Fixed and VariableFor short time periods, it is often useful to think of the inputs employed by a firm as being of two types. The firm employs a given amount of fixed inputs, determined by its past investment decisions. These cannot be changed in the short run and are used in the fixed available amount regardless of the short-term level of output.

In contrast, the firm can increase or decrease the use of variable inputs at will, even in the short run. The use of variable factors as its output increases.

Costs fall into two corresponding categories. Fixed cost is the cost of the services of fixed factors. Variable cost is the cost of variable factors of production. Fixed cost is constant, no matter how much the firm produces, because the available supply of fixed factors is constant. Variable cost is increases as the firm’s output increases, because the firm will have to hire more variable factors as its output increases.

For concreteness, we will call the variable factors labor and the fixed factors capital. Since firms employ many kinds of variable and fixed inputs, these labels are chosen mainly for convenience.

Variable cost, then, is simply the wages of labor. Fixed cost in somewhat more complicated and involves one of the fundamental ideas of economics: opportunity cost.

What we need is a measure of the cost of the services of capital assets. Imagine a building erection at a cost of $5 million and with useful life of 50 years. It would clearly make no sense to treat the cost of the building as $5 million in the year the building goes up and as zero every year there after. What we need is a year-by-year measure of the cost to the firm of using the building.

The correct notion of cost is that of the rental cost of capital services. Even if a firm owns its plant and equipment, from an economic point of view the cost to the firms of using them is the amount the firm could earn by renting them to some other firm.