Academic journal article Journal of Economics and Economic Education Research

Fixed versus Sunk Costs: Creating a Consistent and Simplified Cost Framework

Academic journal article Journal of Economics and Economic Education Research

Fixed versus Sunk Costs: Creating a Consistent and Simplified Cost Framework

Article excerpt

INTRODUCTION

The distinction between fixed and sunk costs is a one of the most important concepts in production theory and one of the most likely to frustrate students. It is built upon the foundation of opportunity cost and is crucial to the construction of the total cost curve, the firm supply curve, the notion of economic profits, and the firm's shutdown condition. Common textbook presentations of fixed and sunk costs, however, are often unclear and theoretically inconsistent. When beginning production theory, students learn that opportunity costs are the only costs to be considered when making decisions. Opportunity costs are defined, in part, as costs that are avoidable and thus are factored into economic decision-making. Sunk costs, on the other hand, are unavoidable and, as such, should not affect decisions. After learning this opportunity cost rule, students are told that total costs are equal to the addition of fixed costs and variable costs. Somewhere in the discussion, however, an implicit assumption is made that fixed costs are costs that cannot be avoided; that is, fixed costs are synonymous with sunk costs. Assuming fixed and sunk costs are synonymous creates unnecessary complications for producer theory and presents an inconsistency in the core concept of economic costs.

The assumption of equality between fixed and sunk costs appears in the majority of microeconomics texts and on some occasions is made explicit. For example, Steven E. Landsburg writes in Price Theory and Applications (2002)

"In the short run, fixed costs are unavoidable. As a result, they have no bearing on any economic decision ... Because sunk costs are sunk, and because the firm's fixed costs are sunk in the short run, it follows that fixed costs are irrelevant to the firm's short-run supply decisions, including the decision about whether to shut down."

Two potential problems arise from this assumption. First, some costs are fixed in both the short run and long run, an idea that contradicts the standard claim that fixed costs, by definition, do not exist in the long run. Second, many short-run fixed costs can be avoided and therefore are not sunk. These problems are resolved by categorizing all costs based on their "avoidability". This simple and intuitive remedy is founded on the core notion that the only costs that matter to economists are opportunity costs. The solution is shown to simplify cost analysis without sacrificing mathematical rigor or important cost relations such as the envelope theorem relating short-run to long-run costs. This simple revision to the principles analysis extends easily to the analysis at the intermediate and advanced levels and follows the early work on costs by writers including John Maurice Clark, Fritz Malchup, and Ronald Coase.

The rest of the paper is organized as follows. Section 2 discusses the standard incorporation of sunk costs into the total cost function and the resulting problem of measuring economic profits. The avoidability criterion is then introduced to remedy the problem. Section 3 discusses how using this criterion allows for a simple and theoretically consistent derivation of the firm supply curve and shutdown condition that improves upon the standard textbook exposition. Section 4 explores the nature of fixed and sunk costs. Section 5 shows how the avoidability criterion ensures important cost relations between the short run and long run that might be unwittingly compromised using the standard pedagogy. Section 6 illustrates the gains from these simple cost revisions with numerical examples. The simplicity of deriving of long-run and short-run cost functions from standard production functions under the avoidability framework is shown. Section 7 provides evidence that indicates the confusion between fixed and sunk costs may extend beyond the classroom to the boardroom in actual firm behavior. Various consulting firms have used techniques along the lines suggested herein to resolve the problem by attributing the relevant opportunity costs to fixed costs formerly assumed to be sunk. …

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