AQA AS Chapter 7

Production and efficiency

Chapter 7In this chapter we introduce the concepts of production, productivity and efficiency, underpinned by some economic ideas, including specialisation and division of labour. These were introduced by Adam Smith over 200 years ago in his famous book The Wealth of Nations. We also discuss business costs and competition within the market.

Learning Objectives At the end of this chapter you will be able to

Define and explain the benefits of specialisation and division of labourDefine and explain production and productivityDefine, explain and illustrate productive efficiencyDefine and give examples of economies and diseconomies of scale and assess their implications for the growth of firms and the structure of markets.

Setting the Scene We will discover in this chapter why, in a modern economy, it is preferable to have production based on the specialisation of individuals and firms rather than each attempting to be a ‘jack of all trades’. Whilst many firms continue to be successful , there are a number of cost-reducing benefits to firms of increasing their scale of production, which may help to explain why many markets seem to be dominated by large, powerful, often multinational firms.

Specialisation, the division of labour and exchange Specialisation involves an individual person, firm or country, producing a limited range of goods and servicesIt occurs between countries – e.g. China specialises in textiles and the US in computer softwareIt happens within a country – the City of London specialises in financial servicesAt the level of the individual this is known as the division of labourThis was developed by a famous economist Adam Smith in 1776 in his book The Wealth of NationsHe described a pin making factory where the pin moves from one man to another - one draws out the wire, one straightens it, one cuts it, etc etc until the pin is completeEach man specialises in a particular taskHe says that if one man were to do all of these jobs that he would make 20 pins per day however 10 men specialising in their task could make 48,000 pins.X box production line showing division of labour

Benefits of the division of labourWhat do you think the benefits of producing this way would be?Increased aptitude – the more a task is done the more expert the person becomesTime saving – less time spent switching between different tasks. Less time for trainingWorking to one’s natural strengths – allows people to do what they are best atUse of capital equipment – as tasks are subdivided, it becomes worthwhile to use machinery (the X box power button being tested)

Benefits of the division of labourSpecialism has enabled people to enjoy a standard of living that could never have been achieved through self-sufficiencyIt does however require exchangeExchange was historically achieved through bartering With the development of money trade and specialisation transformed economies

Production, productivity and productive efficiencyProduction – converting inputs to outputs. Production refers to the total output of goods and services produced within a market.Productivity – economists usually use this to refer to how productive labour is but it is also used for other inputs into production

A company could increase productivity by investing in new capital machinery that reduces the number of workers it requiresThe government aims to improve labour and capital productivity in the UK economy

Measuring productivity

Labour productivity = total output per time period Number of units of labour

Capital productivity = Total output per time period Number of units of capital

The advantages of higher productivityLower average costs – if there are improvements in labour and capital productivity businesses will produce output at a lower average cost. These might be passed on to the consumer which will encourage higher demand leading for higher output and possibly an increase in employment

Improved competitiveness in international markets – when businesses improve their productivity its makes them more competitive; they are able to develop competitive advantage particularly when there is strong overseas price competition

The advantages of higher productivityHigher profits – Revenue less costs = profit therefore if the costs can be reduced the profit will be greater and can be invested in further growthHigher real wages – when the labour force increases its efficiency firms are more willing and better able to increase wagesGrowth of the economy – the capacity of the economy depends on the quantity of factors of production and the quality – quality is measured in terms of productivity. If the rate of growth in quality/productivity of factors improves the PPB will shift outwards allowing more potential growth for the economy

How do firms/industries improve productivity?Up to date capital machineryGood managerial skillsHighly qualified and trained employees

The strength of demand also affects productivity – when demand is high and production plants are running close to full capacity then the output per worker employed is likely to be rising because factors of production are being used to their full extentConversely during a recession utilisation of factors of production falls with lower levels of demand and productivity growth will slow

