Definition

This expression refers to those expenditures (private or public) directed to purchase inputs that remain in the production process over relatively long periods of time (typically, until complete depreciation) and which are independent of the level of output.

The concept along the years

Traditionally, in economics the term “fixed investment” refers to outlays directed to the acquisition of tangible assets (i.e., physical capital, which is normally denoted by “K” in formal models). This is typically one of the two generic inputs (the other is labor) considered in the production function. In this category, it is usually included structures and equipment if our analysis is exclusively focused on firms (micro level) and also infrastructures if we refer to the gross fixed capital formation of a territory (macro level). The difference between gross and net values is depreciation. The term “investment” refers to the addition of new assets during a period of time: It is a “flow.” The overall quantity of this factor of production over total employment (stock of capital to labor ratio) as well as its quality (technology) are essential determinants of labor productivity and, then, of economic growth and social welfare. Therefore, fixed investment has a double influence on the economy: a short-term impact through the generation of additional demand and a long-term effect via the increase in potential output.

The essential meaning of the word “fixed” in this context is that it represents an amount of money directed to those components that remain in the production process over time, normally until they are amortized. That is, these inputs are not easily adaptable to the particular circumstances of the evolution of output and, as such, are considered independent on its volume. This is the reason why the concept of “fixed investment” is usually amplified to include other more specialized expenses directed to intangible assets such as high qualified labor, investment on R&D, the acquisition of particular knowledge about markets or consumers’ behavior, and advertising. In fact, there is a subtle distinction in the literature between “fixed costs” and “sunk costs” when referring to this kind of investment. The latter generally refer to outlays that are focused on very specific economic activities and, therefore, that are not susceptible of alternative uses. That is, “sunk costs” are fixed costs that usually occur only once and which are irreversible.

In sum, the cost of production of a firm is composed by those expenditures that are directly related to the level of production and which are called variable costs (typically, low qualified labor, energy, raw materials, etc.) and those related to fixed investment called fixed costs. In economic models, when modeling the cost function, the marginal cost of production is denoted by “c” (and it is multiplied by the variable reflecting the level of output) and the fixed cost of production is denoted by “F.” The relative weight of fixed costs compared to variable costs in the cost function of firms is generally considered as one of the key determinants of market structure. In fact, in the presence of fixed cost and constant marginal cost, the average (or unitary) cost of production is continuously decreasing as the level of output increases, a circumstance which provides advantage to larger firms over smaller ones thus leading to the appearance of imperfect competition. This occurs more likely in those sectors which require relatively higher amounts of fixed investment in the production process. These internal economies of scale are present in industries such as chemical, machinery, telecommunications, energy, vehicles, iron, and steel, etc.

The decision to invest in permanent assets (tangible or intangible) must be the result of an optimization problem, as it is the norm in economics. In this sense, there are two well-known analytical methods in order to choose the most appropriate project. The first one is the so-called net present value (NPV). The NPV of an investment is defined as the discounted value of the cash flows (profits plus amortizations) generated for the project over time. That is, the expected cash flow obtained from the investment in a given year in the future must be converted to present value using a discount factor. The summation of the corresponding amounts for the foreseeable number of years of life of the project has to be compared with the initial (fixed) investment. Those projects with positive NPV are susceptible to be accepted and the preferable will be the one with the highest NPV. The other method of evaluation of investment projects is the so-called internal rate of return (IRR). This is defined as the discount rate that makes the NPV of a project be equal to zero. Those projects with rates of return higher than the alternative in financial markets (typically, the interest rate of the riskless asset) are acceptable, and the best will be the one with the highest rate of return. This explains why when central banks increase the interest rates of reference in the economy, the expected outcome is a reduction of capital formation by firms (private investment): Under these circumstances the number of profitable projects decreases. When we analyze public projects of investment (essentially, infrastructures) the approach is basically the same and it is called cost-benefit analysis (CBA). The main difference with private projects is that public managers have to take into account social costs and benefits. In this case, the issue is how to assign the corresponding money value. As before, those projects with the discounted present value of profits higher than the discounted present value of costs are potentially eligible.

