Costs and Cost Minimization

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CHAPTER COSTS AND COST MINIMIZATION7 7.1 COST CONCEPTS FOR APPLICATION 7.1 To Smelt or Not to Smelt? DECISION MAKING APPLICATION 7.2 The Costs of DRAM APPLICATION 7.3 What Sparky Didn’t Know (or Did He?) 7.2 THE COST-MINIMIZATION PROBLEM 7.3 C OMPARATIVE STATICS APPLICATION 7.4 Supertankers Are Big in Norway ANALYSIS OF THE APPLICATION 7.5 Automation and the Choice of Inputs COST-MINIMIZATION PROBLEM APPLICATION 7.6 Input Demand in Alabama 7.4 SHORT-RUN COST MINIMIZATION Appendix ADVANCED TOPICS IN COST MINIMIZATION

What’s Behind the Self-Service Revolution? In the last quarter of the twentieth century, self-service became a pervasive feature of certain parts of the American retail landscape.1 Customers have grown so used to pumping their own gasoline or withdrawing money from an ATM (automated teller machine) that it is hard to remember a time when those services were provided by human beings. But in recent years the pace of automation in retail and service businesses seems to have increased. In most large airports these days, you can

1This introduction draws from “More Consumers Reach Out to Touch the Screen,” New York Times (November 17, 2003), pp. A1 and A12. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 222

obtain your boarding pass at an automated check-in machine. Large retail chains such as Kroger and Home Depot have deployed machines that allow customers to scan, bag, and pay for their merchandise themselves. And fast-food restaurants, such as McDonald’s and Jack-in-the-Box, have begun to install automatic ordering machines that eliminate the need to order from a human being. Overall, 13,000 self-checkout systems were installed in U.S. retail establishments in 2003, double the number that had been in place in 2001. What has driven the growth of self-service machines in recent years? Experts believe that one factor is that as consumers have grown more comfortable with personal technologies such as lap- top computers, cell phones, and PDAs, they have become increasingly willing to place their faith in machines when they travel, shop, or purchase fast food. But another key reason is that improve- ments in technology have made it possible for firms to install self-service machines that allow consumers to perform functions such as scanning groceries or transmitting a food order just as fast and accurately as cashiers could, but at a fraction of the cost to the firm. In effect, retailers and other service firms are finding that they can lower their costs by substituting capital (e.g., self-checkout systems) for labor (e.g., cashiers). This chapter studies costs and cost minimization. In this chapter, we will introduce concepts that will help you think more clearly and systematically about what costs are and how they factor into the analysis of decisions, such as the one to adopt self-checkout systems. With the tools that we present in this chapter, we can better understand the nature of the trade-offs that retailers such as Kroger or fast-food restaurants such as McDonald’s face as they contemplate the appropriate degree to which they should automate their service operations.

CHAPTER PREVIEW In this chapter, you will • Learn about different concepts of costs that figure in firms’ decision making, including explicit versus implicit costs, opportunity cost, economic versus accounting costs, and sunk versus nonsunk costs. • Study firms’ cost-minimization problem in the long run, using the concept of isocost lines (the combinations of labor and capital that have the same total cost). • Explore comparative statics analysis of firms’ cost-minimization problem, seeing how changes in prices or in output affect the solution to the problem. • Study firms’ cost-minimization problem in the short run, including how to characterize costs, comparative statics of input demand, and analysis of cases where a firm has at least one fixed input and one or more variable inputs. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 223

