what if your rent goes up? To break even at the end of the month, you increase the price of your goods. In this case, your revenues are equal to your costs. You are not making a profit, but you can continue with your business.
If you want to continue making a profit at the end of the month, you have to increase the price of your goods even more. Unfortunately, your customers might choose to stop buying your baked goods. In this case, you experience an economic loss because your costs are greater than your revenues.
The profit motive drives businesses to do two things:
– Reduce costs whenever possible
– Increase sales whenever possible
Inputs and Outputs
Profit is revenue minus cost. Simple. But what brings in revenue? And what counts as cost?
Revenue is all of the money a business brings in by selling its goods and services. In other words, it is the money derived from its output. For a business to have output, it needs input.
Inputs are what go into production. They can include the land, labor, and capital that are needed to produce any good or service.
Inputs cost money such as wages for workers, rent for land or capital for raw materials and equipment. They involve monetary costs for businesses. A producer’s costs account for all of the inputs necessary for production.
Opportunity Costs
Because profit dominates a producer’s thinking, businesses have to pay close attention to inputs and outputs. This involves making rational production decisions.
Consumers consider opportunity costs to make rational decisions. Businesses do the same. Remember that this is the cost of opportunities that are passed up when deciding to do one thing instead of another.
Business decisions about opportunity costs involve determining inputs and outputs. For example, if you have decided to open a bicycle factory, you have to decide what kinds of bicycles to make. You also have to decide what to use to make your bikes. Say you decide to make aluminum mountain bikes. The opportunity cost of that decision is what you could earn making steel mountain bikes, aluminum children’s bikes, or any of the various combinations available.
Production Possibilities Frontier
Businesses do not just try to guess about opportunity costs. Guesses are often wrong, and wrong answers lead to losses, not profits. Producers need a better tool of analysis. One tool is the production possibilities frontier, also known as the PPF.
A production possibilities frontier is a graph that shows producers how to set up production in an efficient manner. Efficient production allows a producer to maximize profit.
Production Possibilities Frontier
Businesses do not just try to guess about opportunity costs. Guesses are often wrong, and wrong answers lead to losses, not profits. Producers need a better tool of analysis. One tool is the production possibilities frontier, also known as the PPF.
A production possibilities frontier is a graph that shows producers how to set up production in an efficient manner. Efficient production allows a producer to maximize profit.
Working With the PPF
This graph represents the PPF of a bicycle-making business. The red line shows how many of each bike can be made with the inputs available, such as workers, aluminum, plastic, and other supplies in the factory. The points A, B, and C represent the points at which production of mountain bikes and racing bikes is the most efficient.
This table shows when production is the most efficient. Points A, B, and C show some of the many possibilities of producing bicycles where production is maximized. A maximum of 150 racing bikes and 200 mountain bikes can be produced given the set of inputs available.
Let us a look at that PPF graph again for an example of inefficient production. Point X shows an inefficient use of inputs. By making only 100 of each bike, the available workers and materials are not being used efficiently. No producer would want to choose a level of output that falls below the PPF. As long as the points of production stay on the red line, production is maximized.
How can you decide whether A, B, or C – or any other point on the PPF – is the best one? They are all equally efficient. However, unless mountain bikes and racing bikes sell for the same amount, one decision could lead to more revenue than another. To make a fully rational decision, the prices for each bike must be taken into consideration. The PPF cannot predict price so its usefulness is limited, but it is
still an important tool for creating efficient production.
Market Research
The PPF shows a producer how to maximize efficiency, but there is more to making a rational decision than efficiency. Getting the most output from your inputs – productive efficiency – gives you the possibility of maximum revenue with minimum cost.
Consider the previous example. The PPF tells us that any of the three mixes of production will be efficient.
But which one will generate the greatest revenue? Rational choice always requires information. To get this kind of information, producers do market research.
Producers can decide which type of efficient production will also be profit-maximizing production by
– Researching the price of competing goods in the market.
– Finding out what consumers are willing to pay.
– Determining whether consumers want or need what is being offered.
Getting the Profit Motive
Profits drive producers. After all, making a profit is the reason people start a business in the first place. Producers make decisions that are aimed at maximizing efficiency and profits. Making these decisions requires a lot of information about production and the potential market.
In a free-market system, producers are free to make decisions. This freedom creates competition among businesses as they pursue the same goal of selling goods or services.
A typical example of competition is the long-running contest between soda products Coca-Cola and Pepsi. The two companies that produce these popular beverages have engaged in direct competition with each other for over 100 years. Of course, there are lots of other drinks available, too, and Coke and Pepsi compete against all the available options for the biggest share of the multibillion dollar soda market.
Businesses want as big a share as possible in order to maximize profit. They clash in the free market to get consumers to purchase their goods and services instead of those offered by their rivals. Competition pushes businesses to be as efficient as possible so they can offer the lowest prices.