Costs of production

Output

ATC

Q1Illustrating productive efficiency

Productive efficiencyThe diagram below illustrates a firms costs of production. The curve shows the Average Total Costs (ATC) When you get to A2 you will learn more about why the curve is shaped like this but for the moment just accept that this is the shape and that costs fall until they are producing Q1 and after that point they increase For a firm to have productive efficiency it needs to be producing Q1 output because this is the point where average total costs are at their lowest. For an economy to be productively efficient all the firms need to be producing their output at this level.Q1 is the point of maximum productive efficiency

Efficiency and the production possibility boundaryProductive efficiency can also be illustrated using a model introduced earlier – the PPB.If we assume that we have a simple two product economy point X implies that there are unused resourcesIncreasing employment of all factors of production leads to point Y at which it is not possible to produce more with the current factors of productionPoint Y or any point on the PPB is where productive efficiency is maximised. Read the case studies on P79 and 80 and then do the activity on P81

Good B

Good A

X

Y..

A PPB to illustrate productive efficiency

JeopardyFor each of these answers give me the question 1. By drawing a point within the PPB and another on the boundary

and showing the movement from one to the other2. An individual, firm or country producing a limited range of goods

and services3. Revenue – total costs = profit and costs are reducing4. Production5. Growth of the economy and lower average costs6. Exchange7. Division of Labour8. Up to date machinery, good managerial skills and highly

qualified/trained employees9. Labour productivity10. A firm producing output at the lowest point on its average total

cost curve11. Increasing aptitude and time saving

JeopardyFor each of these answers give me the question 1. By drawing a point within the PPB and another on the boundary and

showing the movement from one to the other – Using a PPB how could we illustrate an economy that is not maximising productive efficiency?

2. An individual, firm or country producing a limited range of goods and services – What is specialisation?

3. Revenue – total costs = profit and costs are reducing – How can higher levels of productivity give more profits?

4. Production – What is the term for converting inputs into outputs?5. Growth of the economy and lower average costs – What are 2

benefits of higher productivity?6. Exchange – what must happen for specialisation to lead to higher

levels of welfare?7. Division of Labour – At the level of the individual what term would

you use to describe specialisation?8. Up to date machinery, good managerial skills and highly

qualified/trained employees – How do firms improve productivity?9. Labour productivity – What is the formula ‘total output per time

period/number of units of labour’ used to measure?10. A firm producing output at the lowest point on its average total cost

curve – What is productive efficiency?11. Increasing aptitude and time saving – what are 2 benefits of division

of labour?

Costs of productionCosts are those expenses faced by a business when producing a good or service for a marketTo break even a firm has to earn enough revenue to cover the costs and to make a profit it has to earn more than thatThere are two types of costs (Fixed and Variable)Fixed costs – those that never vary with output levels – if a firm makes 10 units or 100 units the fixed costs remain the sameExamples of fixed costs?rent on buildings, the depreciation in value of capital equipment due to age, Insurance, Salaries (employees that are paid a fixed amount each month), Interest on bank loans or other borrowed money, the costs of purchasing new capital equipment, marketing and advertising costs

Costs of productionAverage fixed costs (AFC) will reduce as output increases (the fixed costs are spread over the number of units that are produced)

if fixed costs are £100 and 10 units are made then AFC is 100/10 = £10 per unitIf fixed costs are £100 and 100 units are made then AFC is 100/100 = £1 per unit

Costs of productionVariable costs – those costs that do change with the level of output – for example if I produce 10 cardboard boxes I have to pay for 10 lots of card – if I produce 100 boxes I have to pay for 100 lots of card.

We can work out the average variable cost (AVC) by dividing these costs by the number of units producedExample of variable costs - Raw materials, Labour costs (flexible workers), Utilities – electricity, water etc

We add fixed costs to variable costs to get Total costs

Economies and Diseconomies of ScaleThe average total cost per unit will reduce as the firm produces more (by expanding their production)

If the firm produces 100 units and total costs are £100 the average total cost per unit will be £1If the firm produces 1000 units and the total costs are £700 the average total cost per unit will be 70p This is because although the variable costs are increasing as the amount of output increases the fixed costs are the same and can be spread over the larger output.