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Managers are most experienced with cost presented as monetary expenses in an 7.1 income statement. Politicians and policy analysts are more familiar with costs as an COST expense item in a budget statement. Consumers think of costs as their monthly bills and other expenses. C ONCEPTS But economists use a broader concept of cost. To an economist, cost is the value FOR DECISION of sacrificed opportunities. What is the cost to you of devoting 20 hours every week to MAKING studying microeconomics? It is the value of whatever you would have done instead with that 20 hours (leisure activities, perhaps). What is the cost to an airline of using one of its planes in scheduled passenger service? In addition to the money the airline spends on items such as fuel, flight-crew salaries, maintenance, airport fees, and food and drinks for passengers, the cost of flying the plane also includes the income the airline sacrifices by not renting out its jet to other parties (e.g., another airline) that would be willing to lease it. What is the cost to repair an expressway in Chicago? Besides the money paid to hire construction workers, purchase materials, and rent equipment, it would also include the value of the time that drivers sacrifice as they sit immobilized in traffic jams. Viewed this way, costs are not necessarily synonymous with monetary outlays. When the airline flies the planes that it owns, it does pay for the fuel, flight-crew salaries, maintenance, and so forth. However, it does not spend money for the use of the airplane itself (i.e., it does not need to lease it from someone else). Still, in most cases, the airline incurs a cost when it uses the plane because it sacrifices the opportunity to lease that airplane to others who could use it. Because not all costs involve direct monetary outlays, economists distinguish between explicit costs and implicit costs. Explicit costs involve a direct monetary out- explicit costs Costs that lay, whereas implicit costs do not. For example, an airline’s expenditures on fuel and involve a direct monetary salaries are explicit costs, whereas the income it forgoes by not leasing its jets is an outlay. implicit cost. The sum total of the explicit costs and the implicit costs represents what implicit costs Costs that the airline sacrifices when it makes the decision to fly one of its planes on a particular do not involve outlays of route. cash.

OPPORTUNITY COST The economist’s notion that cost is the value of sacriﬁced opportunities is based on the concept of opportunity cost. To understand opportunity cost, consider a decision opportunity cost The maker, such as a business ﬁrm, that must choose among a set of mutually exclusive value of the next best alter- alternatives, each of which entails a particular monetary payoff. The opportunity cost native that is forgone when another alternative is chosen. of a particular alternative is the payoff associated with the best of the alternatives that are not chosen. The opportunity cost of an alternative includes all of the explicit and implicit costs associated with that alternative. To illustrate, suppose that you own and manage your own business and that you are contemplating whether you should continue to operate over the next year or go out of business. If you remain in business, you will need to spend $100,000 to hire the services of workers and $80,000 to purchase supplies; if you go out of business, you will not need to incur these expenses. In addition, the business will require 80 hours of your time every week. Your best alternative to managing your own business is to work the same number of hours in a corporation for an income of $75,000 per year. In this example, the opportunity cost of continuing in business over the next year is $255,000. This amount includes an explicit cost of $180,000—the required cash outlays for labor and materials; it also includes an implicit cost of besa44438_ch07.qxd 09/23/2004 08:37 PM Page 224

