Chapter 4

How Businesses Work

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 Learning Objectives
4-1: Explain and apply the economic perspective
on business operations.
4-2: Define and apply the production function,
average product, and marginal product.
4-3: Discuss the implications of the cost function,
average cost, and marginal cost. Explain the
difference between variable costs and fixed
costs.
4-4: Define and apply the revenue function and
marginal revenue.
4-5: Determine the profit-maximizing level of
output.

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 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.

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How a Business Operates

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 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.

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Inputs Used in Production (1 of 3)
Businesses use 5 main inputs in producing
outputs:
1. Labor refers to the hours of work supplied
by the various types of workers.
2. Capital is 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.
3. Land is the actual ground and natural
resources used by a business.
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Inputs Used in Production (2 of 3)

4. Intermediate inputs refer to any goods

and/or 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 Production (3 of 3)

5. 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.
• The success of a restaurant depends on the
recipes and the talent of the chef.

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 Production Function with One
Input: Labor
Number of Lawns Mowed
Hours of Labor
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.

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Graph of Production Function with
One Input: Labor

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 Two Inputs: Capital and Labor

With the capital input, the same number of labor

hours results in more lawns mowed.

Number of Lawns Number of Lawns

Hours of Labor Mowed Using a Hand Mowed with a
Mower Power Mower
0 0 0
1 2 3
2 4 6
3 5 9
4 6 11

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Graph of Production Function with
Two Inputs: Capital and Labor

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Production Function and 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.

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 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.

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 Example of Marginal Product

The following table shows the production function

for an accounting firm.

Output: Number of Marginal Product of

Input: Number
Tax Returns Done in Labor: Additional Tax
of Accountants
a Week Returns per Worker
1 10 10
2 20 10
3 29 9
4 37 8
5 44 7

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 Diminishing Marginal Product

As shown in the table on the previous slide,

marginal product falls as the number of
workers goes up.
Each additional worker (accountant) has a
diminishing marginal product.
• Output increases at a decreasing rate due to
other inputs being fixed; there isn’t enough
room for all the accountants in the office, they
must share a single copy machine or computer.

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 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 (1 of 2)

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 Inputs (2 of 2)
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 = (Cost of labor) + (Cost of
capital and land) + (Cost of intermediate
inputs) + (Cost of accumulating business
know-how)

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 Cost Function
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 $10,100

The cost function measures the cost of producing each

level of output.
The table shows the cost function for a candy
manufacturer.
The left column gives the possible levels of output and
the right column gives their associated cost.

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Graph of Candy Cost Function

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 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)

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 Calculating Marginal Cost

Candy Produced Total Cost Marginal Cost

(Pieces) (Dollars) (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 Cost

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 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 with daily business decisions.
Fixed or long-term costs are harder to
change. The decision to change 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 a company sells only one product at a fixed
price, then revenue is calculated as:
number of units sold × 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 Maximizing

Profits depend on the difference between

revenue and cost.
Both revenue and cost are affected by the
level of production.
Businesses strive to 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 Rule
The business will maximize profits at the
output level where:
marginal revenue = marginal costs
MR = MC
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 Maximization
(1 of 2)

Revenue,
Marginal Assuming Each Marginal
Candy Total Cost Profits
Cost Piece of Candy Revenue
(Pieces) (Dollars) (Dollars)
(Dollars) Sells for $1.50 (Dollars)
(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 $400

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 Example of Profit Maximization
(2 of 2)
The table on the previous slide demonstrates the
profit-maximization rule. MR = MC
Expansion continues until the firm produces 5,000
pieces of candy. At this point, profits are
maximized and marginal revenue equals marginal
cost.
Beyond 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 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-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.
Airplane manufacturing decisions by Boeing
and Airbus are good examples of long-term
decisions.

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 End of Presentation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. 4-35