Remember my productivity experiment?
The one where I kept adding more workers, my variable resource, but kept all other resources
fixed?
Well, if some of my resources are fixed, then there is a component of my cost that’s fixed,
and if I have resources that are variable, then I’ll have costs that are variable.
A fixed cost will be unchanging, no matter how much output is produced, since the amount
of that resource is not changing.
A variable cost will increase as the output increases, since I'll be using more that resource;
the variable cost will decrease as output decreases, since I'll be using less of that
resource.
OK, think about this: What if I decide I want to start selling puppies to supplement my
income.
Consider first the resources that I would need to have to even start my business; the
resources that will be necessary, no matter how much output I produce.
These will be my fixed resources.
Well, first of all, it would probably be a good idea to have two adult dogs, a male and
a female.
Without this resource.
I can't even consider producing any puppies.
What else will I have to have, to even attempt to produce?
What about… food?
Vet care?
Kennel space for the adults?
Then there are also resources like registration and advertising.
Resources that will change with the number of puppies that I produce are my variable
resources.
These would include food, vet care, and kennel space for your puppies.
The more you produce, the more of these resources you'll need.
Your fixed costs, then, are the cost of the fixed resources -- these are my overhead costs
that must be paid to even consider the business, even if I'm unsuccessful and produce zero
output.
The variable costs will change as I use more or less of the resources, corresponding to
the number of puppies I produce.
For the moment, let me just attach some costs to the fixed resources.
When I bought my first dogs, many years ago, the male was $350, and the female was $400.
This is the dog world’s version of gender bias, I suppose; demand for females is typically
higher, so the price is higher.
Food for the adults for a year is about $300; if you're lucky, and all the dogs need are
basic shots, vet care is also around $300 per year.
I happen to have a really big yard, so I don't have to pay for kennel space and dog runs.
Let's say the AKC registration per litter is $100, and that you can run an ad for $50.
In the end, the fixed, or overhead, costs total $1500.
Let me ask you another question: assuming that I could perfectly control the level of
output that I produce -- not so realistic for puppies.
I know, but it is true for most other forms of output -- what happens if I produce only
one puppy?
I mean, that poor little puppy has to bear the entire weight of the $1500 in overhead,
or fixed costs.
Even ignoring the variable costs, I would have to charge $1500 just to break even for
that puppy.
What if I could produce two puppies?
Two puppies means $750 of fixed cost for each puppy.
What about three puppies, or four, or five, or ten?
The cost per puppy -- that is, the average fixed cost -- gets more and more attractive.
So from a fixed cost per unit perspective, the more the better.
But as I increase my output, what's happening to my variable costs?
Well, think once again to the puppy example: large litters, that is, lots of puppies, cost
more in food, vet care, etcetera, but there are also increased health risks to the mother
and the puppies.
With a large litter, some puppies may be stillborn, and some are weak, requiring a lot of additional
time and attention.
This increases not only direct costs, but also opportunity cost, as more time spent
tending to the weak, sick puppies takes away from my time at my regular job.
Variable costs not only increase with the number of puppies, they rapidly increase,
skyrocketing at higher levels of output.
As a business owner, your objective is to maximize profit, which can be achieved in
part by keeping costs low.
As a puppy producer, what do I do?
If I produce a little output, variable costs are lower, but the per unit fixed costs are
very high.
If I produce a lot of output, I keep fixed cost per unit down, but variable costs are
very high.
As we’ll soon see, the ideal amount of production will typically be somewhere in the middle
ground.
NEXT TIME: Cost Curves
TRANSCRIPT0 (MICRO) EPISODE 22: FIXED AND VARIABLE COSTS