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Topic 2.6
Production
This topic covers production and productivity, and how producers can improve these metrics. You will learn new equations used in microeconomics, and the many different types of economies of scale.
Essential
Production & Productivity
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Production
Definition: Production is the total output of goods and services produced by a firm/industry in a given period of time.
An increase in production typically leads to:
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Increased employment
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Increased profits
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Economies of scale
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Higher market share
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Economic growth
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Rise in standard of living
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Productivity
Definition: Productivity is one measure of efficiency in the use of the factors of production in the production process, measured in output per unit of input.
Productivity can be increased by:
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Specialisation
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Investing in new technology (capital)
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Training and improving workers' skills
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Better quality raw materials
Formulas
Average Cost
The cost of producing one single unit
Average Cost = Total Cost/Quantity made
AC = TC/Q
Lower average cost is better as it signals efficiency
Fixed Costs vs Variable Costs: Fixed costs remain constant regardless of the level of output (e.g., rent, insurance). Fixed costs are always there, even if output is 0. Variable costs change in direct proportion to the level of production (e.g., raw materials, direct labor). Total cost is the sum of these two components.
Economies of Scale
Definition: Economies of scale are the cost advantages a firm can gain by increasing the scale of production leading to a fall in average costs.
Total Cost
All the costs of the firm added together
Total Cost = Total Fixed Costs + Total Variable Costs
TC = TFC + TVC
Variable costs can change depending on production, but fixed costs are the same.
Average Revenue
The revenue per unit sold
Average Revenue = Total Revenue/Quantity sold
AR = TR/Q
Average Revenue is the same as price
Total Revenue
The total income of a firm from the sale of goods/services
Total Revenue = Price x Quantity
R = PQ
In 6-markers, talk about increased/decreased revenues
Profit
The difference between revenue and cost, including any opportunity costs
Profit = Revenue - Costs
P = TR-TC
Making profit is the reason why producers produce.
Types of Economies of Scale
Internal economies of scale exist inside of a firm and are due to actions done by the firm itself
Technical - purchasing expensive technical equipment to make production process efficient
Purchasing (Bulk Buying) - Larger firms command higher negotiating power with suppliers, allowing them to buy raw materials or inventory in large volumes for lower unit costs
Managerial - The ability to hire specialist managers (e.g., dedicated marketing directors or logistics experts). Specialists are more efficient at their specific roles, which boosts overall workforce productivity
Financial -Large, established businesses usually have better credit ratings and proven track records. This allows them to secure bank loans, credit lines, and raise capital at significantly lower interest rates
Marketing - Larger businesses can spread their fixed advertising budgets across a vastly greater output. Bulk-buying advertising space or hiring dedicated marketing agencies results in a lower promotional cost per unit sold
Risk-Bearing - Big businesses can diversify their product lines and target multiple markets. If a single product fails, losses can be offset by gains elsewhere, which lowers the overall cost of risk management and insurance
External Economies of Scale:
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These are economies of scale that are outside of a firms control, including:
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Infrastructure and Transport: As a sector expands, governments or private developers are more likely to invest in dedicated infrastructure, such as improved highways, specialised ports, or robust broadband networks. This dramatically lowers transportation and operational costs
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Research, Development, and Information: Growing industries often see the creation of shared research facilities, specialised training institutes, or industry-specific publications. Additionally, knowledge spillovers occur organically as employees share ideas and innovations across different companies in the area
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Location: external economies of scale occur when businesses in the same industry see their production costs drop simply by being physically located near each other
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Evaluating the importance of productivity to the economy
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Evaluations
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Productivity is important to economies because it drives economic growth: when workers and firms produce more efficiently, average costs fall, economies of scale improve, and businesses become more competitive at home and abroad. That greater competitiveness can lead to lower prices and more efficient markets, which encourages consumption and ultimately raises GDP.
