Question

An organization wishing to operate a hospital must pay $100,000 for a license to the state government of Illinois. Once the license is granted, the owner of the license can sell to others at any price. However, the owner of the license can get back $80,000 as a refund from the state of Illinois at any time if the owner of the license decides not to use it.

You paid $100,000 for this 2 years license ago and currently operate a small hospital. You are thinking about getting out of the hospital business. You therefore spend $10,000 on advertising hoping to get $88,000 for the license. (Note that you have not sold the license yet for $88,000).

1. What is your sunk costs? Explain.
2. Was your decision to spend $10,000 on advertising a smart thing to do? Use only the information above.  Explain why or why not.
3. After a long wait, suppose you get an offer of $85,000 for the permit. Should you take the offer of $85,000? Explain why or why not.

Answer 1

The sunk cost is a cost which cannot be recovered. Here the sunk cost of equal to the cost of licence which cannot be recovered, which is equal to,

= cost of license - refund for the license

= $100,000 - $80,000

= $20,000

So sunk cost here is equal to $20,000.

Because You notice that you the license for $100,000 from the government of Illinois but you can only get a refund of $80,000 if you decide to not to use it. The difference between cost and refund is now sunk cost and can't be recovered.

Now the decision spending $10,000 on advertisement in order to sell the license for $88,000 in not a smart thing to do at all. Since even if you succeed to find a buyer by spending $10,000 on advertisement who will pay you $88,000. You are only going to get a net amount of,

= selling price - cost

=$88,000 - $10,000

= $78,000

So the net amount that you're going to get is only $78,000 but notice that you have an option to return the license to the government of Illinois and get a refund of $80,000 which is higher than $78,000. So spending $10, 000 on advertisement is not a smart thing to do.

Now if you get a offer of $85,000 after a long time, then you should definitely accept the offer because if you don't accept the offer then you have a option of getting refund of $80,000 from the government of Illinois which is less than the amount of money you are getting under the offer. So you should accept the offer of $85,000 since accepting the offer will give you an extra amount of,

= amount under offer - amount under refund

= $85,000 - $80,000

= $5,000.

So by accepting the offer you can get an extra amount of $5,000, henge you should accept the offer.