. 7
( 33)


press. . . .
the harder we are to im constant. Although the name of the law is prob-
ws, May 21, 1999 ably new to you, the concept is not.
”Philadelphia Daily Ne

For example, if you are preparing a meal, you the number of workers is varied from zero to 12.
know that a little bit of salt will make the food With no workers, for example, there is no output.
taste better. A bit more may make it tastier still. If the number of workers increases by one, output
Yet, at some point, too much salt will ruin the rises to seven. Add yet another worker and total
meal. As the amount of the input”salt”varies, so output rises to 20. This information is used to con-
does the output”the quality of the meal. struct the production function that appears as the
The Law of Variable Proportions deals with the graph in Panel B, where the variable input is shown
relationship between the input of productive on the horizontal axis with total production on
resources and the output of final products. The the vertical axis.
law helps answer the question: How is the output In this example, only the number of workers
of the final product affected as more units of one changes. No changes occur in the amount of
variable input or resource are added to a fixed machinery used, the level of technology, or the
amount of other resources? quantities of raw materials”unprocessed natural
A farmer, for example, may have all the land, products used in production. Under these condi-
machines, workers, and other items needed to tions, any change in output must be the result of
produce a crop. However, the farmer, may have the variation in the number of workers.
some questions about the use of fertilizer. How
will the crop yield be affected if different amounts
Total Product
of fertilizer are added to fixed amounts of the
The second column in the production schedule
other inputs? In this case, the variable input is the
in Figure 5.5 shows total product, or total output
fertilizer added per acre.
produced by the firm. The numbers indicate that
Of course, it is possible to vary all the inputs at
the plant barely operates when it has only one or
the same time. The farmer may want to know
two workers. As a result, some resources stand idle
what will happen to output if the fertilizer
much of the time.
and other factors of production are varied.
Economists do not like to do this,
however, because when more than
The Production Function
one factor of production is varied,
it becomes harder to gauge the
impact of a single variable on total

The Production Function
The Law of Variable Propor-
tions can be illustrated by
using a production function”a
concept that describes the relation-
ship between changes in output to
different amounts of a single input
while other inputs are held con-
stant. The production function can
be illustrated with a schedule, such
as the one in Panel A of Figure 5.5,
or with a graph like the one in
Inputs and Outputs All businesses must deal with the ques-
Panel B.
tions that surround the production relationship. Why is the use
The production schedule in the of the production function important in business?
figure lists hypothetical output as

ECONOMICS Total Product Rises
Figure 5.5
As more workers are added, how-
ever, total product rises. More work-
The Law of Variable Proportions ers can operate more machinery,
and plant output rises. Additional
A The Production Schedule
workers also means that the workers
Number of Total Marginal Regions of can specialize. For example, one
Workers Product Product* Production group runs the machines, another
handles maintenance, and a third
0 0 0 Stage I
group assembles the products. By
1 7 7
working in this way”as a coordi-
2 20 13
nated whole”the firm can be more
3 38 18
4 62 24
5 90 28
Total Product Slows
6 110 20 Stage II
As even more workers are added
7 129 19
output continues to rise, but it does
8 138 9
so at a slower rate until it can grow
9 144 6
no further. Finally, the addition of
10 148 4
the eleventh and twelfth workers
11 145 “3 Stage III causes total output to go down
12 135 “10 because these workers just get in the
way of the others. Although the
*All figures in terms of output per day
ideal number of workers cannot be
determined until costs are consid-
B The Production Function
ered, it is clear that the eleventh and
twelfth workers will not be hired.

Marginal Product
Total Product

The measure of output shown in
the third column of the production
Stage I Stage II Stage III
80 schedule in Figure 5.5 is an impor-
tant concept in economics. The
measure is known as marginal
product, the extra output or change
in total product caused by the addi-
20 tion of one more unit of variable
As we can see in the figure, the
0 1 2 3 4 5 6 7 8 9 10 11 12 13
marginal product, or extra output of
Variable Input: Number of Workers
the first worker, is seven. Likewise,
the marginal product of the second
Synthesizing Information The law can be shown as the
worker”which is equal to the change
production schedule in A, or as the production function
in total product”is 13. Together,
shown in B. How are the three stages of production
both workers account for 20 units of
total product.

In Stage II, the total production keeps growing,
Three Stages of Production but by smaller and smaller amounts. Any additional
workers hired may stock shelves, package parts, and
When it comes to determining the optimal
do other jobs that leave the machine operators free
number of variable units to be used in pro-
to do their jobs. The rate of increase in total pro-
duction, changes in marginal product are of spe-
duction, however, is now starting to slow down.
cial interest. Figure 5.5 shows the three stages
Each additional worker, then, is making a diminish-
of production”increasing returns, diminishing
ing, but still positive, contribution to total output.
returns, and negative returns”that are based on the
Stage II illustrates the principle of diminishing
way marginal product changes as the variable
returns, the stage where output increases at a
input of labor is changed.
diminishing rate as more units of a variable input
In Stage I, the first workers hired cannot work
are added. In Figure 5.5, Stage II begins when the
efficiently because there are too many resources
sixth worker is hired, because the 20-unit marginal
per worker. As the number of workers increases,
product of that worker is less than the 28-unit
they make better use of their machinery and
marginal product of the fifth worker.
resources. This results in increasing returns (or
The third stage of production begins when the
increasing marginal products) for the first five
eleventh worker is added. By this time, the firm has
workers hired.
hired too many workers, and they are starting to get
As long as each new worker hired contributes
in each other™s way. Marginal product becomes
more to total output than the worker before, total
negative and total plant output decreases.
output rises at an increasingly faster rate. Because
Most companies do not hire workers whose
marginal output increases by a larger amount every
addition would cause total production to decrease.
time a new worker is added, Stage I is known as the
Therefore, the number of workers hired would be
stage of increasing returns. Companies, however,
found only in Stage II. The exact number of work-
do not knowingly produce in Stage I for very long.
ers hired depends on the cost of each worker. If the
As soon as a firm discovers that each new worker
cost is low, the firm should hire at least six, but no
adds more output than the last, the firm is tempted
more than 10, workers.
to hire another worker.

