AQA AS Chapter 7
Production and efficiency
Chapter 7
In 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 labour
Define and explain production and
productivity
Define, explain and illustrate productive
efficiency
Define 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
services
It occurs between countries – e.g. China
specialises in textiles and the US in computer
software
It happens within a country – the City of London
specialises in financial services
At the level of the individual this is known as the
division of labour
This was developed by a famous economist Adam
Smith in 1776 in his book The Wealth of Nations
He 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 complete
Each man specialises in a particular task
He 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
labour
What do you think the benefits of
producing this way would be?
Increased aptitude – the more a task is
done the more expert the person
becomes
Time saving – less time spent
switching between different tasks. Less
time for training
Working to one’s natural strengths –
allows people to do what they are best
at
Use 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
labour
Specialism has enabled people to
enjoy a standard of living that could
never have been achieved through
self-sufficiency
It does however require exchange
Exchange was historically
achieved through bartering
With the development of money
trade and specialisation
transformed economies
Production, productivity
and productive efficiency
Production – 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 requires
The 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
productivity
Lower 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
productivity
Higher profits – Revenue less costs =
profit therefore if the costs can be
reduced the profit will be greater and
can be invested in further growth
Higher real wages – when the labour
force increases its efficiency firms are
more willing and better able to increase
wages
Growth 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 machinery
Good managerial skills
Highly 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 extent
Conversely during a recession utilisation of factors of
production falls with lower levels of demand and
productivity growth will slow
Productive efficiency
The 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
Costs of
production
ATC
Q1
Illustrating productive
efficiency
Output
Efficiency and the production possibility boundary
Productive 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 resources
Increasing employment of all factors of production leads to point Y at
which it is not possible to produce more with the current factors of
production
Point 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
.
Y
.
X
A PPB to illustrate
productive efficiency
Good A
Jeopardy
For 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
2.
An individual, firm or country producing a limited range of goods
and services
3.
Revenue – total costs = profit and costs are reducing
4.
Production
5.
Growth of the economy and lower average costs
6.
Exchange
7.
Division of Labour
8.
Up to date machinery, good managerial skills and highly
qualified/trained employees
9.
Labour productivity
10. A firm producing output at the lowest point on its average total
cost curve
11. Increasing aptitude and time saving
Jeopardy
For 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 production
Costs are those expenses faced by a
business when producing a good or service
for a market
To break even a firm has to earn enough
revenue to cover the costs and to make a
profit it has to earn more than that
There 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 same
Examples 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 production
Average 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 unit
If fixed costs are £100 and
100 units are made then
AFC is 100/100 = £1 per
unit
Costs of production
Variable 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 produced
Example 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 Scale
The 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 £1
If 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 Scale
Economies of scale are cost
advantages that a business can exploit
by expanding their scale of production
These lower costs represent an
improvement in productive efficiency
and can be passed on to the consumer
in lower prices
These lower costs may also give a firm
competitive advantage and possibly
higher profits
The 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
Scale
There 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 sources
We tend to split economies of scale into two
categories – internal and external
Internal 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 that
Specialisation 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
Scale
Marketing economies of scale – the cost of
advertising is fixed therefore the costs can be
spread over the larger output
Managerial 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 scale
External economies of scale
occur outside of the firm but within
the industry such as
A better transportation
network leading to cost
reductions
Development of R&D in
universities
The relocation of component
suppliers or support businesses
closer to manufacturing centre
or science park
Diseconomies of Scale
A firm may eventually experience a
rise in average costs caused by
diseconomies of scale which may
come from
Control – monitoring the productivity
and quality of output from thousands
of employees in a big corporation is
very difficult and costly
Co-ordination – it is difficult to coordinate 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 required
Cooperation – 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 scale
There are ways that firms can try to
avoid diseconomies of scale although, in
reality, they are unlikely to prevent them
entirely
HRM – 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
productivity
Outsourcing – paying other companies
to perform certain areas of the business
where they may not add value and
concentrating on what they do best.
Illustrating economies and diseconomies of scale
We can use the cost of production diagram we saw before to
illustrate economies of scale
From Q1 the firm sees its costs gradually reducing until it
reaches its lowest point – it is experiencing economies of scale
probably for various reasons
At Q2 it is operating at least cost and is productively efficient
After Q2 it starts to suffer from increasing diseconomies of
scale as costs rise
Complete activity on P85
Costs of
production
ATC
Illustrating economies and
diseconomies of scale
Q2
Q1
Economies
of Scale
Q3
Diseconomies
of Scale
Output
Competition and Monopoly
Economists 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 exist
Some of the key arguments in favour of
competitive markets are as follows
1. 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 prices
2. 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 Monopoly
Many 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
Jeopardy
For each of these answers give me the question
1. Fixed costs
2. Average fixed costs
3. By dividing these costs by the number of units produced
4. Total costs
5. Economies of scale
6. They will reduce
7. Internal economies of scale
8. Because of the three C’s – control, co-ordination and
co-operation
9. HRM, Performance related pay schemes and
outsourcing
10. It should lead to productive efficiency and firms will
produce exactly what the consumer wants (consumer
sovereignty)
11. Perfect competition
12. Due to the existence of economies of scale and the urge
to maximise profits
Jeopardy
For each of these answers give me the question
1.
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 costs
4.
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 Terms
Division of labour – breaking the production process down into a
sequence of tasks, with workers assigned to particular tasks
Specialisation – 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 services
Fixed costs – costs of production that stay fixed as output
changes
Variable costs – costs of production that vary with output
Economies of scale – where an increase in the scale of
production leads to reductions in average total cost for firms
Diseconomies 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 sellers
Monopoly – a market structure dominated by a single seller of a
good
Summarising
Read Case Study P49
Answer Questions
ESQ
Homework
Complete activities
Complete notes for Chapter 7
Learn key terms
Exam 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 labour
Define and explain production and productivity
Define, explain and illustrate productive efficiency
Define and give examples of economies and
diseconomies of scale and assess their implications
for the growth of firms and the structure of markets.