Economies and Diseconomies of ScaleEconomies of scale are cost advantages that a business can exploit by expanding their scale of productionThese lower costs represent an improvement in productive efficiency and can be passed on to the consumer in lower pricesThese lower costs may also give a firm competitive advantage and possibly higher profitsThe reason that pc’s, digital cameras and MP3 players fall in price all the time is that the markets are taking advantage of economies of scale bringing down unit costs of production and passing on these savings to consumers in the form of lower prices.

Economies and Diseconomies of ScaleThere are many types of economy of scale and these will depend on the characteristics of the market.They will also come from a combination of sourcesWe tend to split economies of scale into two categories – internal and externalInternal economies of scale are those that arise from the growth of the firm itself and include:Technical economies of scale

Large scale businesses can afford to invest in expensive specialist machinery e.g. a national newspaper could buy a large scale printing press which would increase productivity and reduce unit costs. A local newsletter could not do thatSpecialisation of the workforce – splitting tasks to boost productivity The law of increased dimensions – if an oil producer were to build new larger containers the cost would probably be related to the surface area of the container but the revenue gained from the extra oil it would be able to hold would far outweigh those costs.

Economies and Diseconomies of ScaleMarketing economies of scale – the cost of advertising is fixed therefore the costs can be spread over the larger outputManagerial economies of scale – large firms can justify having specialist managers – better management and investment in human resources raises productivity and reduces unit costs.Financial economies of scale – larger firms are normally more credit worth and will find it easier to raise money for investment and may also be charged lower interest rates than smaller firms. A larger firm may also be able to negotiate discounts with its suppliers as it will be ordering larger amounts of components.Network economies of scale – once the network is built the cost of adding one more user to the network is close to zero but the benefits may be huge because each new user can interact and trade. E.g. air transport networks, online auctions, telecommunications

External Economies of scaleExternal economies of scale occur outside of the firm but within the industry such as

A better transportation network leading to cost reductionsDevelopment of R&D in universitiesThe relocation of component suppliers or support businesses closer to manufacturing centre or science park

Diseconomies of ScaleA firm may eventually experience a rise in average costs caused by diseconomies of scale which may come fromControl – monitoring the productivity and quality of output from thousands of employees in a big corporation is very difficult and costlyCo-ordination – it is difficult to co-ordinate complicated production processes across many different locations that may often be in different countries. Achieving flows of information is very difficult and so is managing the amount of supplier contracts that will be requiredCooperation – workers may feel less of a sense of belonging to a larger company and may feel like a number leading to a loss in productivity.

Avoiding diseconomies of scaleThere are ways that firms can try to avoid diseconomies of scale although, in reality, they are unlikely to prevent them entirelyHRM – Human Resource Management is the management of people within the firm. A firm needs to constantly work on improving recruitment procedures, training, retention and support of the staff.Performance related pay schemes provide incentives to increase productivityOutsourcing – paying other companies to perform certain areas of the business where they may not add value and concentrating on what they do best.

Costs of production

Output

ATC

Q2Illustrating economies and diseconomies of scale

Illustrating economies and diseconomies of scaleWe can use the cost of production diagram we saw before to illustrate economies of scaleFrom Q1 the firm sees its costs gradually reducing until it reaches its lowest point – it is experiencing economies of scale probably for various reasonsAt Q2 it is operating at least cost and is productively efficientAfter Q2 it starts to suffer from increasing diseconomies of scale as costs riseComplete activity on P85

Q3Q1

Economies of Scale

Diseconomies of Scale

Competition and MonopolyEconomists generally accept that a high level of competition is needed for markets to function well (for the signalling, incentives and rationing to work)For perfect competition there needs to be many buyers and sellers who are price takers, products are homogeneous, full information is available, and no barriers to entry or exit should existSome of the key arguments in favour of competitive markets are as follows1. A high level of competition will lead to productive efficiency – any firm that cannot do this will find its market share competed way who have lower costs and can offer lower prices2. A high level of competition will be more likely to ensure that firms produce precisely what consumer want (there will be consumer sovereignty). Any firm that does not will not survive