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When productivity rises, firms can often pay higher wages because each worker produces more output, which raises household income and disposable income. That extra disposable income increases consumer spending, boosts demand for goods and services, encourages firms to hire more workers, and can raise tax revenue as incomes and business activity grow.
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Higher profits can lead to greater output, which supports more employment and higher wages, encourages more people to work, and increases tax revenue
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Productivity might not be as important to the economy if its gains are not shared equally. In that case, firms may keep the extra profits rather than passing them on through higher wages, which can widen inequality between workers and business owners. As a result, household incomes may grow more slowly, reducing consumer spending and overall demand in the economy. Lower demand can then discourage firms from expanding output and hiring, which weakens long-term economic growth.
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Productivity might not be as important to the economy if it reduces jobs, especially when firms improve productivity by investing in more capital instead of labour. In that case, machines may replace workers, which can lead to structural unemployment and create a need for retraining. This can put pressure on education and welfare systems, and higher benefit payments may also widen the budget deficit
Evaluating the importance of production to the economy
Points
Evaluations
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Job creation - Higher production needs more labour, therefore more people are employed in the economy, leading to more income tax collected by the government which they can expend on social services and less benefits. Improved infrastructure
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Multiplier Effect - more consumption so firms have more revenue so even more production, and more consumption and higher incomes so more tax revenue so more investment so more external economies of scale so more production … cycle
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Economic growth (due to more production and consumption)- Higher production leads to higher output of goods and services, leading to an increased GDP as more of these goods can be exported to other countries, which can then be taxed by the government, which the government can use on public expenditure, improving quality of life
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Economies of scale can be achieved
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Negative externalities - Production may not be environmentally sustainable, this is because it may use non-renewable resources or create pollution.
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Capital - Some economies may choose to use capital over labour when wanting to increase their production, this neglects the use of labour, therefore unemployment increases, so more benefits spending and less income tax revenue.
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Key Tip: This topic has a lot of 6-markers that can be asked so a lot needs to be memorised. It is key to learn this topic early, and to be confident with production and productivity. Don't worry if it still seems a bit tricky - once you have studied topics 3.1 and 3.2 it should make more sense and be easier to understand.
Evaluating the importance of profit/revenue for producers
Points
Evaluations
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More resources for internal investment - Profit can generate finance for internal investment as the revenue generated by the firm is larger than the costs of producing the G/S, which gives the producer resources to invest into higher quality factors of production, which will increase output and create a positive feedback loop leading to more profits
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Attracts investment - Increased profits generated will lead to the firm becoming more attractive for investors as the increased profits means investors are more likely to make a positive return on their investment. This gives the firm more resources from the increased investment to invest in higher quality factors of production, leading to more output and then even more profit
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Less important than other factors (e.g. market share) - forward thinking firms might not find short-term profits as important - While profit can be important for firms, it’s less important than other factors. In order to compete effectively, the firm can improve the quality of its product or invest in more advertising to attract more customers. This will increase costs and potentially may cause a decrease in profits in the short term, but in the long term competing effectively will lead to increased revenue and increased profits.
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Attracts increased competition - If a firm generates increased profits, it signals to other producers of a profit opportunity. This will attract more competition, causing demand for the firm's goods to decrease as there are more substitutes available, leading to a decrease in revenue
Evaluating the importance of loss/cost for producers
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Evaluations
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Can drive away competition - so firm can become monopoly or make more money in the long-term when they turn enough money to make profit
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Not that bad in the short term especially if it is a new company, or if it is a monopoly as they can easily turn that around by increasing price or gaining economies of scale - forward thinking firms
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Tells producers that they need to allocate their resources more efficiently
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Will also drive away investment - firm will get less money to reinvest back into the firm that can be used to turn loss into profit, also less competition means less incentive to become more efficient or innovate or improve quality - might actually lead to even more loss in long term
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It is important in the long-term because of opportunity cost: they do not have the finances to fund investment into the company so it will not be able to grow