Fixed Cost
A fixed cost is a cost of production that does not vary with the quantity of output produced, at least over the relevant range and time horizon. Rent, insurance, salaries of permanent staff, and the depreciation of capital equipment are examples. Fixed costs stand in contrast to variable costs, which change with output, and the distinction is central to the analysis of production, pricing, and entry, and to the study of scale and market structure.
The distinction from variable cost
Total cost is the sum of fixed and variable costs. Fixed costs do not change as output changes, while variable costs rise and fall with output. Average fixed cost, the fixed cost divided by output, declines continuously as output rises, an effect known as spreading the overhead. Average variable cost, in contrast, may fall and then rise as diminishing returns set in. Marginal cost, the change in total cost from producing one more unit, depends only on variable cost, since fixed cost does not change with output.
The classification depends on the time horizon. In the short run, some inputs are fixed, and their costs are fixed. In the long run, all inputs can be adjusted, and all costs become variable. A cost that is fixed in the short run, such as the rent on a factory under a multi-year lease, may become variable in the long run when the lease can be renegotiated. The distinction is therefore conditional on the period under consideration.
Economic roles
Fixed costs affect the average cost curve and therefore the relationship between scale and cost. Because fixed costs are spread over more units as output grows, average cost falls, at least initially, generating economies of scale. Where fixed costs are large relative to the market, only a few firms can operate at low average cost, and the market may be concentrated or naturally monopolistic. Industries with high fixed costs, such as utilities, telecommunications, and software, often exhibit these features.
Fixed costs also influence decisions to enter and exit a market. A firm will enter if it expects to cover its total costs, including fixed costs, over the relevant horizon. In the short run, a firm will continue to operate if it covers its variable costs, even if it does not cover fixed costs, because the fixed costs must be paid whether or not it produces. This asymmetry, in which average variable cost is the short-run shut-down point, is a basic result of the theory of the firm.
Sunk and avoidable costs
A distinction is drawn between sunk costs and avoidable fixed costs. A sunk cost is one that has already been incurred and cannot be recovered; it should not influence decisions about the future, because it is unaffected by the choice among alternatives. The principle that sunk costs are irrelevant to forward-looking decisions is fundamental, although in practice decision makers are often influenced by them.
Avoidable fixed costs are those that can be eliminated if the firm ceases the activity, such as a lease that can be terminated or equipment that can be sold. These costs do influence decisions to continue or exit, because they are avoided on exit. The treatment of fixed costs in decisions to discontinue a product, close a plant, or enter a market therefore turns on whether the costs are avoidable or sunk, and on the time horizon over which the decision is made.
Measurement and applications
Measuring fixed and variable costs requires data on cost behaviour at different levels of output, and analysts use accounting records and statistical estimation to separate the two. In practice, many costs are semi-fixed or step-fixed, changing only when output crosses a threshold, so the two-way classification is a simplification. Understanding the structure of costs is essential to pricing, to break-even analysis, and to decisions about capacity.
Fixed costs matter for public policy. In natural monopoly industries, high fixed costs create a case for regulation or public provision. In the design of tariffs, the recovery of fixed costs raises questions about who should pay and how charges should be structured. In antitrust analysis, fixed costs affect entry conditions and the sustainability of competition. The concept is thus both a tool of management accounting and a component of the economic analysis of markets.
Cost behaviour over time
The behaviour of fixed costs over time matters for decisions. In the short run, when some inputs cannot be adjusted, many costs are fixed. In the long run, all inputs can be adjusted, so fixed costs become avoidable and the firm can vary all its costs. This distinction underlies the difference between short-run and long-run cost curves and the analysis of exit and entry, and it explains why a firm may continue to operate at a loss in the short run but exit in the long run.
Cost behaviour also depends on the technology and on the nature of the inputs. Some costs are fixed in the sense that they do not vary with output but do vary with capacity, such as the cost of a second production line. These step costs change discretely as capacity is expanded, creating a cost structure in which average cost falls within each step and rises at the boundaries. Recognising these patterns improves the accuracy of cost analysis and of decisions about capacity.
Fixed costs and pricing
Fixed costs affect pricing decisions. In industries with high fixed costs, average cost exceeds marginal cost by a large margin, and pricing at marginal cost would not cover the fixed costs, leading to losses and exit. Firms must therefore set prices above marginal cost, a practice known as mark-up pricing or cost-plus pricing, and the required mark-up depends on the ratio of fixed to variable costs and on the intensity of competition.
For regulated industries with high fixed costs, the pricing problem is central. Regulators must allow prices that cover total costs, including a fair return on capital, while providing incentives for efficiency and for investment. Different regulatory methods, such as rate-of-return regulation and price-cap regulation, balance these objectives differently, and the choice affects investment, prices, and the quality of service. The recovery of fixed costs is a recurring theme in the design of tariffs and access charges.
Implications for entry and competition
Fixed costs shape entry and competition. Where fixed costs are low, entry is easy, and markets tend toward competition. Where fixed costs are high, entry requires scale, and the number of viable competitors is limited, so markets may be concentrated. The relationship between fixed costs and market structure explains why some industries are naturally concentrated and why policies that seek to promote competition must consider the underlying cost conditions.
The distinction between fixed and sunk costs is crucial for entry. If the fixed cost is sunk, a firm that enters and then exits cannot recover it, so entry decisions must be made carefully and exit may be delayed. If the fixed cost is a rental or another avoidable payment, the risk of entry is lower. Competition authorities and regulators consider these distinctions when assessing barriers to entry and the likely effects of mergers and of liberalisation.