CHAPTER • The Cost of Production 233 lakeshore location is high: That property could have been sold for enough money to buy the Evanston land with substantial funds left over In the end, Northwestern decided to keep the law school in Chicago This was a costly deci- sion It may have been appropriate if the Chicago location was particularly valuable to the law school, but it was inappropriate if it was made on the presumption that the downtown land had no cost Fixed Costs and Variable Costs Some costs vary with output, while others remain unchanged as long as the firm is producing any output at all This distinction will be important when we examine the firm’s profit-maximizing choice of output in the next chapter We therefore divide total cost (TC or C)—the total economic cost of production— into two components • Fixed cost (FC): A cost that does not vary with the level of output and that can be eliminated only by going out of business • Variable cost (VC): A cost that varies as output varies Depending on circumstances, fixed costs may include expenditures for plant maintenance, insurance, heat and electricity, and perhaps a minimal number of employees They remain the same no matter how much output the firm produces Variable costs, which include expenditures for wages, salaries, and raw materials used for production, increase as output increases Fixed cost does not vary with the level of output—it must be paid even if there is no output The only way that a firm can eliminate its fixed costs is by shutting down SHUTTING DOWN Shutting down doesn’t necessarily mean going out of business Suppose a clothing company owns several factories, is experiencing declining demand, and wants to reduce output and costs as much as possible at one factory By reducing the output of that factory to zero, the company could eliminate the costs of raw materials and much of the labor, but it would still incur the fixed costs of paying the factory’s managers, security guards, and ongoing maintenance The only way to eliminate those fixed costs would be to close the doors, turn off the electricity, and perhaps even sell off or scrap the machinery The company would still remain in business and could operate its remaining factories It might even be able to re-open the factory it had closed, although doing so could be costly if it involved buying new machinery or refurbishing the old machinery FIXED OR VARIABLE? How we know which costs are fixed and which are variable? The answer depends on the time horizon that we are considering Over a very short time horizon—say, a few months—most costs are fixed Over such a short period, a firm is usually obligated to pay for contracted shipments of materials and cannot easily lay off workers, no matter how much or how little the firm produces On the other hand, over a longer time period—say, two or three years—many costs become variable Over this time horizon, if the firm wants to reduce its output, it can reduce its workforce, purchase fewer raw materials, and perhaps even sell off some of its machinery Over a very long time horizon—say, ten • total cost (TC or C) Total economic cost of production, consisting of fixed and variable costs • fixed cost (FC) Cost that does not vary with the level of output and that can be eliminated only by shutting down • variable cost (VC) Cost that varies as output varies