Fixed costs matter even when the costs are sunk

Yet, there is considerable evidence that firms incorporate fixed costs in their pricing decisions (e.g., Govindarijian and Anthony, 1983, Shim and Sudit, 1995).

In this note, we show that firms can be right in doing so. The basic idea is as follows. Consider a firm for which a higher output today means more profits in the future, for instance because of switching costs. Consequently, the lifetime profit of the firm is maximized at a lower price than the one that maximizes the firm’s current profit. Suppose further that the firm is liquidity-constrained: it goes bankrupt if it incurs a loss during the current period. The firm is, now, hit by a fixed costs shock. If its costs increase to the point where the lifetime profit-maximizing price would lead to a loss, it is optimal for the firm to raise its price. This shifts profits from the future to the current period, and helps the firm to survive.

In contrast to the important and insightful literature started by Baumol (1971), our explanation also covers situations where fixed costs are sunk.

This research is important for pricing decisions by firms, allowing them to make more profits by knowing when to take fixed costs into account and how. In addition, it allows anti-trust authorities to assess market situations better, both in cases of expected cartels, as well as to understand why crippling fines may also cause prices to rise after the fine.