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$75,000—the income that you forgo by continuing to manage your own firm as opposed to choosing your best available alternative. The concept of opportunity cost is forward looking, in that it measures the value that the decision maker sacrifices at the time the decision is made and beyond. To illustrate this point, consider an automobile firm that has an inventory of sheet steel that it purchased for $1,000,000. It is planning to use the sheet steel to manufacture automobiles. As an alternative, it can resell the steel to other firms. Suppose that the price of sheet steel has gone up since the firm made its purchase, so if it resells its steel the firm would get $1,200,000. The opportunity cost of using the steel to produce automobiles is thus $1,200,000. In this illustration, opportunity cost differs from the original expense incurred by the firm. After reading this last example, students sometimes ask, “Why isn’t the opportunity cost of the steel $200,000: the difference between the market value of the steel ($1,200,000) and its original cost ($1,000,000)?” After all, the firm has already spent $1,000,000 to buy the steel. Why isn’t the opportunity cost the amount above and beyond that original cost ($200,000 in this example)? The way to answer this question is to remember that the notion of opportunity cost is forward looking, not backward looking. To assess opportunity cost we ask: “What does the decision maker give up at the time the decision is being made?” In this case, when the automobile company uses the steel to produce cars, it gives up more than just $200,000. It forecloses the opportunity to receive a payment of $1,200,000 from reselling the steel. The opportunity cost of $1,200,000 measures the full amount the firm sacrifices at the moment it makes the decision to use the steel to produce cars rather than to resell it in the open market. Opportunity Costs Depend on the Decision Being Made The forward-looking nature of opportunity costs implies that opportunity costs can change as time passes and circumstances change. To illustrate this point, let’s return to our example of the automobile firm that purchased $1,000,000 worth of sheet steel. When the firm first confronted the decision to “buy the steel” or “don’t buy the steel,” the relevant opportunity cost was the purchase price of $1,000,000. This is because the firm would save $1,000,000 if it did not buy the steel. But—moving ahead in time—once the firm purchases the steel and the market price of steel changes, the firm faces a different decision: “use the steel to produce cars” or “resell it in the open market.” The opportunity cost of using the steel is the $1,200,000 payment that the firm sacrifices by not selling the steel in the open market. Same steel, same firm, but different opportunity cost! The opportunity costs differ because there are different opportunity costs for different decisions under different circumstances. Opportunity Costs and Market Prices Note that the unifying feature of this example is that the relevant opportunity cost was, in both cases, the current market price of the sheet steel. This is no coincidence. From the firm’s perspective, the opportunity cost of using the productive services of an input is the current market price of the input. The opportunity cost of using the services of an input is what the firm’s owners would save or gain by not using those services. A firm can “not use” the services of an input in two ways. It can refrain from buying those services in the first place, in which case the firm saves an amount equal to the market price of the input. Or it can resell unused services of the input in the open market, in which case it gains an amount equal to the market price of the input. In both cases, the opportunity cost of the input services is the current market price of those services. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 225

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APPLICATION 7.1 2 To Smelt or Not to Smelt? to resell the electricity if market prices escalated. (The BPA offered this option in order to induce Kaiser and We have said that the opportunity cost of an alterna- other aluminum companies to sign long-term contracts tive is the payoff associated with the best of the alter- in the first place.) Thus, by using the electricity it pur- natives that are not chosen. Sometimes that payoff chased from the BPA to produce aluminum in its becomes so large that the optimal course of action is smelters (its intended purpose), Kaiser sacrificed the op- to choose the “best alternative.” Such was the case with portunity to resell that electricity in the open market. Kaiser Aluminum in December 2000. With the price of electricity having risen so sharply, the For many years, Kaiser Aluminum, one of the profit that Kaiser was forgoing by not reselling electric- world’s largest producers of aluminum, operated two ity was huge. And so in December 2000, Kaiser made aluminum smelters in the Pacific Northwest of the the decision to shut down its two aluminum smelters. United States, one near Spokane, Washington, and the Instead of using the electricity it was obligated to buy other near Tacoma, Washington. Aluminum smelters from the BPA at $23 per megawatt hour to manufacture are giant plants that are used to manufacture raw aluminum, Kaiser resold the electricity to the BPA at a aluminum ingots. The production of aluminum requires price of $550 per megawatt hour, which at the time was a substantial amount of electric power, and so one somewhat below the prevailing spot price of electricity. of the most important determinants of the cost of Kaiser wasn’t the only firm to pursue this strategy. producing aluminum is the price of electricity. Fall of 2000 and winter of 2001 were not only a time of In December 2000, Kaiser was purchasing electric- rising electricity prices; natural gas prices also soared ity at a price of about $23 per megawatt hour under a during this period. In response, Terra Industries, a Sioux long-term contract with the Bonneville Power Adminis- City, Iowa producer of fertilizer, closed six of its plants tration (BPA), the federal agency that produces electric- because it was more profitable to resell natural gas ity from dams along the Columbia River. Kaiser and the obtained under long-term contract at prevailing spot BPA had signed this contract in 1996 when the spot mar- market prices than to use it to produce fertilizer. Other ket price of electricity was low. (The spot market price firms in energy-intensive sectors of the economy fol- of electricity is what a buyer would pay if, instead of lowed similar strategies. buying electricity though a long-term contract, it pur- For its part, Kaiser did not reopen the smelters it chased electricity in the open market.) However, in late shut down in December 2000. Even though the market 2000 and early 2001, the spot market price of electric- price of electricity declined in the spring and summer ity in the Pacific Northwest skyrocketed. On some days of 2001, removing the factor responsible for Kaiser’s in December 2000 and January 2001, it averaged over shut-down decision, the market price of aluminum fell $1,000 per megawatt hour.3 to a 2-year low in 2001. As a result, Kaiser decided that So it seems that Kaiser had a great deal: Its contract it was uneconomical to reopen its two plants. In enabled it to buy electricity at rates far below the mar- December 2002, Kaiser announced that it would sell ket price. But the sharply rising electricity prices created its smelter near Tacoma, and in January 2003, it an- a sharply rising opportunity cost for Kaiser as long as it nounced plans to “mothball” its plant near Spokane, used that electricity to operate its aluminum plants, eliminating any hope that the plant would reopen because Kaiser’s contract with the BPA gave it the right anytime soon.4

