Identifying Fixed Costs & Variable Costs for Producers

Identifying Fixed Costs & Variable Costs for Producers
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Ever wonder why the price of brand-name drugs is so much more than generics? Or why all tablet prices seem to congregate at about the same level? This lesson explains those and other mysteries through the lenses of variable and fixed costs.

Costs to Producers

You may be familiar with the fact that producers have to pay for resources in order to be able to create their products. From labor to capital to natural resources, producers have to purchase resources to really do anything, and those resources all come with a cost. After all, we can't just create products out of thin air.

These costs can be best summarized under two distinct categories, fixed costs and variable costs, depending on how they affect each additional item produced. Fixed costs are those costs that are fixed whether one item is produced or whether a thousand are made, whereas variable costs change depending on how many items are produced.

Fixed Costs

If you were to start a company to manufacture tablets, you would have a fair amount of upfront costs. First, you'd have the technical designs necessary to even figure out how to make them. Additionally, you'd have to have a place to make them, as well as the specialized equipment necessary to produce them. In fact, your new tablet company would require various licenses and fees paid to the government to allow you to conduct business. All of these are examples of fixed costs. Notice that these costs don't really change based on the number of items produced -- whether you make one tablet or ten thousand, these costs don't change.

This creates some interesting economic effects. For many businesses, there are significant barriers to entry because of these fixed costs. For example, producing aspirin is actually pretty cheap -- that's why you can buy it for such a low price. In fact, the primary ingredient can be synthesized from certain tree barks! However, any sort of medication requires immaculate conditions for production, no matter how many pills are produced.

Also, think about if your firm were to research new drugs. In the tablet example, you needed technical expertise to be able to essentially copy something that has already been made. You need expertise, but nothing like what you would need for researching new drugs. Those researchers can take years to find cures and treatments and expect to be well paid the entire time.

Notice that labor is still a fixed cost here -- you have to have the researchers whether you want to make one dose or ten million doses. As a result, the fixed cost of research is massive for pharmaceutical companies. In fact, the fixed costs for a pharmaceutical company are much larger than those of a tablet company, simply because of the research.

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