Unit 3 Micro: Fixed and Variable Costs

Why is the distinction between fixed costs and variable costs not always clear?

A distinction between fixed and variable costs is made in the short run production time period. The short run is a time period where at least one factor of production is in fixed supply. We usually assume that the quantity of capital inputs is fixed and that production can be altered through changing variable inputs such as labour, raw materials and energy.

Fixed costs do not vary directly with the level of output. Examples include the rental costs of buildings; the costs of 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 to age) and also the costs of business insurance. An increase in fixed costs has no effect on the variable costs of production, it has no bearing on marginal costs

Basically any business with huge supply capacity will have high fixed costs; an 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.

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.

The distinction between fixed and variable costs is not always clear because many costs for a business appear to be overheads but they are affected in part by the short-term level of output (production). Business costs such as vehicles, computer systems, and buildings will depreciate to a degree even if not used and so it is not always clear whether they are fixed or variable or have an element of both.

Also the time periods used differ from one industry to another, for example, the short-run for the electricity generation industry or telecommunications differs from local sandwich bars. If you are starting out in business with a new venture selling sandwiches and coffees to office workers, how long is your short run? And how long is your long run? The long run could be as short as a few days – enough time to lease a new van and a sandwich-making machine!

Changes in production technology are causing these artificial time periods used in the theory of the firm to become less relevant - for example the development of printing on demand in the publishing industry and the emergence of 3D printing. Additive manufacturing or 3D printing is an emerging technology that takes product design data which provides a geometric representation of a product such as a pen and that data is then sent over to a machine that allows products to be manufactured ‘on the spot’ typically using additive materials in liquid or powder format.

Read: Will a new manufacturing technology change the world?