The goal of business should be to maximize economic profits—to add value. As stated earlier this is the difference between revenue and all costs of production including the costs of capital. In Chapter 4 we focused on the inseparable items of revenue and knowing the customer. In Chapter 5 the costs of production are examined.

The place a discussion of costs must begin is not with costs themselves. The discussion must start with the actual physical process of turning inputs into outputs. Central to this conversion is the law of diminishing marginal returns. This law describes the relationship between changes in variable inputs and the resulting change in output given that some inputs are fixed. At first the marginal returns from adding variable inputs rises rapidly and then more slowly. From this law it is a simple leap to begin to understand why the costs of production behave in the way they do over the short run and over the long run. Within the study of costs the topics of economies and diseconomies of scale and economies of scope can been developed. Chapter 5 concludes by putting into an economic context business jargon like the experience curve, downsizing, outsourcing, joint venture, and supply chain management.

One of the most important relationships developed in this chapter is the relationship between marginal product and marginal costs. In fact, marginal cost is derived from marginal product. The appendix formally presents this derivation.