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Tutor2u - Production, Productivity and Costs


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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.

Published in: Economy & Finance
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Tutor2u - Production, Productivity and Costs

  1. 1. Production, Productivity and Supply Costs
  2. 2. Background to Supply Production, Productivity and Supply Costs
  3. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.
  15. 15. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ
  16. 16. Tutor2u Keep up-to-date with economics, resources, quizzes and worksheets for your economics course.