Checking for Understanding Applying Economic Concepts
1. Main Idea Using your notes from the graphic 6. Diminishing Returns Provide an example of a
organizer activity on page 122, explain how time when you entered a period of diminish-
production is affected by a change in inputs. ing returns or even negative returns. Explain
why this might have occurred.
2. Key Terms Define theory of production, short
run, long run, Law of Variable Proportions,
production function, raw materials, total
product, marginal product, stages of produc- 7. Sequencing Information You need to hire
tion, diminishing returns. workers for a project you are directing.
3. Describe the relationship on which the theory You may add one worker at a time in a
manner that will allow you to measure the
of production is based.
added contribution of each worker. At
4. Explain how marginal product changes in each
what point will you stop hiring workers?
of the three stages of production.
Relate this process to the three stages of
5. Identify what point will eventually be reached the production function.
if companies continue adding workers.
Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

APRIL 19, 1999
expect prices to plummet nearly 15% [in one
The price of the average desktop computer
year], capping industrywide sales growth at less
shrank by 17.3% in just one year. As prices
than 5%. . . .
continue to fall, computer makers are
Suddenly, PC makers are heading off in sur-
scrambling to find other ways to make a
prising new directions. Dell and Compaq are
profit. developing E-commerce businesses”whether
it™s collecting monthly Internet service fees or
becoming online sellers of everything from
printers to carrying cases. . . .
New Directions for Other PC makers think new gizmos are the
answer. Compaq and Packard Bell NEC Inc.
PC Makers are preparing non-PC products such as cell
phones and newfangled devices that act as
Web-access machines. . . .
Hardly a week
Ultimately, these launches into cyberspace
goes by that some
could morph into sweeping new business models
wild-eyed startup
in which PC companies make money not on their
doesn™t announce
hardware but on the services they
a scheme to give
can bundle with their boxes.
away personal
Already, Gateway and Compaq
computers”as if
get a share of monthly revenues
the PC were some
from Internet service providers
throwaway rather
featured on their machines.
than the machine
And the more subscribers
that ushered in the
they sign up, the more adver-
Information Age.
tisers will pay to get their ads
On March 31, fol-
to these potential shoppers.
lowing in the foot-
steps of Free-PC, ”Reprinted from April 19, 1999 issue
of Business Week, by special permission,
NuAction, and copyright © 1999 by The McGraw-
DirectWeb, New Hill Companies, Inc.
York-based Gobi
said it would hand out free PCs to consumers
who sign up for three years of Internet service.
Examining the Newsclip
Meanwhile, emachines Inc. keeps cranking out
PCs priced as low as $399, and startup 1. Understanding Cause and Effect Why are companies
Microworkz Computer Corp. says it will soon moving away from producing PCs?
sell them for $299. . . . 2. Making Generalizations What are some companies
. . . Two years of free-falling prices are squeez- doing in order to stay competitive in the computer
ing the life out of margins, threatening to leave industry?
PC makers gasping for profits. . . . Analysts

Cost, Revenue, and Profit

Main Idea Key Terms
Profit is maximized when the marginal costs of pro- fixed cost, overhead, variable cost, total cost,
duction equal the marginal revenue from sales. marginal cost, e-commerce, total revenue, marginal
revenue, marginal analysis, break-even point, profit-
Reading Strategy maximizing quantity of output
Graphic Organizer As you read the section, complete
a graphic organizer similar to the one below by
explaining how total revenue differs from marginal After studying this section, you will be able to:
revenue. Then provide an example of each. 1. Define four key measures of cost.
2. Identify two key measures of revenue.
3. Apply incremental analysis to business decisions.
Total revenue is: Example:
Applying Economic Concepts
Overhead Overhead is one type of fixed cost that we
Marginal revenue is: Example:
try to avoid whenever we can. Read to see how over-
head can even change the way people do business.

Cover Stor y
ohnelle Lentner talked about eliminating over-
head for her business. Overhead is one of many
different measures of costs.
More Retailers
Discover Net
Measures of Cost
Because the cost of inputs influences effi-
Johnelle Lentner ra
cient production decisions, a business
made more than $250 a
must analyze costs before making its decisions.
ts, pie
peddling benches, ches
To simplify decision making, cost is divided into
safes and other colle
ed in several different categories.
from the space she rent
Collectible available
an Isanti, Minnesota The first category is fixed cost”the cost that a
online business incurs even if the plant is idle and out-
antiques shop.
But last August, Lent put is zero. It makes no difference whether the
r retailing and took her
gave up brick-and-morta business produces nothing, very little, or a large
nce ending the $60-a-
ness entirely online. Si amount. Total fixed cost, or overhead, remains
s to sell over Internet au
lease with Isanti Antique 700%. the same.
thly income has shot up
site eBay, Lentner™s mon u™re
llar amount for what yo Fixed costs include salaries paid to executives,
“You get the highest do .”
there is no overhead. . . interest charges on bonds, rent payments on
trying to sell online, and
leased properties, and local and state property
”USA Today, May 17,
taxes. Fixed costs also include depreciation, the

Figure 5.6

Production, Costs, and Revenues
Production Schedule Costs Revenues Profit
Total Total
Fixed Variable Total Marginal Marginal
Regions of of Total Marginal Total Total
Costs Costs Costs Costs Revenue Revenue
Production Workers Product Product Profit
-- $0 -- “$50
$0 $50
0 0 0 $50
$15 “35
50 90 140 $13 105
1 7 7
Stage I 15 70
50 180 230 6.92 300
2 20 13
5.00 570 15 250
38 18 50 270 320
410 3.75 930 15 520
4 62 24 50
3.21 1,350 15 850
90 28 50 450 500
4.50 1,650 15 1,060
50 540 590
6 110 20
680 4.74 1,935 15 1,210
50 630
7 129 19
Stage II 15 1,300
50 720 770 10.00 2,070
8 138 9
15.00 2,160 15 1,300
144 6 50 810 860
950 22.50 2,220 15 1,270
10 148 4 50
15 1,135
50 990 1,040 -- 2,175
11 145 “3
Stage III
-- 2,025 15 895
50 1,080 1,130
12 135 “10

