Question

Andrew has decided to open an online store that sells home and garden products. After searching around, he chooses the software company Initech to provide the software for his website since their product required the least amount of specialized investments for him to use it. They agreed upon price of $5,000. To use Initech’s software, Andrew makes $2,500 in sunk capital investments and spends 55 hours learning how to use Initech’s software, which is very different from other software packages. Both Andrew and Initech view Andrew’s time as worth $22 per hour and Initech is fully aware of the investments Andrew must make to use their product. After Andrew’s investments were made, Initech came to Andrew and asked for more money.

What do you think is the new price Initech requested Andrew to pay?

Answer 1

The company initially quoted a price of $5,000

Andrew made sunk investments of $2,500

Andrew spent 55 hours worth (55 x 22) = $1,210

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Now, the company knows that Andrew has already spent so much of time and money.

However, sunk costs should not be included in marginal decision making. Even if the company attempts to charge a price inclusive of sunk costs, Andrew will simply decline. These costs are not recoverable, and Andrew will not attempt to recover them in any case.

However, Andrew will be concerned about the 55 hours he has spent.

Thus, the company can charge 5000 + 1210 = $6,210 for the software.

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It is quite likely that Andrew will pay $6,210, due to the opportunity cost of the time invested. However, it is unlikely that Andrew will consider the value of the sunk costs, and the company should not attempt to charge such a high price.