2This example draws from “Plants Shut Down and Sell the Energy” Washington Post (December 21, 2000), and “Kaiser Will Mothball Mead Smelter,” Associated Press (January 14, 2003). 3The reason that the price of electricity in the Pacific Northwest rose so sharply in the fall of 2000 and winter of 2001 is bound up in events that were taking place in California’s electric power markets. The markets for electricity in the Pacific Northwest and California were interrelated, since California relied on imports of electricity generated by hydroelectric dams in the Pacific Northwest to satisfy part of its demand for electricity. Application 2.9 discusses the factors responsible for the California power crisis of 2000 and 2001. 4When a firm like Kaiser “mothballs” a closed plant, the firm moves it from a situation in which it keeps the plant on “standby” status (so that it can be restarted on relatively short notice), to a situation in which it is nearly completely de-manned and becomes extremely expensive to restart. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 226

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APPLICATION 7.2 5 The Costs of DRAM cost will equal the current spot market price, which represents what the firm could get if it resold its inventory DRAM stands for dynamic random access memory. of DRAM chips in the open market. This opportunity DRAM chips are silicon semiconductor integrated cost is a real one. It is not at all difficult for a firm to circuits used to create memory in personal computers. liquidate its inventory of DRAM chips, a phenomenon DRAM chips are produced by companies such as known as backflush. Intel, for example, was part of the Samsung, NEC, and Hitachi, and they are purchased by backflush in November 1995 when it liquidated a huge manufacturers of personal computers, such as Compaq inventory of chips that it had purchased in the expec- and Apple. tation of producing its own personal computers. Firms that buy memory chips typically do so at In mid-1996, with chip prices collapsing, DRAM prices set by contracts covering three to six months. For buyers (e.g., Compaq) that had overestimated demand example, a firm such as Compaq might contract to for Windows 95 and stocked up on higher-priced obtain chips from a DRAM supplier such as Hitachi at a DRAM chips found themselves facing an opportunity price of $25 per megabyte over a three-month period. cost for DRAM chips that was far lower than the histor- But there is also an active spot market for DRAM chips, ical cost they incurred to buy them in the first place.7 and prices in this market can fluctuate a lot. For exam- This created a situation in which the accounting costs ple, between December 1995 and January 1997, prices of of the DRAM chips were greater than the economic DRAM chips fell from over $35 per megabyte to just costs. Thus, from this example we see that accounting over $5 per megabyte.6 costs can sometimes be greater than economic costs. Because the spot market price fluctuates so much, In other words, just because accounting costs exclude the opportunity cost of using DRAM chips in production implicit costs, while economic costs include implicit will not necessarily equal the historical contract price costs, it does not follow that accounting costs are that a firm paid for its chips. Instead, that opportunity always less than economic costs.