Using Tables The concepts of marginal product, marginal cost, and marginal revenue are central to
economic analysis. Marginal product is used to define the three stages of production. Marginal cost
and marginal revenue are used to determine the profit-maximizing quantity of output. How do
total costs differ from marginal costs?

gradual wear and tear on capital goods over time output changes. Other examples of variable costs
and through use. A machine, for example, will not include electric power to run the machines and
last forever because its parts will wear out slowly freight charges to ship the final product.
and eventually break. In Figure 5.6 the only variable cost is labor. If
The nature of fixed costs is illustrated in the fourth one worker costs $90 per day, the total variable
column of the table in Figure 5.6, which is an exten- cost for one worker is $90. Two workers, or two
sion of the production schedule in Figure 5.5. Note units of variable input, cost $180, and so on.
that, regardless of the level of total output, fixed costs The total cost of production is the sum of the
amount to $50. fixed and variable costs. Total cost takes into
Another kind of cost is variable cost, a cost account all the costs a business faces in the course
that changes when the business rate of operation of its operations. The business represented in
or output changes. While fixed costs generally are Figure 5.6, for example, might employ six workers”
associated with machines and other capital goods, costing $90 each for a total of $540”to produce
variable costs generally are associated with labor 110 units of total output. If no other variable costs
and raw materials. For example, wage-earning existed, and if fixed costs amounted to $50, the
workers may be laid off or worked overtime as total cost of production would be $590.

pumps and tanks, and the taxes and licensing fees
paid to state and local governments.
The variable costs, on the other hand, are rela-
Costs and Information Goods
tively small. The station™s variable costs include the
Information goods, rather than industrial
hourly wage paid to the employee, the cost of elec-
goods, are the key forces in many world mar-
tricity for lights and pumps, and the cost of the gas
kets. What are information goods? Essentially,
sold. When all costs are included, however, the
they are anything that can be digitized”base-
ratio of variable to fixed costs is low.
ball scores, music, and stock quotes are all
As a result, the owner may operate the station
information goods. The cost structure of infor-
24 hours a day, seven days a week for a relatively
mation goods is unusual. Production of infor-
mation goods requires high fixed costs but low low cost. Even the extra cost of keeping the sta-
marginal costs. In other words, producing the tion open between the hours of midnight and
first copy of an information good is costly, but 6:00 A.M. is minimal. As a result, the extra wages,
the cost of reproducing additional copies is the electricity, and other variable costs are minor
much less. and may be covered by the profits of the extra

Internet Stores
Another category of cost is marginal cost”the
extra cost incurred when a business produces one Stores are flocking to the Internet, making it one
additional unit of a product. Because fixed costs do of the fastest-growing areas of business today, and
not change from one level of production to for reasons largely related to cost. Specifically,
another, marginal cost is the per-unit increase in many stores are using the Internet because the
variable costs that stems from using additional overhead, or the fixed cost of operation, is so low.
factors of production. An individual engaged in e-commerce”electronic
Figure 5.6 shows that the addition of the first business or exchange conducted over the Internet”
worker increased the total product by seven units. does not need to spend large sums of money
Because total variable costs increased by $90, to rent a building and stock it with inventory.
each of the additional seven units cost $12.86, or Instead, for just a fraction of the cost of a store,
$90 divided by seven. If another worker is added, the e-commerce business owner can purchase Web
13 more units of output will be produced for access along with an e-commerce software package
an additional cost of $90. The marginal, or extra,
cost of each unit of output is $90 divided by 13,
or $6.92.

Applying Cost Principles
The cost and combination, or mix, of
Measures of Cost Variable costs represent ex-
inputs affects the way businesses produce.
penses a corporation incurs that change with that
The following examples illustrate the importance company™s level of business activity. Fixed costs
of costs to business firms. represent expenses a corporation incurs that
remain relatively stable despite a change in the
level of that company™s business activity. Expense
Self-Service Gas Station items which generally remain fixed for any given
Consider the case of a self-serve gas station with reporting period include rent, depreciation, prop-
many pumps and a single attendant who works in erty tax, and executive salaries.
an enclosed booth. This operation is likely to have
large fixed costs, such as the cost of the lot, the

To prepare for doing business in Japan, Leary
took language classes to master basic greetings and
MASTER MARKETER common phrases, studied the culture at the Asia
Society in New York, subscribed to the interna-
Kathryn Leary helps entrepreneurs enter new tional edition of the Japan Times and other maga-
markets. Among the services Leary offers are zines and newsletters and read books on Japanese
establishing contacts and coordinating trade business customs. . . .
”Black Enterprise, August 1999
After viewing the proverbial glass ceiling first-
hand at a majority of firms, Leary, 47, felt it was
time to venture off on her own.
Critical Thinking
“Once I realized the large companies had over-
seas offices, it became my goal to go abroad,” Leary 1. Finding the Main Idea Why did Leary start
her own company?
says. “But this was denied me. I started my company
to help Americans market in other countries.” 2. Analyzing Information What services does
Leary™s company provide? Why do you
think her service is useful?

