Sunk Costs, Entry Deterrence and Financial Constraints

Posted: 22 Mar 2010

See all articles by Stefan Arping

Stefan Arping

University of Amsterdam Business School; Tinbergen Institute

Khaled Diaw

Tilburg University - Center for Economic Research (CentER)

Date Written: 2008

Abstract

This paper studies how sunk costs affect a financially constrained incumbent's ability to deter entry into its market. Sunk costs make it less attractive to the incumbent to accommodate entry by liquidating assets in place and exiting the market. This may render entry by a prospective rival unprofitable, and thereby facilitate entry deterrence. However, sunk costs also make it harder for the incumbent to pledge valuable collateral to outside investors. To make up for the poor collateral value, the incumbent will have to give stronger liquidation rights to its lenders. Consequently, a larger fraction of the incumbent's assets will be liquidated in the event of a liquidity default. This potentially creates room for profitable entry. The overall effect of sunk costs on the incumbent's ability to deter entry into its market is thus ambiguous.

Keywords: Sunk Costs, Irreversible Investment, Entry Deterrence, Financial Constraints

JEL Classification: G2, G3, L1

Suggested Citation

Arping, Stefan and Diaw, Khaled, Sunk Costs, Entry Deterrence and Financial Constraints (2008). International Journal of Industrial Organization, Vol. 26, No. 2, 2008, Available at SSRN: https://ssrn.com/abstract=1553770

Stefan Arping (Contact Author)

University of Amsterdam Business School ( email )

Roetersstraat 18
Amsterdam, 1018WB
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Khaled Diaw

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 0 13 466 3339 (Phone)
+31 0 13 466 8001 (Fax)

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