ECONOMIC VERSUS ACCOUNTING COSTS Closely related to the distinction between explicit and implicit costs is the distinction economic costs The sum between economic costs and accounting costs. Economic costs are synonymous with of the firm’s explicit costs opportunity costs and, as such, are the sum of all decision-relevant explicit and implicit and implicit costs. costs. Accounting costs—the costs that would appear on accounting statements—are accounting costs The total explicit costs that have been incurred in the past. Accounting statements are designed of explicit costs that have to serve an audience outside the firm, such as lenders and equity investors, so account- been incurred in the past. ing costs must be objectively verifiable. That’s why accounting statements typically include historical expenses only—that is, explicit cash outlays already made (e.g., the amounts the firm actually spent on labor and materials in the past year). An accounting statement would not include implicit costs such as the opportunity costs associated

5This example draws from “The DRAM Industry,” a term paper prepared by E. Cappochi, B. Firsov, and L. Pachano, 1997 graduates at the Kellogg School of Management. 6Application 2.7 uses supply and demand analysis to explain why this happened. 7Based on this observation, you might be asking, “If the opportunity cost is the spot price, and the spot price is less than the contract price, why would a firm ever buy chips in advance under contract?” If PC makers had known for certain that the spot price of DRAM chips was going to fall, they would not have bought under contract at a higher price. But in reality these firms did not know for certain what the spot price would be three or six months from the time they signed their contracts. Indeed, an important reason for buying on contract is to eliminate the uncertainty about input prices that the firm would otherwise face if it always purchased in the spot market. In Chapter 15, we discuss reasons why risk reduction might be desirable. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 227

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with the use of the firm’s factories, because such costs are often hard to measure in an objectively verifiable way. For that reason, an accounting statement for an owner- operated small business would not include the opportunity cost of the owner’s time. And because accounting statements use historical costs, not current market prices, to compute costs, the costs on the profit-and-loss statement of the automobile firm that purchased that sheet steel would reflect the $1,000,000 purchase price of that steel, but it would not reflect the $1,200,000 opportunity cost that it incurs when the firm actually uses that steel to manufacture automobiles. In contrast, economic costs include all these decision-relevant costs. To an economist all decision-relevant costs (whether explicit or implicit) are opportunity costs and are therefore included as economic costs.

SUNK (UNAVOIDABLE) VERSUS NONSUNK (AVOIDABLE) COSTS To analyze costs we also need to distinguish between sunk and nonsunk costs. When assessing the costs of a decision, the decision maker should consider only those costs that the decision actually affects. Some costs have already been incurred and therefore cannot be avoided, no matter what decision is made. These are called sunk costs. By sunk costs Costs that have contrast, nonsunk costs are costs that will be incurred only if a particular decision is already been incurred and made and are thus avoided if the decision is not made (for this reason, nonsunk costs cannot be recovered. are also called avoidable costs). When evaluating alternative decisions, the decision nonsunk costs Costs that maker should ignore sunk costs and consider only nonsunk costs. Why? Consider the are incurred only if a particu- following example. lar decision is made. You pay $7.50 to go see a movie. Ten minutes into the movie, it is clear that the movie is awful. You face a choice: Should you leave or stay? The relevant cost of stay- ing is that you could more valuably spend your time doing just about anything else. The relevant cost of leaving is the enjoyment that you might forgo if the movie proves to be better than the first ten minutes suggest. The relevant cost of leaving does not include the $7.50 price of admission. That cost is sunk. No matter what you decide to do, you’ve already paid the admission fee, and its amount should be irrelevant to your decision to leave. The next example further illustrates the distinction between sunk costs and nonsunk costs. Consider a sporting goods firm that manufactures bowling balls. Let’s assume that a bowling ball factory costs $5 million to build and that, once it is built, the factory is so highly specialized that it has no alternative uses. Thus, if the sporting goods firm shuts the factory down and produces nothing, it will not “recover” any of the $5 million it spent to build the factory.

