Saturday, 28 June 2014

A stadium as a firm

When checking out past messages on Offsetting Behaviour I came across one I had missed when it was posted. Eric Crampton commented on the idea that Dunedin's Forsyth Barr Stadium could be mothballed. Eric noted that
I really don't know whether mothballing helps: it depends what portion of the ongoing losses are sunk for the Council and what part are operational losses that could be stemmed by shutting down.
The issue here is whether or not keeping the stadium running generates quasi-rents that can be used to pay at least part of any sunk costs.

Costs in the short-run are either avoidable or sunk (unavoidable or nonrecoverable). Avoidable costs are those which do not have to be paid if the firm shuts down. Sunk costs, on the other hand, have to be paid not matter what the level of production, including zero output. Thus it is better to stay in business if total revenues exceed avoidable costs. This implies that sunk costs are irrelevant to the shutdown decision.

The difference between total revenues and avoidable costs in the short-run equals the firm's quasi-rents. Quasi-rents measure the benefit to the firm of staying in business. Quasi-rents provide a contribution towards the firm’s sunk costs.

So the question for the Dunedin City Council is, Does the stadium generate quasi-rents? If yes then it should stay in business, at least in the short-run. Over the long term all costs are avoidable and thus the decision becomes does the stadium produce economic profit, that is, Are revenues greater than total costs? Or, to put it another way, Are the quasi-rents generated greater than its sunk costs?

Now here the stadium could have a problem. Given the nature of the assets involved, the stadium itself, the sunk costs could be very large. Interest payments, for example, on any loans taken out to finance the stadium could be large and unavoidable, in the short-run. If the council closes the stadium it could sell off the land the stadium is built on, the stadium itself won't be worth much given it can't generate at profit, and recover some of its sunk costs this way. But how much is the question. Hopefully the land is valuable for some other purpose, housing for example.

Perhaps the only positive to come from the Dunedin experience is as a warning to all other councils around the country of the dangers of building a stadium. Are you taking note Christchurch?