Unit 3 Micro: Fixed and Variable Costs

In the short run, because at least one factor of production is fixed, output can be increased by adding more variable factors. We make a distinction in the short run between fixed and variable costs.

In the short run, because at least one factor of production is fixed, output can be increased by adding more variable factors.

Fixed costs

1/ Fixed costs do not vary directly with the level of output

2/ Examples include the rental costs of buildings; the costs of leasing or purchasing capital equipment such as plant and machinery; the annual business rate charged by local authorities; the costs of employing full-time contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.

Basically any business with significant capacity will have high fixed costs; perhaps the classic example is an airline with a large number of routes, or a vehicle manufacturer that spends millions of pounds building a new factory and installing expensive and bulky capital equipment.

Fixed costs are the overhead costs of a business.

Key points:

* Total fixed costs (TFC) (these remain constant as output increases)
* Average fixed cost (AFC) = total fixed costs divided by output
* Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production.
* In industries where the ratio of fixed to variable costs is high, there is scope for a business to exploit lower fixed costs per unit if it can produce at a big enough size.

Consider the Sony PS3 or the iPhone4 where the fixed costs of developing the product are enormous, but these costs can be divided by millions of individual units sold across the world. By some estimates, Call of Duty and Modern Warfare 2 both cost between $40 million to $50 million to produce. Successful product launches and huge volume sales can make a huge difference to the average total costs of production.

Please note! A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs!

Variable Costs

Variable costs are costs that vary directly with output – when output is zero, variable costs will be zero but as production increases, variable cost will rise.

Examples of variable costs include the costs of raw materials and components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear.

* Average variable cost (AVC) = total variable costs (TVC) /output (Q)
* Average Total Cost (ATC or AC)
* Average total cost is the cost per unit produced
* Average total cost (ATC) = total cost (TC) / output (Q)

Marginal Cost

* Marginal cost is the change in total costs from increasing output by one extra unit.
* The marginal cost of supplying extra units of output is linked with the marginal productivity of labour.
* The law of diminishing returns implies that marginal cost will rise as output increases.
* Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases.

Short run cost table - an example

In our example, average cost per unit is minimised at a range of output - 350 and 400 units

Thereafter, because the marginal cost of production exceeds the previous average, so average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).

An example of fixed and variable costs in equation format

If for example, the short-run total costs of a firm are given by the formula

SRTC = $(10 000 + 5X²) where X is the level of output.

· The firm’s total fixed costs are $10,000

· The firm’s average fixed costs are $10,000 / X

· If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500