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Chapter 4
How Businesses Work
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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The nature of business
The flow of money
Profit maximization
Production
Cost
Revenue
4-2
The Nature of Business
• The outputs of a business are the goods
and services that it sells to customers.
• The inputs are the goods and services
that the business uses to produce the
outputs.
• Production is the process of turning
inputs into outputs.
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The Flow of Money
• A business collects and spends money.
• Revenue is the money that customers pay
for the output of a business.
• Cost is the money that the business pays
for its inputs.
• The difference between revenue and cost
is profits.
4-4
Flow of Goods and Services
Flow of goods and services
Inputs
Business
Outputs
Production
Suppliers of
labor and
other inputs
Buyers
Profit maximization
Revenue
from selling
outputs
Cost of
inputs
Flow of money
4-5
Profit Maximization
• The main objective of business is to
maximize profits.
• Business operates to create the largest
difference between revenues and cost.
• It is difficult to consistently produce high
profits.
• Profits vary significantly among different
businesses and firms.
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Inputs Used in Production
Business uses 5 main inputs in producing
outputs:
• Labor refers to the hours of work supplied
by the various types of workers.
• Capital is all the long-lived physical
equipment and structures a businesses
uses in its production process.
– Business can either own or rent the capital it
uses.
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Inputs Used in Production
• The third input is land.
– Some industries are very land-intensive, such
as agriculture and mining.
• Intermediate inputs refer to any goods
and services purchased from other
businesses for immediate use in the
production process.
– For example:
• All businesses need to buy electricity.
• Auto manufacturers need to buy steel.
4-8
Inputs Used in Production
• The final input, business know-how, is all
the knowledge and technology necessary
for the production process.
– Sometimes the knowledge is embodied in the
equipment the companies buy.
– For many companies, business know-how is
the reason for their success.
• The success of Google depends on its search
algorithm and its method of pricing.
4-9
Production Function with One Input:
Labor
Hours of
labor
Number of lawns
mowed using a
hand mower
1
1
10
8
20
14
30
18
• Production function is
mathematical link
between inputs and
outputs.
• Table to left shows
production function
for a lawn mowing
business.
4-10
Graph of Production Function with
One Input: Labor
4-11
Two Inputs: Capital and Labor
With the capital input, the same number of
labor hours results in more lawns mowed.
1
Number of lawns
mowed using a
hand mower
1
Number of lawns
mowed with a
power mower
3
10
8
24
20
14
42
30
18
54
Hours of labor
4-12
Two Inputs: Capital and Labor
Output (number of lawns mowed)
60
Production
function with a
power mower
50
40
30
Production
function with a
hand mower
20
10
0
01
5
10
15
20
25
30
35
Input (hours of labor)
4-13
Marginal Product of Labor
• The production function determines how
much business can produce, given its
inputs.
• It also determines how much extra output
the business will create by:
– Adding more workers.
– Having employees work more hours.
4-14
Marginal Product of Labor
• The marginal product of labor (or simply
‘marginal product’) is the extra amount of
output the firm can generate by adding
one more hour of labor or one more
worker.
– Marginal concepts are important since many
economic decisions are made on the basis of
incremental steps.
4-15
Example of Marginal Product
The following table shows the production
function for an accounting firm.
Number of
accountants
Number of tax returns
prepared in a week
Marginal product of
labor
1
10
10
2
20
10
3
29
9
4
37
8
5
44
7
4-16
Diminishing Marginal Product
• As shown in the table on the previous
slide, marginal product falls as the number
of workers goes up.
• Thus, each additional worker (accountant)
has a diminishing marginal product.
– This occurs because there isn’t enough room
for all the accountants in the office or they
must share a single copy machine or
computer.
4-17
Average Product
• The average product is another piece of
information obtained from the production
function.
• Average product is the output divided by
the number of labor hours or by the
number of workers - in other words, output
per hour or output per worker.
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Cost of Inputs
• Every input used in the production process
has a cost.
• Labor cost is the price of labor (wages
and benefits) multiplied by the number of
hours worked.
• Cost of capital and land depends on
whether business owns or rents the inputs.
– If owned, there is an opportunity cost.
