1. Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 How Businesses Work

2. 4-2 Chapter Objectives The nature of business The flow of money Profit maximization Production Cost Revenue

3. 4-3 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. 4-4 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.

5. 4-5 Flow of Goods and Services 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

6. 4-6 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.

7. 4-7 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.

8. 4-8 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.

9. 4-9 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.

10. 4-10 Production Function with One Input: Labor Production function is mathematical link between inputs and outputs. Table to left shows production function for a lawn mowing business. 1830 1420 810 1 1 Number of lawns mowed using a hand mower Hours of labor

11. 4-11 Graph of Production Function with One Input: Labor

12. 4-12 Two Inputs: Capital and Labor With the capital input, the same number of labor hours results in more lawns mowed. 541830 421420 24810 311 Number of lawns mowed with a power mower Number of lawns mowed using a hand mower Hours of labor

13. 4-13 Two Inputs: Capital and Labor 0 10 20 30 40 50 60 0 5 101520253035 Input (hours of labor) Output (number of lawns mowed ) Production function with a hand mower Production function with a power mower 1

14. 4-14 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.

15. 4-15 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.

16. 4-16 Example of Marginal Product Number of accountants Number of tax returns prepared in a week Marginal product of labor 110 22010 3299 4378 5447 The following table shows the production function for an accounting firm.

17. 4-17 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.

18. 4-18 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.

19. 4-19 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.

20. 4-20 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.

21. 4-21 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)

22. 4-22 Cost Function 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. Candy produced Total cost (dollars) 0500 10001,500 20002,500 30003,600 40004,850 50006,350 60008,100 700010,100

23. 4-23 Graph of Cost Function

24. 4-24 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)

25. 4-25 Calculating Marginal Cost Candy producedTotal cost (dollars) Marginal cost (dollars) 05000 10001,5001.00 20002,5001.00 30003,6001.10 40004,8501.25 50006,3501.50 60008,1001.75 700010,1002.00

26. 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.

27. 4-27 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.

28. 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.

29. 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.

30. 4-30 Example of Profit Maximization Candy produce d Total cost (dollars) Margina l cost (dollars) Revenu e (dollars) Marginal revenue (dollars) Profits (dollar s) 05000000 10001,5001.001,5001.500 20002,5001.003,0001.50500 30003,6001.104,5001.50900 40004,8501.256,0001.501,150 50006,3501.507,5001.501,150 60008,1001.759,0001.50900 700010,1002.0010,5001.50400

31. 4-31 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.

32. 4-32 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.