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Variable and Fixed Costs

February 3, 2012

Marginal cost is difference between producing (n) units and (n+1) units. Variable cost is additional cost of producing more right now, compared to producing more in the long run.

For example, a store might remain open for 24 hours, even if the late night hours are not profitable relative to their total costs. Given that they already pay for the building and rent, and need to do some late night cleaning, the additional variable cost to hiring a late night cashier is small, and so remaining open late at night has low variable costs. Similarly, one could imagine a factory optimized for a certain level of production. If a firm wants to produce more, they may have to hire more mechanics to modify the machinery, or have their workers work overtime. The marginal cost of additional production might actually be lower – in the long run, they could hire more workers and build more machines, but because the firm is set up a certain way, the variable costs are high.

All economic decisions take place at a moment in time. At that moment, everything that has come before is unchangable. Imagining that one can change the past causes the sunk cost fallacy. Economic actors should only consider the possible alternatives which are feasible when deciding what to do. Variable costs still impact behavior, however, because when someone makes a decision whether to invest or not, they make their best estimate of future payoffs. If they expect not to make a good payoff because someone might take advantage of their sunk costs, they will not make the investment to begin with. Economic investments can thus be very strategic and must account for the fact that others will try to capture the rents from them.

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