that provides everything from Web catalog pages The marginal revenues in Figure 5.6 are deter-
to ordering, billing, and accounting software. The mined by dividing the change in total revenue by
e-commerce business owner inserts pictures and the marginal product. When a business has no
descriptions of the products for sale into the soft- workers, it produces no output, and it receives no
ware and loads the program. revenue. When it adds the first worker, total output
When customers visit the “store” on the Web, jumps to 7 units, and $105 of total revenue is gen-
they see what appears to be a full range of mer- erated. Because the $105 is earned from the sale of
chandise for sale. In some cases, the owner has the 7 units of output, each unit must have added $15.
goods in stock, as with Johnelle Lentner™s antique Therefore, the marginal, or extra, revenue each unit
auction site. In other cases, the store takes the of output brings in is $15.
orders and forwards them to the manufacturer or to Keep in mind that whenever an additional
specialty warehouses that handle the shipping. worker is added, the marginal revenue computa-
tion remains the same. If the business employs five
workers, it produces 90 units of output and gener-
ates $1,350 of total revenue. If a sixth worker is
Measures of Revenue added, output increases by 20 units, and total rev-
enues increase to $1,650. To have increased total
Businesses use two key measures of revenue
revenue by $300, each of the 20 additional units of
to find the amount of output that will pro-
output must have added $15.
duce the greatest profits. The first is total revenue,
If each unit of output sells for $15, the marginal
and the second is marginal revenue.
or extra revenue earned by the sale of one more unit
The total revenue is the number of units sold
is $15. For this reason, the marginal revenue appears
multiplied by the average price per unit. If 7 units are
to be constant at $15 for every level of output.
sold at $15 each, the total revenue is $105, as shown
While marginal revenue is constant in Figure 5.6,
in the total revenue column in Figure 5.6. The second,
this will not always be the case. Businesses often find
and more important, measure of revenue is marginal
that marginal revenues start high and then decrease
revenue, the extra revenue associated with the pro-
as more and more units are produced and sold.
duction and sale of one additional unit of output.

Marginal Analysis Having made a profit with the sixth worker, the
business probably would hire the seventh and eighth
Economists use marginal analysis, a type of workers. If it hired the ninth worker, however, the
cost-benefit decision making that compares cost of the additional output would equal the addi-
the extra benefits to the extra costs of an action. tional revenue earned when the product was sold.
Marginal analysis is helpful in a number of situa- The addition of the ninth worker neither adds to nor
tions, including break-even analysis and profit takes away from total profits”so the firm would have
maximization. In each case the process involves little incentive to hire the tenth worker. If it did, it
comparing the costs and benefits of decisions that would quickly discover that profits would go down,
are made in small, incremental steps. and it would go back to using nine workers.
The break-even point is the total output or total When marginal cost is less than marginal rev-
product the business needs to sell in order to cover enue, more variable inputs should be hired to
its total costs. In Figure 5.6, the break-even point is expand output. The profit-maximizing quantity of
between 7 and 20 units of total product, so at least output is reached when marginal cost and marginal
two workers would have to be hired to break even. revenue are equal. In Figure 5.6, profits are maxi-
A business wants to do more than break even, mized when the ninth worker is hired. Other com-
however. It wants to make as much profit as it can. binations may generate equal profits, but no other
We know that the business represented in Figure 5.6 combination will be more profitable.
will break even when it hires the second worker.
But, how many workers and what level of output
are needed to generate the maximum profits?
The owners of the business can decide by com-
paring marginal costs and marginal revenues. The
business would probably hire the sixth worker, for
example, because the extra output would only cost
Student Web Activity Visit the Economics: Principles
$4.50 to produce, and would generate $15 in rev- and Practices Web site at epp.glencoe.com and click
enues. In general, as long as the marginal cost is less on Chapter 5”Student Web Activities for an activity
than the marginal revenue, the business will keep on the operation of a company.
hiring workers.

Checking for Understanding Applying Economic Concepts
1. Main Idea Using your notes from the graphic 6. Overhead How might overhead affect the
organizer activity on page 127, describe how price of a new car?
cost affects total revenue.
2. Key Terms Define fixed cost, overhead,
variable cost, total cost, marginal cost,
e-commerce, total revenue, marginal rev- 7. Understanding Cause and Effect Many oil-
enue, marginal analysis, break-even point, processing plants operate 24 hours a day,
profit-maximizing quantity of output. using several shifts of workers to maintain
operations. How do you think a plant™s
3. List the four measures of cost.
fixed and variable costs affect its decision
4. Describe the two measures of revenue.
to operate around the clock?
5. Explain the use of marginal analysis for
break-even and profit-maximizing decisions. Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

Outlining may be used as a starting point for a writer. The writer begins
with the rough shape of the material and gradually fills in the details in a
logical manner. You may also use outlining as a method of note taking and
organizing information as you read.

Learning the Skill
There are two types of outlines”formal and
informal. Making an informal outline is similar to I. An Introduction to Supply
taking notes”you write words and phrases needed to A. The Supply Schedule
remember main ideas. A formal outline has a standard 1.
format. Follow these steps to formally outline material.
2. Prices and quantities move in
• Read the text to identify the main ideas. Label same direction.
these with Roman numerals. B. The Individual Supply Curve
• Write subtopics
under each main
idea. Label these C. The Market Supply Cuve
ideas with capital 1.
letters. 2.
• Write D.
details for each 1.
subtopic. Label 2.
these with Arabic II. Change in Supply
numerals. A.
• Each level should B. Productivity
have at least two C.
entries and should Production on the D.
assembly line
be indented from E. Expectations
the level above.
• All entries use the same grammatical form, whether G.
phrases or complete sentences.

