Sunk Costs and Risk-Based Barriers to Entry

Abstract

In merger analysis and other antitrust settings, risk is often cited as a potential barrier to entry. But there is little consensus as to the kinds of risk that matter- systematic versus non-systematic and industry-wide versus firm-specific - and the mechanisms through which they affect entry. I show how and to what extent different kinds of risk magnify the deterrent effect of exogenous sunk costs of entry, and thereby affect industry dynamics, concentration, and equilibrium market prices. To do this, I develop a measure of the full, i.e., risk-adjusted, sunk cost of entry. I show that for reasonable parameter values, the full sunk cost is far larger than the direct measure of sunk cost typically used to analyze markets.

Keywords: entry barriers, sunk costs, investment decisions, risk, market power, antitrust

JEL Classification: L40, L10, D43