• In deciding whether to build the factory, the $5 million is a nonsunk cost. It is a cost the sporting goods firm incurs only if it builds the factory. At the time the decision is being considered, the decision maker can avoid spending the $5 million. • After the factory is built, the $5 million is a sunk cost. It is a cost the sporting goods firm incurs no matter what it later chooses to do with the factory, so this cost is unavoidable. When deciding whether to operate the factory or shut it down, the sporting goods firm therefore should ignore this cost.

This example illustrates an important point: Whether a cost is sunk or nonsunk depends on the decision that is being contemplated. To identify what costs are sunk and what costs are nonsunk in a particular decision, you should always ask which costs would besa44438_ch07.qxd 09/23/2004 08:37 PM Page 228

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APPLICATION 7.3 8 What Sparky Didn’t Know (or Did He?) average (ERA) was over 5.00, a poor performance by major league baseball standards of that period. Still, Sparky Anderson was one of the greatest managers in between 1993 and 1995, Sparky used Moore regularly. the history of major league baseball. He managed the He explained to reporters that the Tigers were paying Cincinnati Reds from 1970 to 1978 and the Detroit Tigers this guy a huge salary, so they had to pitch him regularly. from 1979 to 1995. His teams won the World Series This is a sunk cost fallacy. Sparky should have real- three different times (the Reds in 1975 and 1976 and the ized that the Tigers had to pay Moore whether he Tigers in 1984), and he is still the only manager in base- pitched or not. In deciding whether to let Moore pitch, ball history who has won the World Series in both the Moore’s salary was a sunk cost. It should not have National League and American League. In 2000, he was affected Sparky’s decisions. elected to the Baseball Hall of Fame. Why did Sparky do this? It’s hard to say. He was a Despite his greatness, though, late in his career, shrewd manager throughout his career who rarely Sparky Anderson apparently made a critical “sunk cost” made decisions that hurt his teams (like this one did). mistake in deciding who should pitch for the Detroit Maybe he was doing what he felt top Tiger manage- Tigers. In 1992, the Tigers signed a pitcher named Mike ment wanted him to do, reasoning that it would make Moore to a guaranteed contract of $5 million per year, them look bad to pay a pitcher who doesn’t play on a an enormous amount for a pitcher whose career until regular basis such a large salary. Or maybe he felt that then had been less than spectacular. No matter how Moore would eventually improve if he continued to poorly Moore performed, no matter how little he pitch regularly. (He didn’t.) But if he really did continue pitched, the Tigers would have to pay his $5 million an- to pitch Moore because of Moore’s salary, then there is nual salary. A bad decision? Probably. For the next three an important lesson here, even for those of you who seasons, Moore pitched very ineffectively. He lost more don’t aspire to be baseball managers. Don’t be like games than he won, and each season his earned run Sparky and let sunk costs influence your decisions.

change as a result of making one choice as opposed to another. These are the nonsunk costs. The costs that do not change no matter what choice we make are the sunk costs.

LEARNING-BY-DOING EXERCISE 7.1

S Using the Cost Concepts for a College Campus Business

D E Imagine that you have started a snack food delivery business on your college campus. Students send you orders for snacks, such as potato chips and candy bars, via the Internet. You shop at local grocery stores to fill these orders and then deliver the orders. To operate this business, you pay $500 a month to lease computer time from a local Web-hosting company to use their server to host and maintain your Web site. You also own a sports utility vehicle (SUV) that you use to make deliveries. Your monthly car payment is $300, and you pay $100 a month in insurance costs. Each order that you fill takes, on average, a half hour and consumes $0.50 worth of gasoline.9 When you fill an order, you pay the grocer for the merchandise. You then collect a payment, including a delivery fee, from the students to whom you sell. If you did not operate this business, you could work at the campus dining hall, earning $6 an hour. Right now, you

