Chapter 4 How Businesses Work McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 4Chapter 4

How Businesses Work

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning ObjectivesLearning 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.

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The Nature of BusinessThe 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 MoneyThe 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.

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How a Business OperatesHow a Business Operates

Buyers

Flow of goods and services

Flow of money

BusinessInputs Outputs

Cost ofinputs

Revenue from selling outputs

ProductionSuppliers oflabor and other inputs

Profit maximization

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Profit MaximizationProfit 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.

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Inputs Used in ProductionInputs 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.

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Inputs Used in ProductionInputs 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.

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Inputs Used in ProductionInputs 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.

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Production Function with Production Function with One Input: LaborOne Input: Labor

• Production function is the mathematical link between inputs and outputs.

• The table to the left shows the production function for a lawn mowing business.

64

53

42

21

Number of Lawns Mowed Using a

Hand Mower

Hours of Labor

0 0

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Graph of Production Function Graph of Production Function with One Input: Laborwith One Input: Labor

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Two Inputs: Capital and LaborTwo Inputs: Capital and Labor

With the capital input, the same number of labor hours results in more lawns mowed.

1164

953

642321

Number of Lawns Mowed with a Power Mower

Number of Lawns Mowed Using a

Hand MowerHours of Labor

0 0 0

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Two Inputs: Capital and LaborTwo Inputs: Capital and Labor

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Marginal Product of LaborMarginal 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.

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Marginal Product of LaborMarginal 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.

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Example of Marginal ProductExample of Marginal Product

Input: Number of Accountants

Output: Number of Tax Returns Done in

a Week

Marginal Product of Labor: Additional Tax Returns per

Worker

1 10 10

2 20 10

3 29 9

4 37 8

5 44 7

The following table shows the production function for an accounting firm.

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Diminishing Marginal ProductDiminishing 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.

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Average ProductAverage 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 InputsCost 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.

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Cost of InputsCost 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 ProductionTotal 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 know-how)

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Cost FunctionCost Function

• 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.

Candy Produced (Pieces)

Total cost (Dollars)

0 $500

1,000 $1,500

2,000 $2,500

3,000 $3,600

4,000 $4,850

5,000 $6,350

6,000 $8,100

7,000 $10,1004-22

Graph of Candy Cost FunctionGraph of Candy Cost Function

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Marginal CostMarginal 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)

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Calculating Marginal CostCalculating Marginal Cost

Candy Produced (Pieces)

Total Cost (Dollars)

Marginal Cost (Dollars)

0 $500 $0

1,000 $1,500 $1.00

2,000 $2,500 $1.00

3,000 $3,600 $1.10

4,000 $4,850 $1.25

5,000 $6,350 $1.50

6,000 $8,100 $1.75

7,000 $10,100 $2.00

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Graph of Marginal CostGraph of Marginal Cost

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Variable versus Fixed CostsVariable 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 and Marginal RevenueRevenue

• 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.

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Profit MaximizingProfit 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.

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Profit-Maximizing RuleProfit-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.

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Example of Profit MaximizationExample of Profit Maximization

Candy (Pieces)

Total Cost

(Dollars)

Marginal Cost

(Dollars)

Revenue, Assuming

Each Piece of Candy Sells

for $1.50 (Dollars)

Marginal Revenue (Dollars)

Profits (Dollars)

0 $500 - 0 - -$500

1,000 $1,500 $1.00 $1,500 $1.50 $0

2,000 $2,500 $1.00 $3,000 $1.50 $500

3,000 $3,600 $1.10 $4,500 $1.50 $900

4,000 $4,850 $1.25 $6,000 $1.50 $1,150

5,000 $6,350 $1.50 $7,500 $1.50 $1,150

6,000 $8,100 $1.75 $9,000 $1.50 $900

7,000 $10,100 $2.00 $10,500 $1.50 $4004-31

Example of Profit MaximizationExample 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.

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The Law of Supply RevisitedThe 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.

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Short-Term versus Long-TermShort-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.

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