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Chapter 4
How Businesses
Work
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
• Explain and apply the economic perspective on
business operations.
• Define and apply the production function,
average product, and marginal product.
• Discuss the implications of the cost function,
average cost and marginal cost. Explain the
difference between variable costs and fixed
costs.
• Define and apply the revenue function and
marginal revenue.
• Determine the profit-maximizing level of output.
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.
4-3
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
How a Business Operates
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.
• Businesses operate 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.
4-6
Inputs Used in Production
Businesses use 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, software, and structures a
business uses in its production process.
–Businesses can either own or rent the capital
it uses.
4-7
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 knowhow 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
0
0
1
2
2
4
3
5
4
6
• Production
function is the
mathematical link
between inputs
and outputs.
• The table to the
left shows the
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.
Hours of Labor
Number of Lawns
Mowed Using a
Hand Mower
Number of Lawns
Mowed with a
Power Mower
0
0
0
1
2
2
4
3
6
3
5
9
4
6
11
4-12
Two Inputs: Capital and Labor
4-13
Marginal Product of Labor
• The production function determines how
much a 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.
Input: Number of
Accountants
Output: Number of
Marginal Product of
Tax Returns Done in a Labor: Additional
Week
Tax Returns per
Worker
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.
4-18
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 a business owns or rents the
inputs.
– If owned, there is an opportunity cost.
– If rented, the cost is simply the price of
the rental.
4-19
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.
4-20
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 = (Cost of labor) +
(Cost of capital and land) + (Cost
of intermediate inputs) + (Cost of
accumulating business knowhow)
4-21
Cost Function
Candy
Produced
(Pieces)
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
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 each 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 Candy 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
(Pieces)
Total Cost
(Dollars)
Marginal Cost
(Dollars)
0
1,000
$500
$1,500
$0
$1.00
2,000
3,000
4,000
$2,500
$3,600
$4,850
$1.00
$1.10
$1.25
5,000
6,000
$6,350
$8,100
$1.50
$1.75
7,000
$10,100
$2.00
4-25
Graph of Marginal Cost
4-26
Variable versus Fixed Costs
Businesses have two types of cost:
• Variable costs, also known as shortterm 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.
4-27
Revenue and Marginal
Revenue
• Revenue is the amount of money
companies get from selling their products
or services.
• If a 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.
4-28
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
profit-maximizing rule.
4-29
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.
4-30
Example of Profit Maximization
Candy
(Pieces)
Total
Marginal
Cost
Cost
(Dollars) (Dollars)
-
Revenue,
Assuming
Each Piece of
Candy Sells
for $1.50
(Dollars)
0
Marginal Profits
Revenue (Dollars)
(Dollars)
0
$500
-
-$500
1,000
$1,500
$1.00
$1,500
$1.50
$0
2,000
3,000
$2,500
$3,600
$1.00
$1.10
$3,000
$4,500
$1.50
$1.50
$500
$900
4,000
5,000
$4,850
$6,350
$1.25
$1.50
$6,000
$7,500
$1.50
$1.50
$1,150
$1,150
6,000
7,000
$8,100
$10,100
$1.75
$2.00
$9,000
$10,500
$1.50
$1.50
$900
$400
4-31
Example of Profit Maximization
• The table on the previous slide
demonstrates the profit-maximization rule.
• Expansion continues until the firm produces
5,000 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 5,000 units to
6,000), and overall profits decline.
4-32
The Law of Supply Revisited
• The 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.
4-33
Short-Term versus Long-Term
• Short-term profit maximization
focuses on achieving the highest profit,
assuming unchanged fixed costs.
• Long-term profit maximization
assumes a business can vary all its
inputs.
• Boeing versus Airbus is a good
example of a long-term decision.
4-34