Question

1. Provide 3 examples of sunken costs.

2. Explain how American farmers have utilized the concept of economies of scale to increase profits.

Answer 1

1. A sunk cost refers to money that has already been spent and which cannot be recovered. In business, the axiom that one has to "spend money to make money" is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.

Examples of sunken costs

• Advertising expenditure: If you advertise a new product, that money is gone and cannot be retrieved.
• Research into a new product: If the product doesn't work out, you are left with nothing you can sell on.
• Labor costs: If a firm sets up a new business, it will need to employ people to work and manage, these costs cannot be recovered.

2. Economies of scale refer to the cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the inverse relationship between per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output.

Economies of scale relates to structural change in agriculture. Over time, industries adapt to meet changes in technology, consumer preferences, and world conditions. Being able to predict and understand such changes reduces uncertainty for individual firms, mitigates stress for consumers, allows policy makers to design programs that direct change towards desired ends, and helps investors to make wiser decisions in resource allocation.

Farmers are able to spread more production over the same level of fixed expenses thus creating economies of scale. Economies of scale also occur when a farm is able to obtain volume discounts for inputs such as seed or fertilizer.

In many cases the farmer has stepped onto the technology treadmill. They get bigger equipment so they can farm more acres. As they farm more acres they have to adopt techniques that increase their costs but also lower their profit margins. As the farmers' profit margins tighten they need to have more acres to generate an adequate income. With more acres they need bigger equipment so they can farm more acres.