McConnell Campbell R., Brue Stanley L., Barbiero Thomas P. Microeconomics. Ninth Edition
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In the long run an industry and the individual firms it comprises can undertake all
desired resource adjustments. That is, they can change the amount of all inputs
used. The firm can alter its plant capacity; it can build a larger plant or revert to a
smaller plant than that assumed in Table 8-2. The industry also can change its plant
size; the long run allows sufficient time for new firms to enter or for existing firms
to leave an industry. We will discuss the impact of the entry and exit of firms to and
from an industry in the next chapter; here we are concerned only with changes in
plant capacity made by a single firm. Let’s couch our analysis in terms of average
total cost (ATC), making no distinction between fixed and variable costs because all
resources, and therefore all costs, are variable in the long run.
Firm Size and Costs
Suppose a single-plant manufacturer begins on a small scale and, as the result of
successful operations, expands to successively larger plant sizes with larger output
capacities. What happens to average total cost as this occurs? For a time, succes-
sively larger plants will lower average total cost. However, eventually the building
of a still larger plant may cause ATC to rise.
Figure 8-7 illustrates this situation for five possible plant sizes. ATC-1 is the short-
run average-total-cost curve for the smallest of the five plants, and ATC-5 the curve
for the largest. Constructing larger plants will lower the minimum average total
costs through plant size 3, but then larger plants will mean higher minimum aver-
age total costs.
The Long-Run Cost Curve
The vertical lines perpendicular to the output axis in Figure 8-7 indicate those out-
puts at which the firm should change plant size to realize the lowest attainable aver-
age total costs of production. These are the outputs at which the per-unit costs for a
larger plant drop below those for the current, smaller plant. For all outputs up to 20
units, the lowest average total costs are attainable with plant size 1. However, if the
firm’s volume of sales expands to between 20 and 30 units, it can achieve lower per-
unit costs by constructing larger plant size 2. Although total cost will be higher at
200 Part Two • Microeconomics of Product Markets
Long-Run Production Costs
● The law of diminishing returns indicates that,
beyond some point, output will increase by
diminishing amounts as more units of a variable
resource (labour) are added to a fixed resource
(capital).
● In the short run, the total cost of any level of
output is the sum of fixed and variable costs
(TC = TFC + TVC).
● Average fixed, average variable, and average
total costs are fixed, variable, and total costs
per unit of output; marginal cost is the extra
cost of producing one more unit of output.
● Average fixed cost declines continuously as out-
put increases; average-variable-cost and aver-
age-total-costs curves are U-shaped, reflecting
increasing and then diminishing returns; the
marginal-cost curve falls but then rises, inter-
secting both the average-variable-cost-curve
and the average-total-cost curve at their mini-
mum points.
<hadm.sph.sc.edu/
Courses/Econ/Cost/
Cost.html>
A tutorial on total
cost, fixed cost,
variable cost, and
marginal cost
the expanded levels of production, the cost per unit of output will be less. For any
output between 30 and 50 units, plant size 3 will yield the lowest average total costs.
From 50 to 60 units of output, the firm must build plant size 4 to achieve the lowest
unit costs. Lowest average total costs for any output over 60 units require construc-
tion of the still larger plant size 5.
Tracing these adjustments, we find that the long-run ATC curve for the enterprise
is made up of segments of the short-run ATC curves for the various plant sizes that
can be constructed. The long-run ATC curve shows the lowest average total cost at
which any output level can be produced after the firm has had time to make all appro-
priate adjustments in its plant size. In Figure 8-7 the dark blue, bumpy curve is the
firm’s long-run ATC curve or, as it is often called, the firm’s planning curve.
In most lines of production, the choice of plant size is much wider than in our
illustration. In many industries the number of possible plant sizes is virtually
unlimited, and in time quite small changes in the volume of output will lead to
changes in plant size. Graphically, this implies an unlimited number of short-run
ATC curves, one for each output level, as suggested by Figure 8-8 (Key Graph).
Then, rather than consisting of segments of short-run ATC curves as in Figure 8-7,
the long-run ATC curve is made up of all the points of tangency of the unlimited
number of short-run ATC curves from which the long-run ATC curve is derived.
Therefore, the planning curve is smooth rather than bumpy. Each point on it tells us
the minimum ATC of producing the corresponding level of output.
