Question

Suppose that production of widgets requires capital and labor. The production function is constant returns to scale and capital investment is sunk. There are no other barrier to entry. Is the investment in sunk capital a barrier to entry? Explain. What will the market equilibrium be if there are many possible entrants?

Answer 1

Yes; this is a barrier if the entrant fails to succeed in the market.

Sunk costs are those costs which can’t be recovered although incurred earlier at lump-sum, such as the registration fee (lump-sum amount) of doing business. If this kind of costs is very high, firms require increasing returns to scale for increasing the net earnings early. But here the return is constant; it means the firm has to wait till the long-run for getting a substantial amount of earnings, which may not be possible always because the firm may collapse in between; in such case the sunk cost would be a total loss and it becomes a barrier to entry.

If there are many entrants, the market becomes perfectly competitive. The equilibrium condition of such market is the equality of price (P) and marginal cost (MC); (P = MC). Here the price of a product is fixed, based on the market demand and market supply. Both buyers and sellers have to accept that price. Since there are many numbers of firms, a single firm can’t influence on the price. So the firms become price taker.