Entry, Exit, and Sunk Costs

… a core concept in Economic Analysis and Atlas102

ProfitCostCurveVideo

Click for MRU video, minute 8:00

Concept description

Alex Tabarrok (reference below, video on right) identifies the considerations for entering and exiting a competitive industry when there is uncertainty and where there are significant sunk costs.

In general, firms will enter an industry when Profit > Average Cost and will exit the industry when Profit < Average Cost.

Entry costs

However, for industries with significant entry costs, including Sunk Costs (such as drilling an oil well), firms should not enter unless their expected profits will be greater than their minimum average costs for long enough to recover their entry costs.

Exit costs

Similarly, for industries with significant exit costs (such as requirement to cap an oil well) firms tend not to exit an industry immediately when profit falls below average costs, because most industries have exit costs. Typically, a firm would “weather the storm” unless profit is expected to be less than the minimum average cost for some time.

Sunk costs and decision making

Note that (anticipated) Sunk Costs are relevant for the decision on whether and when the firm should enter the market but that (expended) sunk costs are irrelevant for the decision on whether and when the firm should exit the market.

Practice questions

From http://www.mruniversity.com/node/264181, accessed 7 May 2016.

  1. Paulette, Camille, and Hortense each own wineries in France. They produce inexpensive, mass-market wines. Over the last few years, such wines sold for 7 euros per bottle; but with a global recession, the price has fallen to 5 euros per bottle. Given the information below, let’s find out which of these three winemakers (if any) should shut down temporarily until times get better. Remember: Whether or not they shut down, they still have to keep paying fixed costs for at least some time (that’s what makes them “fixed”). To keep things simple, let’s assume that each winemaker has calculated the optimal quantity to produce if they decide to stay in business; your job is simply to figure out if she should produce that amount or just shut down. Which of these women, if any, earned a profit?

Atlas topic, subject, and course

Producer Theory and Competition (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, Maximizing Profit and the Average Cost Curve (12-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-average-cost, accessed 6 May 2016.

Page created by: Ian Clark, last modified 7 May 2016.

Image: Alex Tabarrok, minute 0.14 of Alex Tabarrok, Maximizing Profit and the Average Cost Curve (12-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-average-cost, accessed 6 May 2016.