Final answer:
In business, fixed costs remain constant regardless of production, while variable costs change with output levels. Total costs comprise both fixed and variable expenses, and understanding these is vital for setting prices and ensuring profitability.
Step-by-step explanation:
Understanding Fixed and Variable Costs
Understanding the structure of costs in business is crucial for economic decision making. Fixed costs are expenses that do not change regardless of the production level, such as rent or salaries for permanent staff. An example of a fixed cost is the $160 daily cost to operate a barber shop, including space and equipment, regardless of the number of haircuts given. On the other hand, variable costs are costs that vary with the level of output, such as the wages paid to barbers, which in our example are $80 per barber each day. As production increases, the total cost will be the sum of fixed and variable costs.
Total costs are significant for a business to know in order to determine the pricing of goods or services. The total cost is essential for calculating the average variable cost, which is done by dividing the total variable costs by the total output at each level of production. The average variable cost curve is typically U-shaped, indicating that there is an optimal level of production where these costs are at their lowest.
If a firm's average variable cost of production is lower than the market price for its product, it could be profitable once fixed costs are excluded from the calculation. This understanding helps businesses make informed decisions about production levels and pricing to ensure they cover their costs and make a profit.