Economies and Diseconomies of Scale
We have assumed that for a time increasing plant sizes will lead to lower unit costs
but that beyond some point successively larger plants will mean higher average total
costs. That is, we have assumed that the long-run ATC curve is U-shaped. But why
should this be? Note, first, that the law of diminishing returns does not apply in the
long run because diminishing returns presumes one resource is fixed in supply, while
the long run means all resources are variable. Also, our discussion assumes resource
chapter eight • the organization and the costs of production 201
FIGURE 8-7 THE LONG-RUN AVERAGE-TOTAL-COST CURVE:
FIVE POSSIBLE PLANT SIZES
Average total costs
02030 5060
Q
Output
ATC-1
ATC-2
ATC-3
ATC-4
ATC-5
The long-run
average-total-cost
curve is made up of
segments of the
short-run cost curves
(ATC-1, ATC-2, etc.)
of the various-size
plants from which the
firm might choose.
Each point on the
planning curve shows
the least unit cost
attainable for any
output when the firm
has had time to make
all desired changes in
its plant size.
prices are constant. We can explain the U-shaped long-run average-total-cost curve
in terms of economies and diseconomies of large-scale production.
ECONOMIES OF SCALE
Economies of scale, or economies of mass production, explain the downsloping
part of the long-run ATC curve. As plant size increases, a number of factors will for
a time lead to lower average costs of production.
Labour Specialization Increased specialization in the use of labour becomes more
achievable as a plant increases in size. Hiring more workers means jobs can be
divided and subdivided. Each worker may now have just one task to perform
instead of five or six. Workers can work full time on those tasks for which they have
special skills. In a small plant, skilled machinists may spend half their time per-
forming unskilled tasks, leading to higher production costs.
Further, by working at fewer tasks, workers become proficient at those tasks. The
jack-of-all-trades doing five or six jobs is not likely to be efficient in any of them. By
concentrating on one task, the same worker may become highly efficient.
Finally, greater labour specialization eliminates the loss of time that accompanies
each shift of a worker from one task to another.
Managerial Specialization Large-scale production also means better use of, and
greater specialization in, management. A supervisor who can handle 20 workers is
underused in a small plant that employs only 10 people. The production staff could
be doubled with no increase in supervisory costs.
Small firms cannot use management specialists to best advantage. In a small plant
sales specialists may have to divide their time between several executive functions, for
example, marketing, personnel, and finance. A larger scale of operations means that
the marketing expert can supervise marketing full time, while specialists perform
other managerial functions. Greater efficiency and lower unit costs are the net result.
Efficient Capital Small firms often cannot afford the most efficient equipment. In
many lines of production such machinery is available only in very large and
extremely expensive units. Furthermore, effective use of the equipment demands a
high volume of production, and that again requires large-scale producers.
In the automobile industry the most efficient fabrication method in North Amer-
ica employs robotics and elaborate assembly line equipment. Effective use of this
equipment demands an annual output of perhaps 200,000 to 400,000 automobiles.
Only very large-scale producers can afford to purchase and use this equipment effi-
ciently. The small-scale producer is faced with a dilemma. To fabricate automobiles
using other equipment is inefficient and, therefore, more costly per unit. The alter-
native of purchasing the efficient equipment and underusing it at low levels of out-
put is also inefficient and costly.
Other Factors Many products entail design and development costs, as well as other
start-up costs, that must be incurred irrespective of projected sales. These costs
decline per unit as output is increased. Similarly, advertising costs decline per auto,
per computer, per stereo system, and per box of detergent as more units are produced
and sold. The firm’s production and marketing expertise usually rises as it produces
and sells more output. This learning by doing is a further source of economies of scale.
All these factors contribute to lower average total costs for the firm that is able to
expand its scale of operations. Where economies of scale are possible, an increase in
all resources of, say, 10 percent will cause a more-than-proportionate increase in out-
put of, say, 20 percent. The result will be a decline in ATC.
202 Part Two • Microeconomics of Product Markets
economies
of scale
Reductions in the
average total cost of
producing a product
as the firm expands
the size of plant (its
output) in the long
run; the economies
of mass production.
chapter eight • the organization and the costs of production 203
In many Canadian manufacturing industries, economies of scale have been of
great significance. Firms that have expanded their scale of operations to obtain
economies of mass production have survived and flourished. Those unable to
expand have become relatively high-cost producers, doomed to struggle to survive.
DISECONOMIES OF SCALE
In time the expansion of a firm may lead to diseconomies and, therefore, higher
average total costs.
The main factor causing diseconomies of scale is the difficulty of efficiently con-
trolling and coordinating a firm’s operations as it becomes a large-scale producer.
