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Industrial Network Dynamics & the Role of Sunk Costs January 2002 , 1 st draft

Although the notion of costs is a major mechanism in economic theory explaining the industrial organization, costs associated with various forms of inter-firm relationships have been largely neglected in the literature. This paper deals with the notion of sunk costs related to networks of inter-firm relationships with a focus on the dynamics of the network structures. Two perspectives of sunk costs will be developed. First, the impact of sunk costs on inter-firm relationships here referred to as 'relation specific sunk costs'. Second, the role of sunk costs in the processes of specialization and division of labor referred to as 'industry specific sunk costs'. The first perspective aims to show that costs sunk in a relationship provide a fundamental mechanism for network relationships and constitute a basic condition for trust, stability, reduction of opportunism, and reduction of cognitive distances. The level of costs sunk in a relationship, although matter of subjective judgement, function as the " glue " of networks. At the same time, the level of sunk costs impedes the dynamics of network relationships since it becomes a threshold for change. The second perspective aims to show that the dynamics of network relationships are impeded by costs that have to be sunk when entering new activities or sunk costs leading to exit costs when terminating current activities. While the first perspective discuss changes of relationships without change in the division of labor, the second perspective stress the impact of sunk costs when change of division of labor occurs. Of course, both situations may occur concurrently and cause similar effects on the dynamics of the networks.