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.