In a small plant a single key executive may make all the basic decisions for the
plant’s operation. Because of the firm’s small size, the executive is close to the pro-
duction line, understands the firm’s operations, and can digest information and
make efficient decisions.
This neat picture changes as a firm grows. Many management levels now come
between the executive suite and the assembly line; top management is far
removed from the actual production operations of the plant. One person cannot
assemble, digest, and understand all the information essential to decision making
on a large scale. Authority must be delegated to many vice-presidents, second
vice-presidents, and so forth. This expansion of the management hierarchy leads
to problems of communication and cooperation, bureaucratic red tape, and the
possibility that decisions will not be coordinated. Similarly, decision making may
be slowed down to the point that decisions fail to reflect changes in consumer
tastes or technology quickly enough. The result is impaired efficiency and rising
average total costs.
Also, in massive production facilities workers may feel alienated from their
employers and care little about working efficiently. Opportunities to shirk respon-
sibilities, by avoiding work in favour of on-the-job leisure, may be greater in large
plants than in small ones. Countering worker alienation and shirking may require
additional worker supervision, which increases costs.
Where diseconomies of scale are operative, an increase in all inputs of, say, 10
percent will cause a less-than-proportionate increase in output of, say, 5 percent. As
a consequence, ATC will increase. The rising portion of the long-run cost curves in
Figure 8-9 illustrates diseconomies of scale.
CONSTANT RETURNS TO SCALE
In some industries a rather wide range of output may exist between the output at
which economies of scale end and the output at which diseconomies of scale begin.
That is, a range of constant returns to scale may exist over which long-run average
cost does not change. The q
1
q
2
output range of Figure 8-9(a) is an example. Here a
given percentage increase in all inputs of, say, 10 percent will cause a proportionate
10 percent increase in output. Thus, in this range ATC is constant.
Applications and Illustrations
The business world offers many examples of economies and diseconomies of scale.
Here are just a few.
SUCCESSFUL STARTUP FIRMS
The Canadian economy has greatly benefited over the past few decades by explo-
sive growth of new startup firms. Where economies of scale are significant, such
dis-
economies
of scale
Increases in the
average total cost of
producing a product
as the firm expands
the size of its plant
(its output) in the
long run.
constant
returns
to scale
The
range of output
between the output
at which economies
of scale end and
diseconomies of
scale begin.
<www.theshortrun.com/
classroom/glossary/
micro/costprofit.html>
Cost and profit
summarized,
including constant
returns to scale
204 Part Two • Microeconomics of Product Markets
Average total costs
Output
0
Q
Long-run
ATC
If the number of
possible plant sizes
is very large, the
long-run average-
total-cost curve
approximates a
smooth curve.
Economies of
scale, followed
by diseconomies
of scale, cause
the curve to be
U-shaped.
FIGURE 8-8 THE LONG-RUN AVERAGE-TOTAL-COST
CURVE: UNLIMITED NUMBER OF
PLANT SIZES
Key Graph
Quick Quiz
1. The unlabelled tinted curves in this figure illustrate the
a. long-run average-total-cost curves of various firms constituting the industry.
b. short-run average-total-cost curves of various firms constituting the industry.
c. short-run average-total-cost curves of various plant sizes available to a partic-
ular firm.
d. short-run marginal-cost curves of various plant sizes available to a particular
firm.
2. The unlabelled tinted curves in this figure derive their shapes from
a. decreasing, then increasing, short-run returns.
b. increasing, then decreasing, short-run returns.
c. economies, then diseconomies, of scale.
d. diseconomies, then economies, of scale.
3. The long-run ATC curve in this figure derives its shape from
a. decreasing, then increasing, short-run returns.
b. increasing, then decreasing, short-run returns.
c. economies, then diseconomies, of scale.
d. diseconomies, then economies, of scale.
4. The long-run ATC curve is often called the firm’s
a. planning curve.
b. capital-expansion path.
c. total-product curve.
d. production possibilities curve.
