Sealed Bids, Sunk Costs, and the Process of Competition

Abstract

How do firms recover precontract costs? For example, suppose 10 firms compete in a sealed-bid auction for the right to explore and develop an offshore oil field. Each spends $500,000 to estimate the value of the field and to prepare its bid. Suppose this investigation reveals that the tract is worth approximately $20 million. If sunk costs do not matter, competition dictates that the winner must bid $20 million, but if the winner is to recover its prebid costs the maximum offer can be only $19.5 million. Furthermore, long-run industry equilibrium considerations suggest that the highest bid will be only $15 million ($20 million minus the total bid preparation costs of $5 million). If competition forces firms to charge marginal cost, why do firms ever invest in resources which become sunk? In some industries, inframarginal rents can be used to recover these costs. However, the example above, as well as many others, involves an all-or-none deci-