IUE e-chapter 3: sunk costs and a general sequence model for all industries

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Using the basic concepts explained in Chapter 1, and drawing on modern life and examples of infrastructure over the last two thousand years, Chapter 3 refines and defines the concept of sunk costs in economic theory as an asymmetry in time and technology, noting that most infrastructure investments are sunk costs. However, the concept can also be applied to all specific technologies, so that this has general application to all industries with significant investment in physical capital Рincluding industries like cars, aircraft, aerospace, oil, chemicals, smart phones, and most kinds of non-re-programable hardware etc. It postulates a general sequential model in which new business environments emerge and firms have to rebalance their resources in order to create the capabilities that will be optimal in the new business environment. The economics is perfectly general; there is no presumption of universal efficiency or rationality, technologies can be fixed for as little as one time period, and although knowledge is largely universal, the embodiment of technology in capital equipment by firms takes time, and is not uniform, so firms do not all compete with identical technologies or capital equipment in practice. So there are no common production functions, or fixed cost and revenue curves. Entry and exit conditions are then examined. The economics of large sunk costs for lumpy investments, and then more general (less risky) sequential investments are examined from the different perspectives of investors, who can more easily switch technologies or industries, and managers, who cannot. To check that the general conditions hold at the extremes, the chapter finishes by examining the marginal conditions for investment; as a practical example we look at the development of light railways in the UK under the changing business environments of the 19th and early 20th centuries, and benefit from more than a hundred years of hindsight of what we now know about the evolution of the rival technologies of canals, steam railways, mass-produced cars and changing demand, caused by general changes in society.

The general model described here is more fully developed in the next Chapter 4, where models of markets that require significant sunk costs to enter are clearly developed and explained.

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