Firms and production

Economics · Microeconomic decision-makers. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Firms need land, labour, capital and enterprise to produce. The demand for a factor of production is a derived demand: firms want it only because consumers want the product it helps to make. Firms also look at each factor's price, availability and productivity, and may replace a dear factor with a cheaper one.

Labour-intensive production uses a high proportion of labour compared with capital, as in hand-made carpets. Capital-intensive production uses a high proportion of machinery, as in oil refining.

Production is the total output made. Productivity is output per unit of input, for example output per worker. Investment in new machines and training raises productivity, which lowers the cost of each unit.

Rules to remember

Labour productivity = total output ÷ number of workers (or ÷ hours worked)
Production can rise while productivity falls, if the number of workers rises by a bigger percentage than output
Demand for a factor rises when demand for the product rises, or when the factor becomes cheaper, easier to get or more productive
Labour-intensive: chosen where labour is cheap and plentiful or goods are made to order. Flexible, with low set-up costs, but output is slower and quality can vary
Capital-intensive: chosen for mass production. High output, low average cost and even quality, but high set-up costs, less flexibility and breakdowns stop production
Investment is spending on capital goods; more or better capital per worker raises labour productivity

Common mistake

Using production and productivity as if they mean the same. Production is how much is made in total; productivity is how much is made per worker or per machine.

Worked example

Firm A has 25 workers and makes 2,000 units a day. Firm B has 40 workers and makes 2,800 units a day. Which firm has the higher production and which has the higher labour productivity?

Production: B makes 2,800 units, which is more than A's 2,000 units.
Productivity of A = 2,000 ÷ 25 = 80 units per worker per day.
Productivity of B = 2,800 ÷ 40 = 70 units per worker per day.

Answer: Firm B has the higher production (2,800 units a day), but Firm A has the higher labour productivity (80 against 70 units per worker).

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