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.
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