production and productivity

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Chapter 7 Production and efficiency

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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.

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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.

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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.

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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

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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)

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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

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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

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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 Specialisation video

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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

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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

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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

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Costs of production Output ATC Q1 Illustrating productive efficiency 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

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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 Good A X Y . . A PPB to illustrate productive efficiency

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Jeopardy For each of these answers give me the question By drawing a point within the PPB and another on the boundary and showing the movement from one to the other An individual, firm or country producing a limited range of goods and services Revenue – total costs = profit and costs are reducing Production Growth of the economy and lower average costs Exchange Division of Labour Up to date machinery, good managerial skills and highly qualified/trained employees Labour productivity A firm producing output at the lowest point on its average total cost curve Increasing aptitude and time saving

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Jeopardy For each of these answers give me the question 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? An individual, firm or country producing a limited range of goods and services – What is specialisation? Revenue – total costs = profit and costs are reducing – How can higher levels of productivity give more profits? Production – What is the term for converting inputs into outputs? Growth of the economy and lower average costs – What are 2 benefits of higher productivity? Exchange – what must happen for specialisation to lead to higher levels of welfare? Division of Labour – At the level of the individual what term would you use to describe specialisation? Up to date machinery, good managerial skills and highly qualified/trained employees – How do firms improve productivity? Labour productivity – What is the formula ‘total output per time period/number of units of labour’ used to measure? A firm producing output at the lowest point on its average total cost curve – What is productive efficiency? Increasing aptitude and time saving – what are 2 benefits of division of labour?

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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

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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

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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

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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.

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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.

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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.

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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

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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

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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 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 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.

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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.

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Costs of production Output ATC Q2 Illustrating economies and diseconomies of scale 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 Q3 Q1 Economies of Scale Diseconomies of Scale

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Memory Challenge Productive Efficiency

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Several key terms will appear They will disappear after 30 seconds (do not write anything in this time) Your task: (1)List the terms + (2) Define them (8 mins to get as many as possible)

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Productively efficient Division of Labour Average variable costs Competitive Advantage 3 C’s Fixed costs LRAC specialisation PPB Internal EoS Productivity Division of labour Economies of Scale

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Over to you!

Think, Pair & Share:

Think, Pair & Share Do you think competition is good/monopoly is bad? Read the article http://online.wsj.com/article/SB10001424052748704635704575604993311538482.html Think from the perspective of government, firms and consumers Write your ideas in the ‘think’ section (8 mins) Do not discuss this with your neighbour yet Then share your ideas with your neighbour (2 minutes) Write anything you had not thought of in the pair section Now share with the rest of the class

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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

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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

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Homework ESQs P86 Essay – see stretch and challenge on P86 (no more than 2 pages) Look at the course companion for more info Also tutor 2 u

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Jeopardy For each of these answers give me the question Fixed costs Average fixed costs By dividing these costs by the number of units produced Total costs Economies of scale They will reduce Internal economies of scale Because of the three C’s – control, co-ordination and co-operation HRM, Performance related pay schemes and outsourcing It should lead to productive efficiency and firms will produce exactly what the consumer wants (consumer sovereignty) Perfect competition Due to the existence of economies of scale and the urge to maximise profits

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Jeopardy For each of these answers give me the question Fixed costs – which costs never vary with the level of output? Average fixed costs – which costs will reduce as output increases? By dividing these costs by the number of units produced – how can we work out the average variable costs Total costs – what do we get if the add variable costs to fixed costs? Economies of scale – what do we call the cost advantages a business can exploit as it expands scale of production? They will reduce – what will happen to average total costs as the firm increases production? Internal economies of scale – what are technical eos, marketing eos, managerial eos, financial eos and network eos examples of? Because of the three C’s – control, co-ordination and co-operation – How might a firm eventually experience diseconomies of scale? HRM, Performance related pay schemes and outsourcing – what 3 ways can firms use to try to avoid diseconomies of scale? 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? 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? 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?

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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

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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)

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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.

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