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Sunk Cost
In making economic decisions, the benefits and costs associated with the decision are
considered. But what if a cost has already been incurred and cannot be changed by the current
decision? Should such a cost influence the current decision? No. Such a cost is a sunk cost.
Sunk cost – a past cost that cannot be changed by current decisions.
Example 3: Poppy’s Paper Products has incurred costs of $20,000 to produce stationary for EFG
Co. EFG has now filed for bankruptcy and will not be using or paying for the stationary. Poppy’s
can spend an additional $3,000 altering the stationary and then can sell it to FGH Co. for $5,000.
Or Poppy’s can throw the stationary away. As Poppy’s decides what to do with the stationary, the
$20,000 cost already incurred is a sunk cost. Poppy’s should alter the stationary and sell it to
FGH Co. The revenue from this choice ($5,000) exceeds the cost incurred because of this choice
($3,000).
A sunk cost is a past cost that cannot be changed by current decisions. Thus, a sunk cost should
not influence current decisions. But we humans have a hard time forgetting about sunk costs. If a
person allows a sunk cost to influence a current decision, he or she is more likely to make a bad
current decision.
Example 4: Bernard endures the first half of a terribly boring play. At the intermission, he is
considering going home. Will Bernard’s decision be affected by whether he paid $2 for his ticket
or $100? It shouldn’t be. The price he paid for his ticket is a sunk cost. His current decision is
whether to stay for the second half of the play or whether to go home. If he is not enjoying the
play, he should go home.
Short Run Production versus Long Run Production
Production of goods and services requires resources (inputs). In a limited amount of time, some
of these inputs will be fixed in amount. This is the short run. After a sufficient amount of time has
passed, all inputs can be varied. This is the long run.
Short run – a period in which at least one input is fixed.
Example 5A: Robin Birdwell starts a business building birdhouses. Birdwell rents a small shop in
an industrial park. The rental on the shop is $1,200 per month under a six month lease. For the
next six months, the shop is a fixed input. Birdwell’s short run lasts six months.
Long run – a period in which all inputs can be varied.
In Example 5A, at the end of six months, Birdwell will have a long run decision to make. The
rental of the original shop can be continued, a new shop can be rented, or Birdwell can get out of
the birdhouse building business altogether. Long run decisions are very important, but most
production decisions are made in the short run. This chapter focuses on short run production.
Example 5B: Robin Birdwell begins production of birdhouses. The most important variable input
is labor. Experiments with different numbers of workers give the following results:
Total
Marginal
Workers Product Physical Product
0 0 X
1 12 12
2 26 14
3 36 10
4 42 6
5 44 2
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Production and Costs 20 - 2