Answers
1. c; 2. b; 3. c; 4. a
firms can enjoy years or even decades of growth accompanied by lower average
total costs. That has been the case for such internationally recognized firms as Intel
(microchips), Starbucks (coffee), Ballard Power Systems (fuel cells), Microsoft (soft-
ware), Celestica (computer components), Dell (personal computers), Yahoo (Inter-
net search engine), Cisco Systems (Internet switching), Nortel Networks (fibre
optics), Federal Express (overnight delivery), and America Online (Internet access).
chapter eight • the organization and the costs of production 205
FIGURE 8-9 VARIOUS POSSIBLE LONG-RUN AVERAGE-TOTAL-
COST CURVES
Economies
of scale
Constant returns
to scale
Diseconomies
of scale
Long-run
ATC
Average total costs
Output
0
q
1
q
2
Average total costs
Output
0
(a)
(b)
(c)
Average total costs
Output
0
Long-run ATC
Long-run ATC
In panel (a),
economies of scale
are rather rapidly
obtained as plant
size rises, and disec-
onomies of scale are
not encountered until
a considerably large
scale of output has
been achieved. Thus,
long-run average
total cost is constant
over a wide range of
output. In panel (b),
economies of scale
are extensive, and
diseconomies of
scale occur only at
very large outputs.
Average total cost,
therefore, declines
over a broad range
of output. In panel (c),
economies of scale
are exhausted
quickly, followed
immediately by disec-
onomies of scale.
Minimum ATC thus
occurs at a relatively
low output.
206 Part Two • Microeconomics of Product Markets
A major source of these economies of scale is the ability to spread huge product
development and advertising costs over an increasing number of units of output.
These firms also benefit from the greater specialization of labour, management, and
capital equipment permitted by larger firm size. In some cases, the full exploitation
of economies of scale is still continuing. For example, Bell Canada’s cost of deliver-
ing Internet access to each additional user is very low. Thus, its average total cost
probably will continue to fall as it signs up more subscribers.
THE VERSON STAMPING MACHINE
In 1996 Verson (a U.S. firm located in Chicago) introduced a 15-metre-tall metal-
stamping machine that is the size of a house and weighs as much as 12 locomotives.
This $30 million machine, which cuts and sculpts raw sheets of steel into automo-
bile hoods and fenders, enables automakers to make new parts in just five minutes
compared with eight hours for older stamping presses. A single machine is designed
to make five million auto parts a year. So, to achieve the cost saving from this
machine, an auto manufacturer must have sufficient auto production to use all these
parts. By allowing the use of this cost-saving piece of equipment, large firm size
achieves economies of scale.
THE DAILY NEWSPAPER
The daily newspaper is undoubtedly one of the economy’s great bargains. Think of
all the resources that are combined to produce it: reporters, delivery people, pho-
tographers, editors, management, printing presses, pulp mills, pulp mill workers,
ink manufacturers, forest-product firms, loggers, logging truck drivers, and on and
on. Yet, for 50¢ you can buy a high-quality newspaper in major cities.
The fundamental reason that newspapers have such low prices are the low costs
resulting from economies of scale. If only 100 or 200 people bought the paper each
day, the average cost of each paper would be exceedingly high because the overhead
(fixed) costs of producing the paper would be spread over so few readers. But when
publishers sell thousands or hundreds of thousands of newspapers each day, they
spread their overhead cost very widely. They also can fully use expensive but
highly efficient printing presses. For both reasons, the average total cost of a paper
sinks to a few dimes. Moreover, the greater the number of readers, the more money
advertisers are willing to pay for ad space. That added revenue helps keep the price
of the newspaper low.
GENERAL MOTORS
Executives of General Motors, the world’s largest auto producer, are well aware
of the realities of diseconomies of scale. Experts on the auto industry say GM’s
large size may be a liability; it is substantially larger than Ford and Daimler-
Chrysler and is larger than Toyota and Honda combined. Compared with these
competitors, GM has a cost disadvantage that may help explain its substantial
decline in long-term market share. Despite billions of dollars of investment in
modern equipment, GM still has the lowest productivity and the highest cost per
car in the industry.
To try to reduce scale diseconomies, GM has taken several actions. It has estab-
lished joint ventures (combined projects) with smaller foreign rivals such as Toyota
to reduce its production costs. It has created Saturn, a separate, stand-alone auto
manufacturing company. It has given each of its five automotive divisions (Chevro-
let, Buick, Pontiac, Oldsmobile, and Cadillac) greater autonomy with respect to
styling, engineering, and marketing decisions to reduce the layers of managerial
approval required in decision making. Finally, GM has reorganized into a small-car
group and a midsize and luxury group to try to cut costs and bring new cars to the
market faster. Whether these actions will overcome GM’s diseconomies of scale
remains to be seen.
Minimum Efficient Scale and Industry Structure
Economies and diseconomies of scale are an important determinant of an industry’s
structure. Here we introduce the concept of minimum efficient scale (MES), which
is the lowest level of output at which a firm can minimize long-run average costs.
