Sunk costs and hit-and-run entry

Overview

Sunk cost, hit-and-run entry and asset specificity matter for contestability.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a sunk cost?

   Model answer

   A sunk cost is a cost that has been incurred and cannot be recovered if the firm leaves the market. Money spent on a specialised machine with no resale value, on advertising to build a brand, on regulatory approval or on non-refundable licence fees is sunk, because none of it comes back when the firm shuts down.

2. 2

   Why is a sunk cost different from a fixed cost?

   Model answer

   A fixed cost is one that does not vary with output, and a large fixed cost need not be sunk. An aircraft or a fleet of lorries is a large fixed cost that can be sold or leased out on exit, so almost nothing is lost. Advertising to establish a new brand is also a fixed cost, but it is entirely sunk because there is nothing left to sell. It is the recoverability, not the size or the relationship to output, that determines whether a cost is sunk.

3. 3

   Explain precisely why sunk costs, rather than capital requirements, are what determine contestability.

   Model answer

   A large capital requirement can be financed if the assets behind it hold their value, because a lender is secured on something that can be resold and the entrant risks only the difference. A sunk cost cannot be recovered at all, so the entrant risks the entire amount on the venture succeeding. Two markets can require identical capital and be quite differently contestable if in one the assets have a deep second-hand market and in the other they are worthless outside the firm.

4. 4

   What is hit-and-run entry?

   Model answer

   Hit-and-run entry is entering a market to capture short-lived supernormal profit and then leaving as soon as the profit disappears, typically once the incumbent responds by cutting its price. It is only worth attempting where exit is cheap, because the profit captured over a short period must exceed whatever cannot be recovered on the way out.

5. 5

   An incumbent earns supernormal profit of £645 per period. Entering requires £700 of capital. Show how the recoverability of that capital determines whether a hit-and-run raid is worth attempting.

   Model answer

   Suppose the £700 buys assets with a deep second-hand market, so that on exit the entrant recovers the full amount and the only cost of the raid is the financing charge of, say, 5 per cent, which is £35. The raid then yields 645 - 35 = £610, so entry is clearly worthwhile. Now suppose the £700 is entirely sunk, spent on assets with no alternative use. The raid yields 645 - 700 = -£55, so entry is not worthwhile. The capital requirement, the incumbent's profit and the market are identical in both cases; only the recoverability of the outlay differs, and it reverses the decision.

6. 6

   Using the same market, where an incumbent earns £645 per period and entry requires £700, explain what the incumbent must do to deter entry when the entrant's capital is fully recoverable.

   Model answer

   The entrant will raid whenever the profit available exceeds the £35 financing cost of a recoverable £700. Cutting price to the allocatively efficient level of £55, which still leaves £476.25 of profit, is not enough, because the raid would still yield 476.25 - 35 = £441.25. The incumbent must go all the way down to a price that leaves essentially no supernormal profit. Where entry costs nothing that cannot be recovered, the threat alone forces the incumbent to the normal-profit outcome even though it remains the only firm in the market.

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