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In: Economics

The company that you manage has invested $5 million in developing a new product, but the...

The company that you manage has invested $5 million in developing a new product, but the development is not quite finished. At a recent meeting, your salespeople report that the introduction of competing products has reduced the expected sales of your new product to $3 million. If it would cost $1 million to finish development and make the product, you   go ahead and do so. The most you should pay to complete development is

million.

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Expert Solution

In economics, the lessons about the decision making of an individual include that individuals face trade-offs, cost of an activity is the opportunity cost give up, individuals make rational decisions by comparing marginal benefit and marginal cost, and individual change behavior according to the incentives.

A company has invested $5 million for development of new product. The company came to know that other competing products in the market could reduce the expected sales by $3 million. Now, the company has to decide whether it should make the product by investing $1 million. In this case, the amount invested ($5 million) is sunk cost because it is invested irrespective of the completion of the development project. The company will lose $5 million if the development project is not complete. On the other hand, the company will lose $6 million ($5 million of sunk cost plus $1 million of additional investment) and gain $3 million if the development project is complete. Thus, the net loss with the completion of the development project is $3 million. Hence, the company will be better off by investing an additional $1 million because the loss will be reduced by $2 million.

The maximum amount the company should pay to complete the development project is $3 million. This is because if $3 million is invested to complete the development project then the company could lose $5 million (loss to quit development). But, if the future sales increases then the company could earn more profit.

Rahul Sunny answered 9 months ago
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