8This example draws from The Bill James Guide to Baseball Managers From 1870 to Today (New York: Scribner, 1997). 9For simplicity, let’s ignore other costs such as wear and tear on your vehicle. besa44438_ch07.qxd 09/23/2004 08:37 PM Page 229

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operate your business five days a week, Monday through Friday. On weekends, your business is idle, and you work in the campus dining hall. Problem (a) What are your explicit costs and what are your implicit costs? What are your accounting costs and what are your economic costs, and how would they differ? (b) Last week you purchased five large cases of Fritos for a customer who, as it turned out, did not accept delivery. You paid $100 for these cases. You have a deal with your grocers that they will pay you $0.25 for each dollar of returned merchandise. Just this week, you found a fraternity on campus that will buy the five cartons for $55 (and will pick them up from your apartment, relieving you of the need to deliver them to the frat house). What is the opportunity cost of filling this order (i.e. selling these cartons to the fraternity)? Should you sell the Fritos to the fraternity? (c) Suppose you are thinking of cutting back your operation from five days to four days a week. (You will not operate on Monday and instead will work in the campus dining hall.) What costs are nonsunk with respect to this decision? What costs are sunk? (d) Suppose you contemplate going out of business altogether. What costs are nonsunk with respect to this decision? What costs are sunk? Solution (a) Your explicit costs are those that involve direct monetary outlays. These include your car payment, insurance, leasing computer time, gasoline, and the money you pay grocers for the merchandise you deliver. Your main implicit cost is the opportunity cost of your time—$6 per hour. Your economic costs are the sum of these explicit and implicit costs. Your accounting costs would include all of the explicit costs but not the implicit opportunity cost of your time. Moreover, your accounting costs would be historical (e.g., the actual costs you incurred last year). Thus, if gasoline prices have gone down since last year, your current gasoline costs would not equal your historical accounting costs. (b) The opportunity cost of filling the order is $25. This is what you could have gotten for the Fritos if you had resold them to your grocer and thus represents what you sacrifice if you sell the Fritos to the fraternity instead. Because you can sell the Fritos at a price that exceeds this opportunity cost, you should fill the order. What, then, does the $75 difference between your $100 original cost and the $25 opportunity cost represent? It is the cost you incurred in trying to satisfy a customer who proved to be unreliable. It is a sunk cost of doing business. (c) Your nonsunk costs with respect to this decision are those costs that you will avoid if you make this decision. These include the cost of gasoline and the cost of purchased merchandise. (Of course, you also “avoid” receiving the revenue from delivering this merchandise.) In addition, though, you avoid one day of the implicit opportunity cost of your time (you no longer sacrifice the opportunity to work in the dining hall on Mondays). Your sunk costs are those that you cannot avoid by making this decision. Because you still need your SUV for deliveries, your car and insurance payments are sunk. Your leasing of computer time is also sunk, since you still need to maintain your Web site. (d) You certainly will avoid your merchandising costs and gasoline costs if you cease operations. These costs are thus nonsunk with respect to the shut-down decision. You also avoid the opportunity cost of your time, so this too is a nonsunk cost. And you avoid the cost of leasing computer time. Thus, while the computer leasing cost was sunk with respect to the besa44438_ch07.qxd 09/23/2004 08:37 PM Page 230

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decision to scale back operations by one day, it is nonsunk with respect to the decision to cease operations altogether. What about the costs of your SUV? Suppose you plan to get rid of it, which means that you can avoid your $100 a month insurance bill, so your insurance costs are nonsunk. But suppose that you customized the SUV by painting your logo on it. Because of this and because people are wary about buying used vehicles, you can recover only 30 percent of the cost you paid for it. This means that 70 percent of your car payment is sunk, while 30 percent is nonsunk.