Firms and production-Economics chapter 21

• The demand for any factor of production is of derived demand. (means that a factor of production is not demanded for its own sake, but for the goods and services that it is used to produce.)

  • This means that the demand for factors of production depends on the demand for the goods and services which the factors will be used to produce.
  • For example, economics lecturers at university are hired only if there is demand for economics courses from undergraduates.
• One a macroeconomic scale, the demand for the factors of production in a country results from the total level of demand for goods and services in the economy.

  For instance, during an economic recession, firms will demand less labour

  In addition to the derived demand for land labour and capital, the demand for factors of production also depends on their costs, availability and quality
• The demand for factors of production depends on these factors:

  • The cost of factors of production — the higher the cost of land, labour and capital, the lower their demand tends to be.
  • By contrast, if labour costs are relatively high compared to the cost of capital, then workers might be replaced by machinery and technology. The demand for capital depends on the cost of borrowing money — higher interest rates increase the cost of financing capital-intensive production.
• Determinants of demand of factors of production:

  • The quantity (or availability) of factors of production — the greater the availability of land, labour and capital, the lower their cost tends to be, and hence the higher their demand. For example, the relatively large size and availability of the workforce in India and China has boosted the demand for labour from multinational companies seeking to expand their operations.
  • In general, the greater the quantity of a factor of production, the lower its cost tends to be
• Determinants of the factors of production:

  • The productivity of factors of production — better-quality resources tend to demand a higher price due to their high productivity. For example, surgeons, pilots and barristers are in high demand due to their highly valued skills and qualifications.
  • China, India, Vietnam and Thailand have good-quality land for growing rice, whereas Scandinavian countries do not have the natural climate to do so
• Labour-intensive industries: In labour-intensive industries, the cost of labour is proportionately higher than the cost of other factors of production. Examples are traditional forms of agricultural farming, teaching
• Labour-intensive production can be very expensive. For example, in private fee-paying schools and health clinics, labour costs account for the largest proportion of production costs, so the price charged to customers is relatively high. Labour-intensive production processes tend to be used to produce individual or personalised products (such as a Hollywood movie or a custom-made wedding dress)
• • Capital-intensive industries: In capital intensive industries, the use and cost of capital is more prominent than that of any other factor of production.
  • Capital-intensive production takes place if a firm spends more on capital costs than on any other factor of production. This includes expenditure on capital equipment such as tools.
  • Therefore, firms operating capital-intensive production need a lot of money to fund their activities. This can act as a barrier to entry since it proves expensive for new firms to enter such industries. Examples are aircraft and motor vehicle manufacturers
• • Despite the initially high costs of capital-intensive production, there are potentially huge cost savings in the form of technological economies of scale in the long run.
  • Firms that become more capital-intensive usually do so to increase their output and productivity levels by mass-producing their products.
  • In this way, their unit costs of production are relatively low. As countries such as India and China industrialise, production also tends to become more capital-intensive.
• Choosing between capital and labour intensive production:

  • The cost of labour compared to the cost of capital — firms tend to choose more capital-intensive methods of production if labour costs are relatively high (assuming that they can substitute factors of production in the output process), and vice versa.
• Choosing between capital and labour intensive production:

  • The size of the market — capital-intensive production tends to take place for mass-market products such as soft drinks, passenger vehicles and consumer electronics. Labour-intensive methods are often used for personalised services, such as a private tutor, counsellor, adviser, instructor or coach.
• Choosing between capital and labour intensive production:

  • The firm’s objectives — profit maximisers operating in mass markets tend to opt for capital-intensive production to minimise their unit costs of production. Other firms might choose to use labour-intensive methods as they operate on a smaller scale or to safeguard jobs. For example, manufacturers such as Black & Decker operating in Shenzhen, China, use labour-intensive production methods to create jobs in the special economic zone,benefiting from tax incentives from the government
• Reasons for using capital-intensive production:

  • Capital-intensive production enables firms to use mass production techniques, such as automation in car manufacturing. This enables more output to be produced in less time than using labour-intensive methods. For example, Coca-Cola produces 2000 cans of Coke per minute at its bottling plant when operating at full capacity!
  • Unit costs of production are therefore relatively low. 
• Reasons for using capital-intensive production:

  • The use of capital-intensive technologies reduces human error in the production process — that is, machinery is more accurate than humans in the production process.
  • However, there are drawbacks too. Capital-intensive methods of production can involve huge set-up costs (such as purchase and installation), running costs (such as servicing and maintenance) and replacement costs (when equipment becomes outdated and in need of upgrading). The reliance on assembly lines means any breakdowns will cause major problems for the business
• Reasons for using labour-intensive production:

  • It is suitable for producing products that are highly customised (individualised), such as tailor-made suits and wedding gowns.
  • Similarly, labour-intensive output enables customers to receive a personalised service, so it is appropriate for firms to charge higher prices.
  • As workers are highly skilled and experienced, the quality of the product will also be high.
• Reasons for using labour intensive production:

  • Labour-intensive production is more flexible than capital-intensive methods. Labour, unlike capital (such as machinery), can be used flexibly to meet changing levels of demand. For example, retail businesses tend to hire more temporary workers during peak trading seasons. 
  • However, labour-intensive output can be expensive. Hiring highly skilled and experienced workers results in higher costs of production and hence a higher price charged to customers
• Production refers to the total output of goods and services in the production process
• Productivity is a measure of efficiency found by calculating the amount of output per unit of a factor input, eg output per worker or output per machine hour
• Labour productivity measures the efficiency of the workforce in terms of output per worker.

  • It can be improved by having a better-skilled workforce (through education and training) or by allowing workers to use better =, more efficient technologies to increase their output.
• The use of automation like robotics and specialised computer equipment in car manufacturing, can help to raise capital productivity without the need to hire more workers
• Labour productivity:

  Average product of labour= total output per period divided by number of employees

  Average revenue product of labour= Total revenue per period divided by the number of employees
• Higher productivity is important to the economy for several reasons:

  • Higher profits — productivity gains are a source of higher profits for firms. These profits can be reinvested in the business to fund research and development or to expand the operations of the business. Higher profits help to fund long-term survival of the firm.
  • Higher wages — highly productive firms that enjoy cost savings and higher profitability can afford to pay higher wages to their workers, especially if they become more efficient.
• Higher productivity is important to the economy for several reasons:

  • Improved competitiveness — productive firms are more efficient and so can compete more effectively on a global scale.
  • Economic growth — productivity is a source of economic growth because it increases the productive capacity of an economy, thus shifting out its production possibility curve. This helps to raise employment and standards of living in the economy.
• Differences between production and productivity:

  • Productivity is a measure of the degree of efficiency in the use of factors inputs in the production process. It takes an average measure of this efficiency, such as output per worker, sales revenue per person, or output per machine hour.
  • Can also be measured as a ratio, value of output compared to cost of inputs
  • Production refers to the total output of goods and services in the production process. Production can be increased either by using more factor inputs or by raising the productivity of existing factors of production
• Innovation: Is the commercialisation of new ideas and products. It is a vital source of productivity.
• Influences on productivity:

  • Investment — this is the expenditure on physical capital such as machinery, equipment and buildings. For example, investment in the latest technologies generally helps workers to do their jobs better — that is, to produce more and better-quality output. The degree of investment is determined by the level of interest rates. In general, the higher the interest rate, the more expensive capital expenditure will be, thus discouraging investment in the economy.
• Influences on productivity:

  • Innovation — this refers to the commercialisation of new ideas and products. The invention of tablet computers and smartphones has transformed the way many people work, as they can conduct their business while mobile rather than at the office. Such innovations have increased the speed of work, improved communications and enhanced organisation at work. Thus, innovation can boost productivity.
• Influences on productivity:

  • Skills and experience — the productivity of labour is determined by the quantity and quality of labour. The latter can be increased by improving the skills and experience of the labour force. Education and training, for example, enhance the human capital (skills and experiences of the workforce) in the economy, thus helping to increase productivity.
• Influences on productivity:

  • Entrepreneurial spirit — entrepreneurs take risks in the production process in the pursuit of profit. They plan and organise the various factors of production in the production process. Productivity depends on the drive (motivation) of entrepreneurs, such as their willingness and ability to exploit new business opportunities.
• Influences on productivity:

  • Competition — rivalry creates an incentive for firms to be more productive. Without competition, firms might lack the incentive to be efficient or innovative. Competition helps to boost the economy’s overall productivity