Key points

  • Looked at from a short-run perspective, a firm’s total costs can be divided into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing.
  • Fixed costs are sunk costs—because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing.
  • Variable costs typically show diminishing marginal returns, so the marginal cost of producing higher levels of output rises.
  • Total cost is the sum of fixed and variable costs of production.

The structure of costs in the short run

The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.
However, the cost structure of all firms can be broken down into some common underlying patterns. When a firm looks at its total cost of production in the short run, a useful starting point is to divide total cost into two categories: fixed costs that cannot be changed in the short run and variable costs that can be changed in the short run.

Fixed and variable costs

Fixed costs are expenditures that do not change based on the level of production, at least not in the short term. Whether you produce a lot or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease runs out.
Fixed costs can take many other forms. For example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even advertising to popularize a brand name are all fixed costs. The level of fixed costs varies according to the specific line of business. Manufacturing computer chips, for instance, requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs, on the other hand, are incurred in the act of producing—the more you produce, the greater the variable cost. Labor is treated as a variable cost since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs also include raw materials.
As a concrete example of fixed and variable costs, we'll imagine a barber shop called The Clip Joint. The table below shows the data for the barber shop's output and costs. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example are $80 per barber each day.
The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. These numbers are calculated by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost 2, times, dollar sign, 80, equals, dollar sign, 160.
Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. So, for example, with two barbers the total cost is dollar sign, 160, plus, dollar sign, 160, equals, dollar sign, 320.
Output and total costs
Labor Quantity Fixed cost Variable cost Total cost
1 16 $160 $80 $240
2 40 $160 $160 $320
3 60 $160 $240 $400
4 72 $160 $320 $480
5 80 $160 $400 $560
6 84 $160 $480 $640
7 82 $160 $560 $720
Next, we'll use the graph below to examine the relationship between the quantity of output being produced and the cost of producing that output. Fixed costs are always shown as the vertical intercept of the total cost curve; they are the costs incurred when output is zero, so there are no variable costs.
You can see in the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This phenomenon is caused by diminishing marginal returns.
As the number of barbers increases from zero to one in the table, output increases from zero to 16 for a marginal gain of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal gain in output diminishes as each additional barber is added. For example, as the number of barbers rises from two to three, the marginal output gain is only 20; and as the number rises from three to four, the marginal gain is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything—say hello to people entering, answer the phone, cut hair, sweep up, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks and allows a greater division of labor and specialization. The result can be greater increasing marginal returns. However, as other barbers are added, the advantage of each additional barber is less since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did.
This is the pattern of diminishing marginal returns. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as shown in the last row of the table where quantity has decreased from 84 to 82 despite the addition of another barber.
This pattern of diminishing marginal returns is common in production. It occurs because, at a given level of fixed costs, each additional input contributes less and less to overall production.

Summary

  • Looked at from a short-run perspective, a firm’s total costs can be divided into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing.
  • Fixed costs are sunk costs—because they are in the past and cannot be altered, they should play no role in economic decisions about future production or pricing.
  • Variable costs typically show diminishing marginal returns, so the marginal cost of producing higher levels of output rises.
  • Total cost is the sum of fixed and variable costs of production.