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 Buyers Flow of goods and services Flow of money Business InputsOutputs Cost of inputs Revenue from selling outputs Production Suppliers of labor and other inputs Profit maximization 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 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 Production function is the mathematical link between inputs and outputs. The table to the left shows the production function for a lawn mowing business Number of Lawns Mowed Using a Hand Mower Hours of Labor

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 Number of Lawns Mowed with a Power Mower Number of Lawns Mowed Using a Hand Mower Hours of Labor

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 Input: Number of Accountants Output: Number of Tax Returns Done in a Week Marginal Product of Labor: Additional Tax Returns per Worker The following table shows the production function for an accounting firm. 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 know- how) 4-21

Cost 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,

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 $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$10,100$

Graph of Marginal Cost 4-26

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

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