Competition and MonopolyMany markets, in reality, do not have such high levels of competition for some of these reasons

Economies of scale – if there was a high level of competition there would be many suppliers and no room for growth meaning firms would not be able to benefit from economies of scale. For there to be economies of scale there needs to be few suppliers or maybe only one (a pure monopoly)Profits - We know that firms want to maximise profits and so they will naturally want to get rid of the competition. Also profits from economies of scale can be used to invest in R&D allowing them to provide new goods and services that consumers want and further eliminate competitors

JeopardyFor each of these answers give me the question1. Fixed costs2. Average fixed costs3. By dividing these costs by the number of units produced4. Total costs5. Economies of scale6. They will reduce7. Internal economies of scale8. Because of the three C’s – control, co-ordination and

co-operation9. HRM, Performance related pay schemes and

outsourcing10. It should lead to productive efficiency and firms will

produce exactly what the consumer wants (consumer sovereignty)

11. Perfect competition12. Due to the existence of economies of scale and the urge

to maximise profits

JeopardyFor each of these answers give me the question1. Fixed costs – which costs never vary with the level of output?2. Average fixed costs – which costs will reduce as output increases?3. By dividing these costs by the number of units produced – how can we work

out the average variable costs4. Total costs – what do we get if the add variable costs to fixed costs?5. Economies of scale – what do we call the cost advantages a business can

exploit as it expands scale of production?6. They will reduce – what will happen to average total costs as the firm

increases production?7. Internal economies of scale – what are technical eos, marketing eos,

managerial eos, financial eos and network eos examples of?8. Because of the three C’s – control, co-ordination and co-operation – How

might a firm eventually experience diseconomies of scale?9. HRM, Performance related pay schemes and outsourcing – what 3 ways can

firms use to try to avoid diseconomies of scale?10. It should lead to productive efficiency and firms will produce exactly what the

consumer wants (consumer sovereignty) – Why is it good to have a highly competitive market?

11. Perfect competition – if there are many buyers an sellers who are price takers, products are homogeneous, full information is available and there are no barriers to entry what kind of competition would we say existed?

12. Due to the existence of economies of scale and the urge to maximise profits – why, in reality, are there markets that do not have perfect competition?

Key TermsDivision of labour – breaking the production process down into a sequence of tasks, with workers assigned to particular tasksSpecialisation – the production of a limited range of goods by an individual factor of production or firm or country, in co-operation with others so that together a complete range of goods is produced.Production – the process that converts factor inputs into outputs of goods and servicesFixed costs – costs of production that stay fixed as output changesVariable costs – costs of production that vary with outputEconomies of scale – where an increase in the scale of production leads to reductions in average total cost for firmsDiseconomies of scale – where an increase in the scale of production leads to increases in average total costs for firms.Competition – a market situation in which there are a large number of buyers and sellersMonopoly – a market structure dominated by a single seller of a good

SummarisingRead Case Study P49Answer QuestionsESQ

HomeworkComplete activitiesComplete notes for Chapter 7Learn key termsExam style questions P86

Additional reading - reading of all these is optional but remember that the students that get the best marks are those that read widely and who can make valid judgements. Take at least one (more would be better!) of these articles and explain what is happening using the theory that you have learned.

Consoles look to hit their stride (BBC news, July 2008)Cost headache for games developers (BBC news, December 2007)Economies of scale in printing (Tutor2u economics blog, March 2008)GM installs world's biggest rooftop solar panels (Guardian, July 2008)How world's biggest ship is delivering our Christmas - all the way from China (Guardian)Mobile web reaches critical mass (BBC news, July 2008)Salad production on a massive scale (BBC news, June 2008)

Learning Objectives - did we achieve them?

At the end of this chapter you will be able to Define and explain the benefits of specialisation and division of labourDefine and explain production and productivityDefine, explain and illustrate productive efficiencyDefine and give examples of economies and diseconomies of scale and assess their implications for the growth of firms and the structure of markets.