In Figure 8-9(a) that level occurs at q
1
units of output. Because of the extended range
of constant returns to scale, firms producing substantially greater outputs could also
realize the minimum attainable average costs. Specifically, firms within the q
1
to q
2
range would be equally efficient, so we would not be surprised to find an industry
with such cost conditions to be populated by firms of quite different sizes. The
apparel, food processing, furniture, wood products, snowboard, and small-
appliance industries are examples. With an extended range of constant returns to
scale, relatively large and relatively small firms can coexist in an industry and be
equally successful.
Compare this with Figure 8-9(b), where economies of scale prevail over a wide
range of output and diseconomies of scale appear only at very high levels of out-
put. This pattern of declining long-run average total cost may occur over an
extended range of output, as in the automobile, aluminum, steel, and other heavy
industries. The same pattern holds in several of the new industries related to infor-
mation technology, for example, computer microchips, operating system software,
and Internet service provision.
Given consumer demand, efficient production will be achieved with a few large-
scale producers. Small firms cannot realize the minimum efficient scale and will not
be able to compete. In the extreme, economies of scale might extend beyond the
market’s size, resulting in what is termed natural monopoly, a relatively rare mar-
ket situation in which average total cost is minimized when only one firm produces
the particular good or service.
Where economies of scale are few and diseconomies come into play quickly, the
minimum efficient size occurs at a low level of output, as shown in Figure 8-9(c). In
such industries a particular level of consumer demand will support a large number
of relatively small producers. Many retail trades and some types of farming fall into
this category. So do certain kinds of light manufacturing, such as the baking, cloth-
ing, and shoe industries. Fairly small firms are as efficient as, or more efficient than,
large-scale producers in such industries.
Our point here is that the shape of the long-run average-total-cost curve is deter-
mined by technology and the economies and diseconomies of scale that result. The
shape of the long-run ATC curve, in turn, can be significant in determining whether
an industry is populated by a relatively large number of small firms or is dominated
by a few large producers, or lies somewhere in between.
We must be cautious in our assessment, because industry structure does not
depend on cost conditions alone. Government policies, the geographic size of mar-
kets, managerial strategy and skill, and other factors must be considered in explain-
ing the structure of a particular industry. (Key Question 12)
chapter eight • the organization and the costs of production 207
minimum
efficient
scale (mes)
The lowest level of
output at which a
firm can minimize
long-run average
costs.
natural
monopoly
An
industry in which
economies of scale
are so great that a
single firm can
produce the product
at a lower average
total cost than if
more than one
firm produced the
product.
208 Part Two • Microeconomics of Product Markets
There is an old saying: Don’t cry
over spilt milk. The message is
that once you have spilled a glass
of milk, there is nothing you can
do to recover it, so you should
forget about it and move on from
there. This saying has great rele-
vance to what economists call
sunk costs. Such costs are like
sunken ships on the ocean floor:
once these costs are incurred,
they cannot be recovered.
Let’s gain an understanding of
this idea by applying it first to con-
sumers and then to businesses.
Suppose you buy an expensive
ticket to an upcoming football
game, but the morning of the
game you wake up with a bad case
of the flu. Feeling miserable, you
step outside to find that the wind
chill is about –20 degrees. You ab-
solutely do not want to go to the
game, buy you remind yourself
that you paid a steep price for the
ticket. You call several people to
try to sell the ticket, but you soon
discover that no one is interested
in it, even at a discounted price.
You conclude that everyone who
wants a ticket has one.
Should you go to the game?
Economic analysis says that you
should not take actions for which
marginal cost exceeds marginal
benefit. In this situation, the price
you paid for the ticket is irrele-
vant to the decision; both mar-
ginal or additional costs and
marginal or additional benefit
are forward-looking. If the mar-
ginal cost of going to the game is
greater than the marginal bene-
fit, the best decision is to go back
to bed. This decision should be
the same whether you paid $2,
$20, or $200 for the game ticket,
because the price that you pay
for something does not affect is
marginal benefit. Once the ticket
has been purchased and cannot
be resold, its cost is irrelevant to
the decision to attend the game.
Since you absolutely do not want
to go, clearly the marginal cost
exceeds the marginal benefit of
the game.
Here is a second consumer
example. Suppose a family is on
vacation and stops at a roadside
stand to buy some apples. The
kids get back into the car and
bite into their apples, immedi-
ately pronouncing them “totally
mushy” and unworthy of an-
other bite. Both parents agree
that the apples are “terrible,”
but the father continues to eat
his, because, as he says, “We
paid a premium price for them.”