Practicing the Skill
On a separate sheet of paper, copy the following
outline of the main ideas in the first part of Section 1
of Chapter 5. Then use your textbook to fill in the Following the guidelines above, prepare an out-
missing subtopics and details. line for Section 3 of Chapter 3.
Practice and assess key social studies skills with the
Glencoe Skillbuilder Interactive Workbook, Level 2.
Section 1 • The theory of production deals with the short run,
a production period so short that only the variable
What Is Supply? (pages 113“120) input (usually labor) can be changed. This contrasts
to the long run, a production period long enough
• Supply is the quantities of output that producers will for all inputs”including capital”to vary.
bring to market at each and every price. Supply can
• The Law of Variable Proportions
be represented in a supply schedule, or graphically
states that the quantity of output
as a supply curve.
will vary as increasing units of a
• The Law of Supply states that the quantities of an single input are added. This law
economic product offered for sale vary directly with is presented graphically in the
its price. If prices are high, suppliers will offer greater form of a production function.
quantities for sale. If prices are low, they will offer
• The two most important measures
smaller quantities for sale.
of output are total product and
• The market supply curve is the sum of the individ- marginal product, the extra out-
ual supply curves. put gained from adding one addi-
• A change in quantity supplied is represented by a tional unit of input.
movement along the supply curve.
• Three stages of production”increasing returns,
• A change in supply is a change in the quantity that diminishing returns, and negative returns”show
will be supplied at each and every price. An increase how marginal product changes when additional
in supply is presented graphically as a shift of the variable inputs are added. Production takes place
supply curve to the right, and a decrease in supply in Stage II under conditions of diminishing
appears as a shift of the supply curve to the left. returns.
• Changes in supply can be caused by a change in the
Section 3
cost of inputs, productivity, new technology, taxes,
subsidies, expectations, government regulations, and
Cost, Revenue, and Profit
number of sellers.
• Supply elasticity describes how a change in quantity
Maximization (pages 127“131)
supplied responds to a change in price.
• Four important measures of cost exist: total cost,
• If supply is elastic, a given change in price will cause a
which is the sum of fixed cost and variable cost,
more than proportional change in quantity supplied.
and marginal cost, which is the increase in total
If supply is inelastic, a given change in price will cause
cost that stems from producing one additional unit
a less than proportional change in quantity supplied.
of output.
If supply is unit elastic, a given change in price will

cause a proportional change in quantity supplied. The mix of variable and fixed costs that a business
faces affects the way the business operates.
• The key measure of revenue is marginal revenue,
Section 2 which is the change in total revenue when one more
unit of output is sold.
The Theory of Production (pages 122“125) • The profit-maximizing quantity of output occurs
• when marginal cost is exactly equal to marginal
The theory of production deals with the relationship
revenue. Other quantities of output may yield the
between the factors of production and the output of
same profit, but none yield more.
goods and services.

Reviewing the Facts
Section 1 (pages 113“120)
1. Describe what is meant by supply.
Self-Check Quiz Visit the Economics: Principles
2. Distinguish between the individual supply curve
and Practices Web site at epp.glencoe.com and
click on Chapter 5”Self-Check Quizzes to prepare and the market supply curve.
for the chapter test.
3. Explain what is meant by a change in quantity
4. Identify the factors that cause a change in supply.
Identifying Key Terms
Section 2 (pages 122“125)
On a separate sheet of paper, write the letter of the key term
that best matches each definition below. 5. Describe the Law of Variable Proportions.
a. depreciation g. production function 6. Explain the difference between total product and
b. diminishing returns h. profit-maximizing marginal product.
c. fixed cost i. total cost
7. Identify the three stages of production.
d. marginal analysis j. variable cost
e. marginal product k. overhead
Section 3 (pages 127“131)
f. marginal revenue l. total product
8. Describe the relationship between marginal cost
1. a production cost that does not change as total
and total cost.
business output changes
9. Identify four measures of cost.
2. decision making that compares the additional
costs with the additional benefits of an action 10. Describe one practical application of cost principles.
3. associated with Stage II of production
4. a production cost that changes when output
Thinking Critically
5. a graphical representation of the theory of 1. Making Comparisons Create a chart like the one
production below to help you explain how supply differs from
6. the additional output produced when one addi-
tional unit of input is added
Supply Demand
7. change in total revenue from the sale of one addi-
tional unit of output
8. the gradual wearing out of capital goods
9. the sum of variable and fixed costs
2. Making Generalizations Why might production
10. when marginal revenue equals marginal cost functions tend to differ from one firm to another?
11. total output produced by a firm 3. Understanding Cause and Effect Explain why
e-commerce reduces fixed costs.
12. total fixed costs

Applying Economic Concepts 1. Define and name the fields in your database. The
following can be used as examples:
1. Supply According to the Law of Supply, what will
Field Name Field Type
happen to the number of products a firm offers for
Job/Service Text
sale when prices go down? What will happen to
Employer™s Name Text
the cost of additional units of production when a
Employer™s Phone Number
firm starts having diminishing returns? What will
Hourly Wage/Fee Number
happen to the number of products a firm will offer
Hours Worked Number
for sale if its cost of production increases while
2. Save the database.
prices remain the same?
3. Change field size as needed so that all informa-
2. Marginal Analysis Give an example of a recent
tion in each field is visible.
decision you made in which you used the tools
of marginal analysis. 4. Use the speller, proofread, and preview the data-
base. Save the database again.
5. Print your database while in list view.
Math Practice
Create a supply schedule and a supply graph that
shows the following information: American auto-
makers are willing to sell 200,000 cars per year when Outlining On a separate sheet of paper, add
supporting details to the outline of Section 2
the price of a car is $6,000. They are willing to sell
400,000 when the price is $12,000, and 600,000 at
a price of $18,000. I. Law of Variable Proportions

Thinking Like an Economist 1.
Label the following actions according to their place- B.
ment in the stages of production: (a) After many
hours of studying, you are forgetting some of the
material you learned earlier. (b) You are studying for
II. The Production Function
a test and learning rapidly. (c) After a few hours, you
are still learning but not as fast as before.
Technology Skill B.
Using a Database For one week, record every service
or job you perform for anyone else. Organize the
III. Three Stages of Production
services and the amount of time spent on each into
two columns: Paid Work and Unpaid Work. Use this A.
information to help you build an “employment” B.
database. C.
Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

What factors do you
consider when you
need to make a decision to buy
something? Price may be one of
the most important factors of
all. In this chapter, you will learn
how price serves as a signal to
both buyers and sellers. To learn
more about the effect of supply
and demand on prices, view the
Chapter 12 video lesson:
The Price System at Work
Prices for products in a market
economy are determined by the
interaction of supply and demand.

