Wednesday, March 30, 2011

Sunk Cost Example

The Financial Times reported that some shipowners are canceling contracts to purchase new ships, and that they will be forfeiting millions of dollars in deposits to do so. This is an excellent example of why sunk costs do not matter in making output decisions - but they do in terms of profitability.

The issue here is that once the deposit is made, it will not be recouped. Some contracts may allow the deposit to be applied to the final purchase price, but it is still an outlay that the purchaser will not be able to recoup. So, with an economic downturn, the shipowner must make a decision about continuing with the contract or not continuing with the contract to purchase a new shipping vessel. Independent of what the shipping owner decides - continue or not - the shipowner is out the deposit, and that makes the deposit a sunk cost. The factors that really influence the shipowners choice are the expected profits from continuing with the contract versus the expected profits of canceling the contract. It seems that many shipowners at this time expected profits to be more by canceling the existing contracts.

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