, as
economic conditions change. Thirdly, the barometric firm usually has proved itself as a
reasonably good forecaster of changes in cost and demand conditions in the particular
industry and the economy as a whole, and by following it the other firms can be reasonably
sure that they choose the correct price policy.

Duopoly

Duopoly is a form of oligopoly. In its purest form two firms

control all of the market, but in reality the term duopoly is used
to describe any market where two firms dominate

Examples of duopolistic markets: There are many examples

of duopoly including the following:

Coca-Cola and Pepsi (soft drinks), Unilever and

Proctor & Gamble (detergents)

Bloomberg and Reuters (Financial information services), Sotheby's and Christie's

(auctioneers of antiques/paintings)

Airbus and Boeing (aircraft manufacturers)

US diesel locomotive market is a duopoly of General Electric's GE Transportation

and Caterpillar's EMD

Glencore and Trafigura form a duopoly that controls as much as 60 per cent of some
markets, such as zinc

Construction and maintenance of UK road and rail networks is largely undertaken by

two companies Carillion and Costain

In these imperfectly competitive markets entry barriers are high although there are usually
smaller players in the market surviving successfully. The high entry barriers in duopolies are
usually based on one or more of the following: brand loyalty, product differentiation and huge
research economies of scale.

Video link about these topics:

Sunk Costs

http://study.com/academy/lesson/sunk-costs-definition-examples.html

Collusion

http://study.com/academy/lesson/collusion-in-economics-definition-examples.html
Price Discrimination
http://study.com/academy/lesson/price-discrimination-definition-types-examples.html