Essays

Our previous analysis demonstrates that although the amount of total profits is affected by both fixed and variable costs, only variable costs will affect the price and quantity level where a business finds its maximum total profits. Conversely, fixed costs can vary all they want, and although they will directly affect the level of profits a business achieves, they cannot, and will not, affect the price and quantity at which the maximum total profit will be reached.

If that isn't clear, you need to review the pages prior to this page. Only variable costs affect the slope of the total cost curve, and only the slope of the total cost curve will affect the point where maximum profits are achieved. Variable costs can be influenced by fixed costs, but only indirectly: an efficient machine can change variable costs, and the cost of the machine is a fixed cost. However, the efficiency of the machine is not determined by its cost. Once that is understood, some very interesting conclusions plop into view.

The first is that only variable costs can be passed on to the consumer. If variable costs increase, the consumer will see higher prices; if variable costs decrease, the consumer will see lower prices. This is true not because the business wants to pass costs on to the consumer, but because the point of maximum total profits changes. A business can maintain higher prices if it wants to, but that will result in lower profits, so why should it?

The second conclusion follows directly from the first. Variable costs are, by definition, those total costs that change depending on the quantity that is produced. With most businesses, labor is directly linked to the quantity of production, and therefore the cost of labor is a variable cost: the more you produce, the more labor you have to pay for.

However, this is not true for basketball teams. The owner signs up a team and rents a stadium. Those costs are fixed: they stay the same regardless of how many fans come to the game. In other words, paying the players more or less will not change the number of tickets sold: people do not come to the game to see how much the players are paid. Player salaries merely change how much of the total profit a team owner gets to keep. The total profit will stay the same regardless of what the team is paid. It is true that hiring a more talented (efficient) player will increase attendance, but this is like hiring a more efficient machine: the price that is paid is still a fixed cost.

The key to basketball ticket prices is the point of maximum profits ($max) that the owner can receive from ticket sales, and that is determined by the variable cost curve. The team owner will always raise prices to the point where there are empty seats in the stadium. This is because if the owner didn't, then some fans would resell their tickets at a profit to someone who was willing to pay a higher price, and the fans would pocket profits that could have gone to the owner.

Again: if fans are willing to pay a higher price for tickets, then the owner is selling below the point of maximum profits. The owner can increase prices until the loss of revenue from unsold seats is greater than the increase in revenue from higher prices on all the sold seats. This is what the total revenue curve shows: how does total revenue change when prices change consumer behavior (the consumer demand curve).

However, it is important to recognize that this is a maximum REVENUE argument, but the actual price of tickets will be set by a maximum PROFITS argument. When the owner raises prices, it reduces volume (ticket sales), but it also reduces costs. The more people who come to a basketball game, the more it costs for ushers, parking attendants, and other costs that depend on how many tickets are sold. These are variable costs, and even if the revenue gained from higher prices EQUALS the revenue lost from unsold tickets, there is a cost reduction from unsold tickets that makes it advisable for the owner to raise prices even further until the loss of revenue from unsold tickets EQUALS the gain in revenue from higher prices PLUS the reduction in costs from unsold tickets.

This is what the analysis from the variable cost curve and total revenue curve explains analytically. The players' salaries never enter into the equation: the players' salaries are fixed costs that do not effect how many tickets are sold or unsold. What seems bizarre at first, is none-the-less true: ushers and janitors salaries will affect the price of basketball tickets, but player salaries will not.

It is true because ushers and janitors are needed only to the extent that people attend the game. The players are needed regardless of how many people attend the game. That distinction is not always obvious, and rarely appreciated. Even experts in economics often fail to consider that fixed and variable costs have totally distinct impacts on the marketplace. There are very important relationships that affect the marketplace in the same way that gravity and air flow affect aviation. And like gravity and aerodynamics, it is not always obvious how they interact.

Up to now we have looked at the reality of the marketplace set by the consumer demand curve. The analysis did not distinguish between the costs of a single firm or a hundred firms: the analysis is the same. In the abstract, nature doesn't really care: one firm or a hundred firms, they have to obey the same laws in economics just like the laws of gravity and aerodynamics. As we noted before, you can pretend that they don't exist, but you are likely to get hurt very bad.

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