Chapter Overview Visit the Economics: Principles
and Practices Web site at epp.glencoe.com and
click on Chapter 6”Chapter Overviews to preview
chapter information.
Prices as Signals
Main Idea Key Terms
Competitive markets and prices are important to price, rationing, ration coupon, rebate
Reading Strategy After studying this section, you will be able to:
1. Explain how prices act as signals.
Graphic Organizer As you read the section, complete
2. Describe the advantages of using prices as a way
a graphic organizer similar to the one below by pro-
to allocate economic products.
viding examples from your own experience that show
3. Understand the difficulty of allocating scarce goods
how the price system provides for freedom of choice.
and services without using prices.
Applying Economic Concepts
Example 1
Rationing Have you and your friends ever tried to
Freedom of
Price system share something”a candy bar, cake, or pizza”when
Example 2
there really wasn™t enough to go around? Read to
find out about different ways to deal with making
Example 3

ife is full of signals that help us make decisions.
Cover Stor y For example, when we pull up to an intersec-
tion, we look to see if the traffic light is green,
uban Fans Left Out of O™s
yellow, or red. We look at the other cars to see if any
C have their blinkers on, and in this way receive signals
seball fans expr
HAVANA”Cuban ba from other drivers regarding their intentions to turn.
ndance at Sunday™s high
smay Thursday that atte Doctors even tell us that pain is a signal that some-
anticipated exhibi- thing is wrong with our body and may need attention.
tion game with the But have you ever thought about the signals that help
Baltimore Orioles us make our everyday economic decisions?
would be by invi- It turns out that something as simple as a price”the
tation only. monetary value of a product as established by supply
Only Cubans
and demand”is a signal that helps us make our eco-
invited by the
nomic decisions. Prices communicate information
Communist Party
and provide incentives to buyers and sellers. High
or trade unions
prices are signals for producers to produce more and
will be allowed to er-
Off-the-field controversy ov
attend the game for buyers to buy less. Low prices are signals for pro-
shadowed the game.
with the Orioles, ducers to produce less and for buyers to buy more.
team to play here since
the first Major League
1959. . . .
Castro came to power in ess.
e no secret of their distr
Advantages of Prices
Baseball fans here mad .
liente (Hot Corner), . .
At Havana™s Esquino Ca o got
“90% of the people wh Prices serve as a link between producers
(fans) complained that ns are
ow baseball. The real fa and consumers. In doing so, they help
the invitations don™t kn
the seats.”
the people who deserve decide the three basic WHAT, HOW, and FOR
, 1999 WHOM questions all societies face. Without
”USA Today, March 26

prices, the economy would not run as smoothly, Price flexibility also allows the market economy
and decisions about allocating goods and services to accommodate change. The development of the
would have to be made some other way. Prices personal computer provides an example. The early
perform the allocation function very well for the personal computers were relatively scarce and expen-
following reasons. sive, which attracted new producers. The resulting
First, prices in a competitive market economy competition, along with advances in technology and
are neutral because they favor neither the producer production methods, soon drove prices lower, which
nor the consumer. This is because prices are the attracted more consumers. More computers were
result of competition between buyers and sellers needed to meet the demand, which brought more
and, in this way, represent compromises that both producers into the market. This new round of com-
sides can live with. The more competitive the mar- petition lowered prices even more, which attracted
ket, the more efficient the price adjustment even more buyers. Consequently, a major innova-
process. tion”the computer”entered the economy with the
Second, prices in a market economy are flexible. help of the price system and without the involve-
Unforeseen events such as natural disasters and war ment of government or one of its bureaucracies.
affect the prices of many items. Buyers and sellers Third, prices have no cost of administration.
react to the new level of prices and adjust their con- Competitive markets tend to find their own prices
sumption and production accordingly. Before without outside help or interference. No bureau-
long, the system functions as smoothly again as it crats need to be hired, no committees formed, no
had before. The ability of the price system to laws passed, or other decisions made. Even when
absorb unexpected “shocks” is one of the strengths prices adjust from one level to another, the change
of a market economy. is usually so gradual that people hardly notice.

$18.79 United States $28.14 Madrid, Spain
The cost for a market
basket of staple items varies
$23.19 London, England $30.10 Paris, France
widely around the world.
The prices shown are for
$27.38 Rome, Italy $74.23 Tokyo, Japan
capital cities.

Source: USDA, 1999

One way to compare prices is to study a repre- • 2 pounds of sirloin steak
sentative sample, called the market basket. The • 2 pounds of apples
figures in the chart are based on a market basket • 5 pounds of sugar
that includes these staples:
• 1 gallon of milk
Critical Thinking
• 1 dozen eggs
1. Analyzing Information In which location
• 1 pound of cheddar cheese
are these items the costliest?
2. Drawing Conclusions What factors do you
think account for the wide range of prices?

Finally, prices are something that Prices
we have known about all our lives,
from the time we were old enough
to ask our parents to buy us some-
thing to the age where we were old
enough to buy it ourselves. As a
result, prices are familiar and easily
understood. There is no ambiguity
over a price”if something costs
$1.99, then we know exactly what
we have to pay for it. This allows
people to make decisions quickly
and efficiently, with a minimum of
time and effort.

