This chapter considers some core concepts relating to production and productivity (they are not the same!) which will be useful in understanding the theory of market supply. Productivity is a measure of efficiency and changes in productivity have an important effect on the unit costs of supply. In this section we also briefly cover fixed and variable costs and the sources of some long run economies of scale which benefit bigger businesses as they expand. Specialisation is an important AS concept – be ready to apply it to the production possibility frontier for example.

1. Production, Productivity and Supply
Costs

2. Background to Supply
Production,
Productivity and
Supply Costs

3. The Difference between Production & Productivity
It is important for students to make clear the distinction between
production and productivity
• Production
• Production measures the value of an output of goods and
services e.g. measured by national GDP or an index of
production in specific industry such as car manufacturing
• Productivity
• A measure of the efficiency of factors of production
• Measured by output per person employed
• Or output per person hour
• An increase in production DOES NOT automatically mean an
increase in productivity – it depends on how many factors of
production have been utilised to supply the extra output

4. Productivity
Productivity measures the efficiency of the production process
• In the long run, productivity is a major determinant of
economic growth and of inflation.
• A fall in labour productivity leads to a rise in firms’ (unit) costs of
production (assuming that the level of wages remains the same)
• Higher productivity allows businesses to pay higher wages and
achieve increased profits at the same time.
Factor
Inputs
(land,
labour and
capital)
Factor
Productivity
(efficiency)
Output of
goods and
services

5. The degree of
competition in a
market / industry
Advances in
production
technology
Investment in
Apprenticeships /
training to boost
labour skills
Quality of
management in a
business
What Factors Affect the Level of (Labour) Productivity?
Many demand and supply-side factors affect labour productivity
Specialisation
(division of labour)
within businesses
Higher business
investment in new
capital inputs
Having a high
quality national
infrastructure
Strength of
demand for a
product in the
market

6. Costs of Production in the Short Run
Commission Bonuses Wage Costs
Component parts Basic raw materials
Variable Costs
Variable costs relate directly to the
production or sale of a product. An increase
in short run output will cause total variable
cost to rise. Average variable cost = total
variable cost / output
Fixed Costs
Fixed cost has to be paid, whatever the
level of sales achieved. The higher the
level of fixed costs in a business, the
higher must be the achieved output in
order to break-even
Insurance Salaried staff
Capital depreciation Research Projects

7. Internal Economies of Scale (IEoS) in the Long Run
• Economies of scale are the reductions in long run average cost
arising from a business expanding the scale of their operations
Technical
economies i.e.
containerization
Purchasing
economies e.g. bulk
buy purchases
Managerial
economies –
specialized staff
Financial economies
e.g. lower interest
rates on loans
Risk-bearing
economies from
diversification
Network economies –
networks of suppliers /
customers

8. Economies of Scale in the Long Run – Analysis Diagram
Q1
Average
Cost
(Unit
Cost)
Output
LRAC
Q2 Q3
Economies of
scale cause
AC to fall
Lowest point on LRAC
is output of
productive efficiency
Economies of scale arise from increasing returns to scale in the long run

9. External Economies of Scale (EEoS)
• External economies of scale occur outside of a firm but within an
industry. Examples include:
University
Research
Transport
Networks
Relocation of
Suppliers
Influx of human
capital – skilled
workers
External economies of scale
involve changes outside of the
business i.e. they result from
the expansion of the entire
industry of which the business
is a member. They lower unit
costs for many / all firms
inside the market
Agglomeration economies are
important. Businesses in
similar industries cluster
together and attract an influx
of skilled talent which
provides human capital to
expanding businesses.

10. Diseconomies of Scale (Rising Long Run Unit Costs)
• Diseconomies lead to a rise in a firm’s
long run average cost of production.
• They result from a business expanding
beyond an optimum size and losing
productive efficiency
• Diseconomies may be due to:
1. Control – problems in monitoring
productivity and work quality,
increasing wastage of resources
2. Co-operation - workers in large firms
may develop a sense of alienation
and loss of morale
3. Negative effects of internal politics,
information over-load, unrealistic
expectations among managers and
cultural clashes between senior
people with inflated egos
Regulatory Costs
Office Politics /
Industrial Relations
Risk Aversion
Waste / Inefficiency
in large organisations
Bigger businesses are more complex
and this leads to higher fixed costs

11. Specialisation
• Specialisation is when we concentrate on a product or task
• Specialisation happens at all levels of economic activity:
1. Specialization of tasks within extended families in many of the
world’s poorest countries
2. Within businesses and organizations e.g. in mass
manufacturing of vehicles or in the building industry
3. In a country – Bangladesh is a major producer and exporter of
textiles; the USA is a leading shale oil and gas supplier. And
Ghana is one of the biggest producers of cocoa in the world.
4. In a region of a country – for many years the West Midlands
has been a centre for motor car assembly, there has been
huge investment in recent years in the Mini plant at Oxford.
Specialisation in localities / regions can lead to the benefits of
agglomeration

12. The Division of Labour
• The division of labour occurs
where production is broken down
into many separate tasks.
• Division of labour can raise
output per person as people
become proficient through
constant repetition of a task
• This is called “learning by doing”.
• This gain in productivity helps to
lower the supply cost per unit
• Reduced supply costs should lead
to lower prices for consumers of
goods and services causing gains
in economic welfare
Specialisation of
task in the
production
process……………
Can lead to higher
output per person /
per hour worked

13. Advantages of Specialisation
Higher labour productivity and business profits
• Learning by doing increases output per hour worked
• Higher productivity lowers the unit cost of supply
• Increased productivity leads to higher profits for businesses
Specialisation creates surplus output that can then
be traded internationally
• The theory of comparative advantage is key to this
• Businesses / countries specialize in areas of relative advantage
Lower prices, higher real incomes an GDP growth
• Lower prices gives consumers greater real purchasing power
• Higher productivity allows businesses to pay increases wages
• Successful specialization is one of the key causes of growth

14. Disadvantages of Specialisation and Division of Labour
1. Unrewarding, repetitive work that requires little skill can lower
motivation and eventually causes lower productivity.
2. Workers may take less pride in their work and quality suffers.
3. Dissatisfied workers become less punctual at work and the rate
of absenteeism increases.
4. Many people may choose to move to less boring jobs creating a
problem of high worker turnover for businesses. The highest
labour turnover is in retailing, hotels, catering and leisure, call
centres and other lower-paid private sector services groups.
5. Some workers receive little training and may not be able to find
alternative jobs if they find themselves out of work - they may
then suffer structural unemployment / occupational immobility
6. Mass-produced standardized goods lack variety for consumers.

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