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Volume 35, Number 4, April 2018

Answers

The economics of patents

Jon Guest
This resource provides answers to the questions set in the article on patents, on pp. 7–9 of the
April 2018 issue of ECONOMIC REVIEW.

Question 1
What are sunk costs? Use some examples to explain your answer.

Sunk costs are costs that cannot be recouped no matter what decision is made by the consumer or
the firm. For example, a firm may have previously purchased a piece of machinery that is highly
specialised and tailored to its own production process. If this machinery is of no value to any other
firms and has no scrap value, the opportunity cost of using it is zero — it is a sunk cost. Other
examples include expenditure on research and development to develop a new product or complying
with government regulation. Once these costs have been incurred they can never be recouped.

Question 2
Explain how the existence of sunk costs can create a barrier to entry.

There is always an element of risk whenever a firm is thinking of entering an industry. It is difficult to
forecast costs and future demand accurately and there is no guarantee these forecasts will prove to
be correct. For example:

 There could be an unanticipated fall in demand for the product caused by a negative shock
such as a recession.
 The technology used by the entrant might quickly become obsolete, especially if it is entering
an industry with high levels of innovation.

 The established firm may respond far more aggressively than the new entrant anticipated,
leaving it unable to make any supernormal profit.

The latter risk matters more when the firm has to incur large sunk costs to enter the market. When
these costs are high the firm stands to lose more if things go wrong. If, however, investments generate
similar returns in alternative uses, then the exit costs for the firm are relatively low. If things go wrong,
it will not lose very much. This encourages the firm to take the risk of entering the market in the first
place.

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Question 3
Discuss how a ‘pay for delay’ deal can be in both the interests of a patent holder and a generic
competitor.
If the payment made by the patent holder is (a) greater than the profit anticipated by the generic
competitor from entry into the market and (b) less than the extra profit the patent holder earns from
maintaining its monopoly position then it is in the interests of both parties.

This resource is part of ECONOMIC REVIEW, a magazine written for A-level students by subject experts.
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