Allocations Without Prices
Prices are important because
they help us make the every- Advantages When energy prices rose, demand for luxury cars
fell, while demand for smaller, more fuel-efficient autos jumped.
day economic decisions that allocate
Why are prices considered neutral?
scarce resources and the products
made from them. But what would
life be like without a price system?
the oil crisis of the early 1970s, for example, the
How would a car dealer allocate a limited supply of
government made plans for, but never imple-
sports cars? Would intelligence, or perhaps good
mented, a gas rationing program. One of the major
looks, or even political connections, determine
problems with the program was determining how
who could get a car?
to allocate the gas rationing coupons. Any number
These criteria may seem far-fetched, but they are
of ways to allocate the gas coupons were formu-
used in many parts of the world today, especially in
lated, but the issue of fairness was never resolved.
countries with command economies, such as Cuba.
After all, the local baseball fans did not get to see
the exhibition game with the Baltimore Orioles in
High Administrative Cost
Havana. Instead, the seats were reserved for
A second problem is the cost. Someone has to
Communist Party and trade union members.
pay for printing the coupons and the salaries of the
Without prices, another system must be used to
people who distribute them. In addition, no matter
decide who gets what. One method is rationing”a
how much care is taken, some coupons will be
system under which an agency such as government
stolen, sold, or counterfeited and used to acquire a
decides everyone™s “fair” share. Under such a sys-
product intended for someone else.
tem, people receive a ration coupon, a ticket or a
receipt that entitles the holder to obtain a certain
amount of a product. Rationing is used in many
Diminishing Incentive
societies today, and it has been widely used during
A third problem is that rationing has a negative
wartime, but it can lead to problems.
impact on people™s incentive to work and produce.
Suppose that authorities went ahead with a
The Problem of Fairness rationing system and that you were given a certain
The first problem with rationing is that almost number of coupons. How would this affect your
everyone feels his or her share is too small. During incentive to work? If you could not get more

coupons by working harder, and if you got the same cars and more smaller ones, leaving dealerships
amount of coupons if you worked less, you cer- with huge inventories of gas guzzlers.
tainly would lose some of your incentive to work. At first, automakers thought the increase in gas
Nonprice allocation mechanisms, such as prices would be temporary, so they were reluctant
rationing, raise issues that do not occur under a to switch over to smaller, more fuel-efficient mod-
price allocation system. As long as we have prices, els. As time went on, however, the surplus of unsold
goods can be allocated through a system that is neu- cars remained. To move their inventories, some
tral, flexible, efficient, and easily understood by all. manufacturers began to offer a rebate”a partial
refund of the original price of the product. The
rebate was the same as a temporary price reduction,
because consumers were offered $500, $600, and
Prices as a System even $1,000 back on each new car they bought.
Finally, automakers began reducing their produc-
Because of the many difficulties with non-
tion of large cars. They closed plants, laid off work-
price allocation systems, economists over-
ers, and started to change to small car production.
whelmingly favor the price system. In fact, prices
Many of the automobile workers who lost their jobs
do more than help individuals in specific markets
eventually found new ones in other industries. The
make decisions: they also serve as signals that help
result of higher prices in the international oil market,
allocate resources between markets.
then, was a shift of productive resources out of the
Consider the way in which higher oil prices
large car market into other markets. Although the
affected producer and consumer decisions when
process was a painful one for many in the industry, it
the price of oil went from $5 to over $40 a barrel
was natural and necessary for a market economy.
in the 1970s. Because the demand for oil is basi-
In the end, prices do more than convey infor-
cally inelastic, people spent a greater part of their
mation to buyers and sellers in a market”they also
income on energy. Higher energy costs left them
help buyers and sellers allocate resources between
with less to spend elsewhere.
markets. This is why economists think of prices as
The market for full-size automobiles was one of
a “system””part of an informational network”that
the first to feel the effects. Because most large cars
links all markets in the economy.
got poor gas mileage, people bought fewer large

Checking for Understanding Applying Economic Concepts
1. Main Idea Using your notes from the 6. Rationing From your own experience,
graphic organizer activity on page 137, describe a situation that required some form
describe how price affects decisions that of rationing. What criteria were used to allo-
consumers make. cate the good or service, and what were some
of the problems with each of the criteria?
2. Key Terms Define price, rationing, ration
coupon, rebate.
3. Describe how producers and consumers
react to prices. 7. Understanding Cause and Effect List five
4. List the advantages of using prices to distrib- items you would like to buy. How does the
price of each item affect your decision to
ute economic products.
allocate your scarce resources”your money
5. Explain the difficulties of allocating goods
and your time? Explain.
and services without a price system.
Practice and assess key social studies skills with
the Glencoe Skillbuilder Interactive Workbook,
Level 2.

Society and
Gary Becker

Gary Stanley Becker is a profes-
sor of economics at the prestigious
University of Chicago. Becker™s
work? The pioneering application
of economic analysis to social prob-
Monetarism Man:
lems such as crime, discrimination,
and drug abuse. For his unique
insight, Becker was awarded the
Nobel Prize in economics in 1992.
Friedman state of the economy. The key to
Professor Becker views individ- his argument is that changes in the
uals as rational decision makers. (1912“) rate of growth of the money sup-
People, he says, make life decisions ply have varying and unpredictable
Milton Friedman is one of the
largely in the economic terms of lags, which makes fine-tuning the
best-known economists working
self-interest and the incentives of economy virtually impossible.
today. His popular column in
the market. He argues that view- Friedman claims that the Federal
Newsweek helped make his a
ing individual decisions in this Reserve System should let the
household name.
way”as choices based on costs money supply grow at a constant
Friedman™s writings have covered
and benefits”helps explain indi- rate to avoid destabilizing the
an extraordinary variety of topics,
vidual human behaviors and their economy. For his theories on eco-
many of which were put forth in
societal results. Becker offered an nomic stabilization, Friedman was
his book, Capitalism and Freedom
example of a life choice based on awarded the Nobel Prize in eco-
(1962), which has become a stan-
economic thinking: “The number nomics in 1976.
dard. Friedman voiced opposition
of children a couple has depends
to such popular policies as agricul-
on the costs and benefits of child
tural subsidies, price controls, and
rearing. . . . [C]ouples tend to
Examining the Profiles
a minimum wage.
have fewer children when the wife
Friedman has been most influ-
works and has a better-paying job, 1. Making Comparisons How are
ential as an unwavering supporter
when subsidies and tax deductions Becker™s and Friedman™s ideas similar
and different?
of monetarism”the theory that the
for dependents are smaller, when
quantity of money in an economy
the cost of educating and training 2. For Further Research Read an article
is a critical factor in the overall
children rises, and so forth.” or book by Becker or Friedman.
Present a summary of the work to
the class.

