Explaining Fixed and Variable Costs of Production

This study note and video provides a short introduction to fixed and variable costs for businesses in the short run

Key Terms

Average fixed cost: Fixed cost per unit AFC= TC/Q

Average total cost: AC = cost per unit = TC/Q

Average variable cost: Variable cost per unit; AVC = TVC/Q

Diminishing marginal productivity: Falling MP as more units of a variable factor are added to a fixed factor

Long run production: Time period where all factor inputs are variable

Marginal cost: MC is change in total cost from supplying one extra unit

Short run production: Time period when at least one factor input is fixed

Sunk cost: A cost that cannot be recovered in a business closes down or leaves an industry

Total cost: TC = total fixed cost + total variable cost

Total fixed cost: Costs that do not depend on the level of output in the short run

Total variable cost: Variable costs are costs that vary directly with the level of output

Examples of rises in fixed costs

Here are four examples of changes in fixed costs for businesses in the UK:

1. Rent and lease costs - Rent and lease costs are a common fixed cost for businesses. Changes in rental or lease rates can have a significant impact on a business's fixed costs. For example, if a business has to relocate to a larger premises or if the landlord increases the rent, the fixed costs will increase.
2. Equipment and machinery - Businesses that rely on equipment and machinery to operate may face changes in fixed costs if they need to purchase or repair equipment. For example, a manufacturing company may need to replace a broken machine, which would increase its fixed costs.
3. Insurance - Many businesses have insurance policies to protect against risks such as property damage, liability claims or business interruption. The cost of these insurance policies can be a fixed cost. For example, if a business's insurance premiums increase due to an increase in claims or changes in regulations, its fixed costs will increase.
4. Salaries and benefits - Salaries and benefits for employees are often fixed costs for businesses. For example, if a business decides to increase the salaries of its employees or offer new benefits such as health insurance or retirement plans, its fixed costs will increase. Similarly, if a business reduces its workforce, its fixed costs will decrease.