The Intuition Behind Sutton's Theory of Endogenous Sunk Costs

To explain why many manufacturing industries have remained highly concentrated, John Sutton has developed a new theory of endogenous sunk costs which predicts that industries with significant endogenous sunk costs will have a lower bound on concentration even as industry demand increases. Endogenous sunk costs are fixed costs that firms can choose to invest in, which affect the price-cost margin of a firm. Any optional fixed investments in quality, advertising, and cost-reducing plant, that allow the firm to raise its price or lower its variable costs, qualify as endogenous sunk costs. This paper cuts through the mathematical complexity of the model and examines the intuition behind the theory, to provide a better understanding of how and when the theory of endogenous sunk costs can be applied, and its limitations. How the incentive for firms to invest in endogenous sunk costs increases as the market expands, and how this can limit the number of firms that can profitably remain in the market, is discussed. The paper examines the key conditions required for this effect, and shows how the same basic results can be obtained even if some of Sutton's assumptions are relaxed. It also examines the reasons for the model's unusual result that in some circumstances, a market expansion can actually induce a reduction in the number of firms, contrary to the usual expectation in industrial organization theory. A proof is provided of the proposition that concentration is bounded below for the Cournot model. The paper then discusses how endogenous sunk costs are likely to have a significant impact on industrial development in ways that Sutton did not discuss, for example when firms have a choice of variable cost-reducing investments.