The Price System at Work
Main Idea Key Terms
Changes in demand and supply cause prices to change. economic model, market equilibrium, surplus, short-
age, equilibrium price
Reading Strategy
Graphic Organizer As you read the section, complete a
graphic organizer similar to this, showing how a sur- After studying this section, you will be able to:
1. Understand how prices are determined in competi-
plus and shortage affect prices, demand, and supply.
tive markets.
2. Explain how economic models can be used to pre-
The effects of The effects of
a SURPLUS a SHORTAGE dict and explain price changes.
3. Apply the concepts of elasticity to changes in prices.
on prices on prices
Applying Economic Concepts
on demand on demand
Equilibrium Price When something is at equilibrium,
it tends to remain at rest. Read to find out what
on supply on supply
causes prices to reach, and then stay at, equilibrium.

ne of the most appealing features of a com-
petitive market economy is that everyone
Cover Stor y who participates has a hand in determining
prices. This is why economists consider prices to be
neutral and impartial.
Engineering Extra Tickets The process of establishing prices, as illustrated
Technology students
sachusetts Institute of by the example of the Graduation Ticket Trading
If Mas
mand coming into
the law of supply and de Center, is remarkable because buyers and sellers
don™t know
school, they sure have exactly the opposite hopes and desires. Buyers
have it down by want to find good buys at low prices. Sellers hope
graduation. Just ask for high prices and large profits. Neither can get
Steve Shapiro. exactly what they want, so some adjustment is nec-
Like all graduat- essary to reach a compromise.
ing seniors, he was
allotted four free
The Price Adjustment Process
tickets to his June 4
Because transactions in a market economy
UN Secretary-General Kofi
But 11 relatives uates.
Annan addresses MIT grad are voluntary, the compromise that even-
are planning to
tually takes place must be to the benefit of both
attend. . . .
cket Trading Center, a
ter the Graduation Ti parties, or the compromise would not occur in
1999 for seniors who
e set up by MIT™s class of
Web sit the first place.
ts to the ceremony. . . .
want to buy or sell ticke
t. Most suppliers were
clearly a seller™s marke
t, though one fellow had An Economic Model
g for about $100 a ticke
would take a final exam
tickets for anyone who To show how the adjustment process takes
for him. . . . place, we use the supply and demand illustration
”USA Today, May 27,
shown in Figure 6.1”one of the more popular

“tools” used by economists. The figure illustrates The numbers in the first and third column of the
an economic model”a set of assumptions that can schedule and the market supply curve SS come
be listed in a table, illustrated with a graph, or even from Figure 5.2 on page 117. This information
stated algebraically”to help analyze behavior and reflects the Law of Supply, showing that suppliers
predict outcomes. will offer more for sale at higher prices and less at
The data in the figure is already familiar to you. lower ones.
The numbers in the first two columns in the sched- Separately, each of these graphs represents the
ule and the market demand curve DD are from demand and the supply sides of the market. When
Figure 4.2 on page 92. The information in the they are combined, as in Panel B of Figure 6.1, we
schedule and curve reflects the Law of Demand, have a complete model of the market, which will
showing that consumers will buy more at lower allow us to analyze how the interaction of buyers
prices and less at higher prices. and sellers results in a price that is agreeable to all.

Market Equilibrium
ECONOMICS In a competitive market, the adjust-
Figure 6.1
ment process moves toward market
equilibrium”a situation in which
A Model of the CD Market prices are relatively stable, and the
quantity of goods or services supplied
A Market Demand and Supply Schedules
is equal to the quantity demanded. In
Figure 6.1, equilibrium is reached
Quantity Quantity Surplus/
Price Demanded Supplied Shortage when the price is $15 and the quantity
supplied is six units.
$30 0 13 13
How does the market find this equi-
25 1 11 10
librium on its own? Why did the mar-
20 3 9 6
ket settle at $15, rather than $20, or
15 6 6 0
$10, or at some other price? To answer
10 10 3 “7
these questions, we have to examine
5 15 0 “15
the reactions of buyers and sellers to
market prices. In addition, we assume
B Market Demand and Supply Curves that neither knows the final price, so
we™ll have to find it using trial and
$30 D
error”like the MIT seniors did when
they introduced their Graduation
Ticket Trading Center Web site
described in the cover story.

We start on Day 1 with sellers think-
S D ing that the price for musical CDs will
be $25. If you examine the supply
0 1 3 6 9 1011 13 15
schedule and curve in Figure 6.1, you
see that suppliers will produce 11 units
for sale at that price. However, the sup-
Using Tables and Graphs An economic model of the CD
pliers soon discover that buyers will
market includes both supply and demand. At what price
purchase only one CD at a price of
does quantity demanded equal quantity supplied?
$25, leaving a surplus of 10.

to three compact discs. However, as Panel B in
Price Determination
Figure 6.2 shows, this price turns out to be too low.
At a market price of $10, only three CDs are sup-
plied and 10 are demanded”leaving a shortage of
seven CDs.
A shortage is a situation in which the quantity
demanded is greater than the quantity supplied at
a given price. When a shortage happens, producers
have no more CDs to sell, and they end the day
wishing that they had charged higher prices for
their products.
As a result, both the price and the quantity sup-
plied will go up in the next trading period. While
our model does not show exactly how much the
price will go up, we can assume that the next price
will be less than $25, which we already know is
too high.


. 7
( 33)