The aforementioned economic tools of analysis can be useful in the ambit of law and economics. The existence of required initial fixed investment in business activities which are the result of a contractual relationship between parties can be studied under this perspective. One example is the franchise contract (see García-Herrera and Llorca-Vivero (2010)) in which the franchisor imposes to the franchisee not only the initial fixed investment (with the proper characteristic of sunk cost) in order to maintain the standard quality of the network but also other relevant variables such as resale prices. In this context, contract duration is going to be an essential element of adjustment to the equilibrium (for a general analysis about duration contracts, see also Guriev and Kvassov (2005)). Therefore, in order to reach the equilibrium, a positive correlation should be observed between the amount of the compulsory fixed investment and the duration of the franchise contract conditioned to other variables which are specific to the industry or to the business nature (i.e., price-cost margins, experience).

The consideration of the existence of fixed costs in production has led to the development of new theories in some branches of economics. For instance, the traditional trade theory was only capable to explain interindustry trade, that is, international trade that takes place in different industries among countries. This occurs because countries differ on technology (Ricardo’s theory) or resources’ endowment (Heckscher-Ohlin theorem). Or, in other words, countries trade because they have comparative advantage in different types of goods (industries). However, the fact that the majority of trade among developed countries, which are similar in these two characteristics (technology and resources), is of an intraindustrial nature (trade of different varieties within the same industry) leads to the necessity of developing a new paradigm. The “new trade theory,” formulated by Krugman (1979, 1980), centers the analysis in the existence of internal scale economies and product differentiation. In a monopolistic competition model, in which international trade is a way of expansion in market size, consumers have access to a higher number of varieties in a given industry at a lower price. This benefits obtained from world trade occur because firms are able to exploit economies of scale by means of output’ expansion given the existence of fixed costs in production. That is to say, each country specializes in a reduced range of varieties. Obviously, the number of varieties in equilibrium is lower than the summation of existent varieties within countries in autarky but higher than the number of varieties consumers have at their disposal in the respective countries when no trade occurs.

More recently, the consideration of the existence of “sunk cost” as barrier to entry in international markets has led to further developments in modeling international trade. These “entry cost” are those required to profitable sales in foreign markets such as acquisition of knowledge about consumers’ tastes or regulations (technical barriers), advertising, and the establishment of distribution channels. The theoretical and empirical models considering these sunk entry cost are known as the “new-new trade theory.” This expression is normally used by reference to the influent Melitz (2003) article although some other authors previously emphasized the role of sunk cost in exporting as, for instance, Baldwin and Krugman (1989) or Roberts and Tybout (1997). Melitz (2003) notes, in a model with heterogeneous firms, than only the more productive ones are able to enter into export markets, giving an explanation to the observed pattern that just a small fraction of domestic firms become exporters, a characteristic which is common across countries. The reason is that the fixed investment necessary to enter into foreign markets acts as a minimum threshold to be surpassed. Only those firms with expected net profits from exporting greater than this threshold will become exporters. In this sense, a theoretical and empirical distinction is made between the extensive margin of trade (which makes reference to the number of exporters) and the intensive margin of trade (which focuses in the volume of exports of these exporters). This line of research has demonstrated (see, for instance, Dixit (1989)) that the existence of sunk cost (for entry or exit) generates hysteresis in exporting, that is, prior experience is a determinant factor for current participation in exports markets. However, it seems that these fixed investments that generate such sunk costs rapidly depreciate after firm’s entry and, therefore, are irrecoverable in the event of firm exit.

In a similar manner, irreversible fixed investment (sunk cost) has revealed as a strategic variable for firms’ competition in the recent industrial organization theory. John Sutton (1991), in a work which encapsulates previous research (i.e., Shaked and Sutton (1983, 1987)) obtains relevant conclusions about market structure making a distinction between exogenous and endogenous sunk cost. In this context, the acquisition of a single plant of minimum efficient scale is considered as an exogenous sunk cost for firms given that the achievement of scale economies is conditioned by the existing technology. Decision variables for firms as advertising and R&D outlays (among other possibilities) are endogenous sunk costs, whose effect is the increase in consumers’ willingness-to-pay (in Sutton’ words) for the firm’s product. The author demonstrates that, under the presence of endogenous sunk costs, the different industries will present a lower bound for market concentration, which is not affected by the increase in demand. This result is valid under very general assumptions about the nature of oligopoly models (number of products offered, type of price competition, etc.). This fact justifies why a high level of concentration persists in some industries and it contradicts the previous general belief in the sense that market concentration indefinitely declines as the size of the markets increases, leaving this outcome as a special case in which endogenous sunk costs are nil. In a similar manner, an incumbent firm can preempt entry of potential competitors by investing in “sunk costs” such as advertising. This action will reduce the expected profits of these firms avoiding their entrance.

Cross-References