Sunk costs, entry deterrence, and financial constraints

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. (C) 2007 Elsevier B.V. All rights reserved.