Question

An organization wishing to operate a hospital must pay $100,000 for a license to the state government of Illinois. Once the license is granted, the owner of the license can sell to others at any price. However,the owner of the license can get back $80,000 as a refund from the state of Illinois  at any time if the owner of the license decides not to use it.

You paid $100,000 for this 2 years license ago and currently operate a small hospital. You are thinking about getting out of the hospital business. You therefore spend $10,000 on advertising hoping to get $88,000 for the license. (Note that you have not sold the license yet for $88,000).

1. What is your sunk costs? Explain.

2. Was your decision to spend $10,000 on advertising a smart thing to do? Use only the information above.  Explain why or why not.

After a long wait, suppose you get an offer of $85,000 for the permit.

3. Should you take the offer of $85,000? Explain why or why not.

Answer 1

1) Sunk cost are those fixed cost that can't be recovered. For example ,if firm couldn't sell license after it bought.,so 100,000 would be the sunk cost.

Because you can only recover 80,000 of the license fee. So 20,000 is sunk cost ,which u can't recover and also the advertising cost =10,000

Total sunk cost=30,000

2)No, because even he can get 88,000 for permit.

But to get additional 8000, he spend additional 10,000.

Which result in additional loss of 2000.

So now, actually he will get 78,000 for license ( if he can get 88,000 for license)

3)Yes ,As time passes,value of permit will decrease more . So if he didn't accept 85,000, so later he will get lesser amount of permit .