Sunday, November 25, 2012

Fixed Costs and Market Size

A student asked what is so intriguing about fixed costs.  This is part of my reply.

Suppose the market for t-shirts is 1000 customers.  The shirts are sold for $20 each.  Suppose that the shirts can be produced in a thousand different color, but the set up cost for a shirt is $100 and to produce a shirt costs $15.  In a competitive market, a firm will produce as long as they are covering their variable costs.  In this example, variable costs are $15,000 ($15 x 1000).  Since revenues in this market are $20,000 ($20 x 1000) that leaves $5,000 for profit.  Now divide $5000/100 (profit divided by fixed cost), and that means that only 50 colors can be made.  Therefore, the market doesn't satisfy half of the market.  The half that isn't satisfied must choose a color close to the one that they want.  If fixed costs were higher, then there would be less color choice.

This example was modified from, The Tyranny of the Market, by Joel Waldfogel. His book gives a complete treatment of the subject.

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