Sunk costs and the speed of market selection

Abstract

This paper studies the influence of sunk costs on industry evolution using the stylized pure selection model developed by Metcalfe. It is shown that sunk costs influence industry dynamics by reducing the speed of the replicator dynamics of competitive selection. Based on the theoretical model, we argue that sunk costs should lead to a reduction of market share reallocation dynamics and a larger share of stable firms. We validate these predictions empirically, finding that higher-sunk-cost industries have a larger share of stable firms and display lower market share dynamics. The result has practical implications for the interpretation of productivity decompositions.