A cost is fixed if it does not depend on the level of output produced (or, the scale of operations). For example, if a telecommunications network operator could use the same feeder and distribution loop plant to serve 10 customers or 10,000 customers, then the cost of that plant would be fixed regardless of how many customers it actually serves (provided there are no more than 10,000 customers).
A cost is sunk when it cannot be recovered or reversed by simply stopping (or shutting down) the activity that gave rise to it. Once the loop plant has been placed, it is usually impossible or extremely costly to redeploy it elsewhere or in alternative uses, even if the network operator has no customers left to serve. The operator incurs the cost of the plant when it is installed, and cannot later recover that cost even if it stops providing service.
Sunk costs raise barriers to entry (and exit) by imposing very high penalties for failure on potential competitors. A new network operator that wishes to enter the market must carefully weigh its chances of surviving in the long run, particularly when it has to compete against an incumbent with a well-established market presence.
When the new operator decides to enter using its own facilities, the possibility of failure becomes a critical factor in that decision for two reasons:
- First, the new operator must be prepared to incur substantial upfront cost, much (if not all) of which is likely to be fixed and even sunk
- Second, the operator must be prepared to absorb the entire sunk portion of that cost in the event that it does fail.
At the time that the new carrier is weighing its prospects and incurring sunk costs, the incumbent carrier faces none of the same risks or costs (even if it did so at an earlier point in time). This basic asymmetry in their positions may pose an entry barrier for the prospective new operator.
Policy Responses to High Sunk Costs
The public policy response to the problem of high sunk costs of entry has traditionally been to lower those costs through certain types of ex ante regulation. Such regulation shifts the onus for facilitating entry at least partly on to incumbent firms. The most common instruments for this purpose are
- Mandatory unbundling by incumbents of productive assets that are associated with high sunk entry costs. For example, in many countries, incumbent telecommunications operators that once had monopoly control over their network facilities are now required to “unbundle” those facilities. Unbundled facilities must be leased at regulated rates to new entrants and other competitors that may lack facilities of their own, or that find it technologically or economically infeasible to duplicate the facilities, and
- Structural or functional separation of wholesale and retail operations of vertically integrated incumbents. For example, in the United Kingdom, British Telecom recently implemented operational separation of its wholesale fixed access business from its retail functions. (This was part of a wider regulatory settlement with the regulator, Ofcom.)
Both forms of regulation seek to reduce the incentive and the ability of incumbent firms to prevent or hinder competitive entry. In some instances, regulation tries to skew entry conditions in favor of new competitors until a certain competitive balance has been achieved in the market.
These regulatory responses are controversial. They try to facilitate competitive entry and produce efficiency gains in the long run. However, they may also damage incumbents’ ability to operate efficiently and thus harm consumers. Experience shows that mandatory unbundling policies may reduce investment incentives for both incumbent operators and new entrants, and harm consumers, if the policies:
- Lead to poorly justified lease prices for unbundled facilities, or
- Persist longer than they need to.
Similarly, forcing the separation of different stages of operations within a vertically integrated incumbent can lead to significant losses of efficiency that may or may not be offset by gains to competitors. Those efficiency losses ultimately harm the public interest.
Ex ante regulation of this type undeniably has a role in facilitating competition by lowering entry barriers and making the market more contestable. However, heavy-handed or an overly persistent application of ex ante regulation may harm the public interest in the long run. To avoid this, competition policy should provide for a rapid transition to more ex post forms of regulation (or minimal regulation) once entry barriers are deemed to have been lowered “sufficiently”.