Competitive Strategy

and Industrial Structure

Competitive implications of cost distortions:

⇒The sunk cost bias

Alp Atakan
Review of the role of sunk cost in pricing

A cost expenditure is sunk if no current or future action can impact it

Examples:
❖ R&D expenditures to develop a new drug
❖ Money spent on making a movie
❖ Marketing and advertising associated with the launch of a product
❖ On-the-job training of employees
 Costs and pricing
❖ Only marginal cost should be taken into account in pricing
◆ Fixed and sunk costs are not relevant in pricing
◆ They are relevant to your entry and exit decisions

$/unit

Optimal price
Demand
Marginal cost (direct
cost) - These are costs
directly impacted by
output
Optimal level of output
and price is set when
marginal revenue equals Q Quantity
marginal cost
Marginal Revenue
 Incorporating irrelevant costs in pricing
❖ If you misperceive marginal cost to be
higher than what it is
$/unit ◆ You tend to price higher
• You lose A in lost volume, but
Price under the • gain B in higher margins
sunk cost fallacy ◆ Since A>B, your pricing is sub-
B optimal
Optimal price Demand
A
Incorrect Marginal cost
(includes a charge for sunk
True Marginal cost capital expenditures)

Q Quantity
Marginal Revenue Magnitude of cost
misperception
Auctioning locations for gas stations

In response to plans by the Dutch government to auction locations for gas

stations along highways, Shell’s spokesman argued:

“Auctioning the selling points drives up costs… ultimately, these costs

will have to be included in the product price. The extra revenue to the
government will be paid by motorists.”
Numerical example
❖ Two firms with demand functions
Q1=12-2P1+P2 and Q2=12-2P2+P1

❖ Marginal (production) cost

c1 = c2 = 2

❖ Capacity is 10 million units

❖ There is a one-time capital expenditure of S

◆ Capital is completely sunk
◆ Capital cost per period is $20M
Calculations

❖ Demand : Q1=12-2P1+P2
❖ Inverse demand is P1 =6+0.5P2-0.5Q1 and MR1 =6+0.5P2-Q1
❖ Equating MR1 =MC=2, the profit maximizing quantity is
Q1=4+0.5P2
❖ Substitute back into inverse demand to get the reaction function:
P1 =6+0.5P2-0.5(4+0.5P2)=4+0.25P2
❖ As problem is symmetric, we have
P1 =P2 = 16/3=5.33
 Equilibrium when both firms price taking only
marginal cost into account
F1’s reaction function based on correct
P2
calculation of relevant cost

F2’s reaction function

Equilibrium
price ❖ Eqm quantity is 4 + 0.5*5.33 = 6.67
P2=5.33 A
❖ And eqm gross profit is
(5.33-2)6.67 = 22.22 > 20

P1
Equilibrium price
P1=5.33
 Sunk cost fallacy
❖ A firm’s management team adopts the following pricing practice:

1. Add to the marginal cost of $2 a charge of $x per unit to reflect sunk

capital expenditure and overhead

2. Maximize profit under the assumption that your cost per unit is $(2+x)
Eventually, everyone must face facts…..

❖ x may represent the firm’s “costing methodology”

◆ This is the firm’s accounting philosophy regarding how much of its sunk
cost and overhead is allocated to per unit cost

❖ Adopting distorted costing methodologies that ignore Economics

does not mean that Economics stops working!

❖ The success of the company is measured by the difference between its

revenues and its true variable cost
Calculations Firm 1 makes a small distortion x=0.5

❖ Demand : Q1=12-2P1+P2
❖ Inverse demand is P1 =6+0.5P2-0.5Q1 and MR1 =6+0.5P2-Q1
❖ Equating MR1 =MC=2.5, the profit maximizing quantity is
Q1=3.5+0.5P2
❖ Substitute back into inverse demand to get Firm’s 1 reaction function:
P1 =6+0.5P2-0.5(3.5+0.5P2)=4.25+0.25P2
❖ Firm 2’s reaction function has not changed
❖ Solving for eqm prices, we get:
P1 =4.25+0.25(4+0.25P1)
P1 = 5.60 and P2 = 5.40
Q1=6.2 and Q2=6.8
❖ Gross profits are (5.6-2)6.2=22.3 for firm 1 and (5.4-2)6.8=23.1 for
firm 2.
 Effects of one firm committing the sunk cost fallacy
** Firm 1 makes a small distortion x=0.5

F1’s reaction function shifts to the right

P2
as a result of marking up its cost to
“recover sunk cost”

F2’s reaction function based

on correct calculation of
5.40 relevant costs
B
5.33
A Profits net of capital cost (in
millions):
A π1=2.2 π2=2.2
B π1=2.3 π2=3.1
P1
5.33 5.60
What if both firms behave as if marginal cost is 2.5?

❖ Reaction functions: P1 =P2=4.25+0.25P2

❖ This implies
P1 =4/3*4.25 =5.67 =P2
Q1=12-5.67=6.33=Q2
❖ and true net profits are: (5.67-2)6.33-20 = 3.2
 It is even better when both firms are irrational!

F1’s reaction functions

P2

5.67 C F2’s reaction functions

B
5.3
A

P1
5.3 5.67
 It is even better when both firms are irrational!

F1’s reaction functions

P2

5.67 C F2’s reaction functions

Profits net of capital cost (in

B millions):
5.3 A π1=2.2 π2=2.2
A
B π1=2.3 π2=3.1
C π1=3.2 π2=3.2

P1 Implication: the beneficial

effects of the distortions are
5.3 5.67 self-reinforcing
Game of Choosing an Accounting Standard

Firm 2 uses Firm 2 commits the

correct MC sunk cost fallacy
costing

Firm 1 uses 2.22, 2.22 3.1, 2.3

correct MC
costing

Firm 1 commits
the 2.3, 3.1 3.2, 3.2
sunk cost fallacy
Summary and take-away points

❖ Correct cost for pricing in non-strategic situations is marginal cost

❖ Monopoly and competitive market

❖ Sunk cost bias does not necessarily have an adverse effect in strategic
situations
❖ It softens price competition
❖ A behavioral/organizational bias may give rise to a self-sustaining industry
norm closer to “full-costing”

❖ Competitive strategy implications:

❖ Accounting standards can have subtle competitive consequences
❖ Beware of simplistic applications of economic concepts that ignore strategic
effects