One of the older children replies,
“Dad, that is irrelevant.” Al-
though not stated very diplomat-
ically, the child is exactly right.
In making a new decision, you
should ignore all costs that are
not affected by the decision. The
prior bad decision (in retrospect)
to buy the apples should not dic-
tate a second decision for which
marginal benefit is less than
marginal cost.
Now let’s apply the idea of
sunk costs to firms. Some of a
firm’s costs are not only fixed (re-
curring, but unrelated to the level
of output) but are sunk (unrecov-
erable). For example, a nonre-
fundable annual lease payment
for the use of a store cannot be
IRRELEVANCY OF SUNK COSTS
Sunk costs should be disregarded in decision making.
● Most firms have U-shaped long-run average-
total-cost curves, reflecting economies and then
diseconomies of scale.
● Economies of scale are the consequence of
greater specialization of labour and management,
more efficient capital equipment, and the spread-
ing of startup costs among more units of output.
● Diseconomies of scale are caused by the prob-
lems of coordination and communication that
arise in large firms.
● Minimum efficient scale is the lowest level of
output at which a firm’s long-run average total
cost is at a minimum.
chapter eight • the organization and the costs of production 209
chapter summary
1. The firm is the most efficient form of organ-
izing production and distribution. The main
goal of a firm is to maximize profit.
2. Sole proprietorships, partnerships, and cor-
porations are the major legal forms that busi-
ness enterprises may assume. Though
proprietorships dominate numerically, the
bulk of total output is produced by corpora-
tions. Corporations have grown to their posi-
tion of dominance in the business sector
primarily because they are characterized by
limited liability and can acquire money capi-
tal for expansion more easily than other
firms can.
3. Economic costs include all payments that
must be received by resource owners to
ensure a continued supply of needed re-
sources to a particular line of production.
Economic costs include explicit costs, which
flow to resources owned and supplied by
others, and implicit costs, which are pay-
ments for the use of self-owned and self-
employed resources. One implicit cost is a
normal profit to the entrepreneur. Economic
profit occurs when total revenue exceeds
total cost (= explicit costs + implicit costs,
including a normal profit).
4. In the short run a firm’s plant capacity is
fixed. The firm can use its plant more or less
intensively by adding or subtracting units of
various resources, but it does not have suffi-
cient time in the short run to alter plant size.
5. The law of diminishing returns describes
what happens to output as a fixed plant is
used more intensively. As successive units
of a variable resource such as labour are
added to a fixed plant, beyond some point
the marginal product associated with each
additional worker declines.
6. Because some resources are variable and
others are fixed, costs can be classified
as variable or fixed in the short run. Fixed
costs are independent of the level of output;
recouped once it has been paid.
A firm’s decision about whether
to move from the store to a more
profitable location does not de-
pend on the amount of time re-
maining on the lease. If moving
means greater profit, it makes
sense to move whether there are
300 days, 30 days, or 3 days left
on the lease.
Or, as another example, sup-
pose a firm spends $1 million on
R&D to bring out a new product,
only to discover that the product
sells very poorly. Should the firm
continue to produce the product
at a loss even when there is no
realistic hope for future success?
Obviously, it should not. In mak-
ing this decision, the firm real-
izes that the amount it has spent
in developing the product is irrel-
evant; it should stop production
of the product and cut its losses.
In fact, many firms have dropped
products after spending millions
of dollars on their development.
Examples are the quick decision
by Coca-Cola to drop its New
Coke and the eventual decision
by McDonald’s to drop its
McLean Burger.
Consider a final real-world ex-
ample. For decades, Boeing and
McDonnell Douglas were keen
rivals in the worldwide sale of
commercial airplanes. Each com-
pany spent billions of dollars on
R&D and marketing in an at-
tempt to gain competitive ad-
vantages over each other. Then,
in 1996 they suddenly merged.
Many observers wondered how
two fierce rivals who had spent
such huge amounts to compete
could suddenly forget the past
and agree to merge. But these
past efforts and expenditures
were irrelevant to the decision;
they were sunk costs. The for-
ward-looking decision led both
companies to conclude, each for
its own reasons, that the mar-
ginal benefit of a merger would
outweigh the marginal cost.
In short, if a cost has been in-
curred and cannot be partly or
fully recouped by some other
choice, a rational consumer or
firm should ignore it. Sunk costs
are irrelevant. Or, as the saying
goes, don’t cry over spilt milk.