– If rented, the cost is simply the price of the
rental.
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Cost of Inputs
• The cost of intermediate inputs is the money
that a business pays for goods and services
purchased from other companies
• Any outlays that increase a company’s
knowledge and capabilities are part of the cost
of accumulating business know-how. This
includes:
– Conducting research into new technologies.
– Hiring engineers and designers to develop
new products.
– Conducting marketing studies.
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Total Cost of Production
• Total cost is the sum of the cost of each
of the inputs.
• Total cost is determined by the following:
Total Cost = (Labor Cost) + (Cost of
Capital) + (Cost of Land) + (Cost of
Intermediate Inputs) + (Cost of
Accumulating Business Know-How)
4-21
Cost Function
Candy
produced
0
1000
2000
3000
4000
5000
6000
7000
Total cost
(dollars)
500
1,500
2,500
3,600
4,850
6,350
8,100
10,100
• The cost function
measures the cost of
producing a given
level of output.
• The cost function for
a candy manufacturer
is shown in the
adjacent table.
• The left column gives
the possible levels of
output and the right
column gives their
associated cost.
4-22
Graph of Cost Function
4-23
Marginal Cost
• The concept of marginal cost is key to
profit maximization.
• The marginal cost, or MC, is the added
expense of producing one more unit of
output given by the following:
Marginal Cost = (Added cost of
producing additional units of output)
÷ (Number of additional units of
output)
4-24
Calculating Marginal Cost
Candy produced
0
1000
Total cost
(dollars)
500
1,500
Marginal cost
(dollars)
0
1.00
2000
3000
4000
5000
6000
7000
2,500
3,600
4,850
6,350
8,100
10,100
1.00
1.10
1.25
1.50
1.75
2.00
4-25
Variable versus Fixed Costs
Businesses have two types of cost:
• Variable costs, also known as short-term
costs, are those that managers can quickly
raise or lower by means of decisions they
make today.
• Fixed or long-term costs are harder to
change - or more precisely, a decision by
a business to change its fixed costs will
take longer to have an effect.
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Revenue and Marginal Revenue
• Revenue is the amount of money
companies get from selling their products
or services.
• If company sells only one product at a
fixed price, then revenue is calculated by:
– Multiplying the number of units sold by the
price per unit.
• The marginal revenue is the additional
money that the business gets from
producing and selling one more unit of
output.
4-27
Profit Maximizing
• Profits depend on the difference between
revenue and cost.
• Both revenue and cost are affected by the
level of production.
• The business should produce at an output
level that maximizes profits.
• This level can be found by using the profitmaximizing rule.
4-28
Profit Maximizing Rule
• The business will maximize profits at the
output level where:
marginal revenue = marginal costs
• This means that a profit-maximizing
business will increase production as long
as marginal revenue exceeds marginal
costs.
– It makes sense to increase production in this
case, since it will earn a profit for the firm.
4-29
Example of Profit Maximization
Candy
Total Margina Revenu Marginal Profits
produce
cost
l cost
e
revenue (dollar
d
(dollars) (dollars) (dollars) (dollars)
s)
0
500
0
0
0
0
1000
2000
1,500
2,500
1.00
1.00
1,500
3,000
1.50
1.50
0
500
3000
4000
3,600
4,850
1.10
1.25
4,500
6,000
1.50
1.50
900
1,150
5000
6,350
1.50
7,500
1.50
1,150
6000
7000
8,100
10,100
1.75
2.00
9,000
10,500
1.50
1.50
900
400
4-30
Example of Profit Maximization
• The table on the previous slide demonstrates
the profit maximization rule.
• Expansion continues until the firm produces
5000 pieces of candy. At this point, profits are
maximized and marginal revenue equals
marginal cost.
• After this point, marginal cost rises to $1.75,
which is above the marginal revenue of $1.50.
• The business has a loss on this incremental
increase in production (from 5000 units to 6000),
and overall profits decline.
4-31
Law of Supply, Revisited
• Law of supply states that the quantity
supplied in a market rises as prices
increase.
• This follows from the profit maximization
rule.
• Businesses can increase profits by
expanding production when the market
price of the goods or services increases.
4-32