Firms and production | IGCSE Class 10 Economics Notes

This note covers the factors of production and how a firm turns them into output, the influences on a firm's demand for factors of production, the difference between labour-intensive and capital-intensive production with their advantages and disadvantages, and the difference between production and productivity and what influences each.

What are the factors of production and how does a firm turn them into output?

A firm is an organisation that combines inputs to make goods or services that it can sell. The inputs a firm buys are called factors of production: land, labour, capital and enterprise.

The four factors of production

Land covers natural resources, labour is the human effort used in production, capital is the man-made equipment used to produce further goods (machinery, tools, buildings), and enterprise is the risk-taking and organising ability of the entrepreneur.

Definition: factors of production. The inputs a firm uses to produce output, grouped into land, labour, capital and enterprise.

For example, a tailor combines a sewing machine, cloth, thread and his own labour to produce shirts; a car manufacturer combines a factory, machinery, labour and raw materials such as steel to produce cars.

How does a firm turn inputs into output?

Production is the process by which inputs are transformed into output. A firm acquires inputs such as labour, machines, land and raw materials, pays for them, and uses them to produce goods or services that consumers buy or that other firms use for further production.

What determines a firm's demand for factors of production?

A firm's demand for a factor of production is not wanted for its own sake; it is wanted because of what it helps the firm produce.

Derived demand

This is why it is described as a derived demand: the demand for labour, machinery or land comes from the demand for the final good or service they help make.

Definition: derived demand. Demand for a factor of production that arises only because of the demand for the goods or services that factor is used to produce.

Four influences on demand for a factor

Several influences decide how much of a factor a firm chooses to employ.

1. Demand for the product. If demand for a firm's output rises, the firm needs more labour, machinery and raw materials to produce enough to meet that demand; if demand falls, the firm's demand for factors falls too.
2. The price of different factors of production. If labour becomes more expensive relative to capital, a firm has an incentive to use less labour and more capital (and the other way round), so firms compare the relative prices of the factors they could use.
3. Availability of factors. A firm cannot employ a factor it cannot obtain locally, such as skilled labour of a particular type or land in a crowded city, so availability limits how much of a factor can actually be used even if the firm would like more.
4. Productivity of the factor. A more productive worker or machine, one that produces more output per unit of input, is more attractive to employ because it adds more to the firm's output for the same cost.

These four influences interact. A firm producing a good in high demand, using a factor that is cheap, available and productive, will employ a large amount of that factor; the opposite combination of influences reduces the firm's demand for it.

What is the difference between labour-intensive and capital-intensive production?

Firms producing the same good can often choose between different combinations of labour and capital. A given level of output can be produced using more labour and less capital, or less labour and more capital, and the firm still reaches the same output.

Definition: labour-intensive production. A method of production that uses a relatively large amount of labour compared with capital to produce a given output.

Definition: capital-intensive production. A method of production that uses a relatively large amount of capital (machinery and equipment) compared with labour to produce a given output.

The ratio in which the two factors are combined is called the factor proportions of the production process. A firm chooses which combination to adopt mainly by comparing the cost of each option: with given factor prices, it picks the combination that produces the required output at the lowest cost.

Several things push a firm towards one method rather than the other: the relative price of labour compared with capital in that country or industry, the availability of skilled workers or of reliable machinery and electricity, the nature of the product (a handmade craft item needs skilled labour; a standardised mass-produced item suits machinery), the scale of output required, and the level of technology available to the firm.

A small bakery making a few dozen loaves a day typically has little reason to install expensive automated ovens, whereas a factory baking thousands of loaves finds the machinery worthwhile because the large volume spreads its cost over many units. In this sense, the choice of method is really a choice about how to combine the four factors of production discussed above: a firm with cheap, available labour and expensive, scarce capital will lean towards the labour-intensive option, and the other way round.

No firm is purely one or the other in practice; most firms use some combination of labour and capital, and the terms simply describe which factor dominates relative to the other for the output being produced.

What is the difference between production and productivity?

Production is the total amount of output a firm makes in a period, for example 5,000 shirts a week.

Definition: productivity. Output per unit of input used, for example output per worker or output per hour of labour.

Productivity is different: it measures output per unit of input, not total output. The most common measure is labour productivity, the output per worker (or per worker-hour).

Labour productivity = total output ÷ number of workers

A table for a workshop whose machinery stays the same while it takes on more workers shows the difference between total output and output per worker clearly.

Production keeps rising right across this table, from 10 up to 57. But productivity rises at first, reaches a maximum of 13.33 with 3 workers, and then falls.

This shows why production and productivity are not the same thing: production can still be increasing even while productivity is falling, because each extra worker has less machinery to work with and adds less to output than the workers before.

The two can also move the other way. If a firm cuts its workforce but trains the workers who remain or gives them better machines, production may fall while productivity rises.

Worked example 1. With 4 workers the workshop produces 50 units; with 5 workers it produces 56 units.

Answer: production rises by 56 − 50 = 6 units. Labour productivity with 4 workers = 50 ÷ 4 = 12.5 units per worker; with 5 workers = 56 ÷ 5 = 11.2 units per worker.

So production has risen while productivity has fallen. The firm should hire the fifth worker only if the extra 6 units are worth more than that worker's wage.

What influences production?

Production, the total output a firm makes, changes when the quantity of the inputs it uses changes, or when the same inputs can produce more.

1. The quantity of factors of production employed. A firm that hires more workers, buys more machinery or uses more land can produce more output, so a rise in the inputs used raises production.
2. The productivity of the factors. If each worker or machine produces more output per unit, the same quantity of inputs yields a larger total output, so production rises without any extra inputs.
3. Technology. Better technology raises the maximum output obtainable from any given combination of inputs, so it raises production at every level of employment.
4. Availability of factors. A firm cannot produce more if it cannot obtain the labour, raw materials or machinery it needs, so shortages of inputs limit production even when demand for the product is high.

What influences productivity?

Productivity changes mainly because of changes in the proportion in which factors are combined, and because of improvements that make each unit of a factor more effective.

Four influences on productivity

1. Factor proportions. As more of one input, say labour, is added while another input (such as land or machinery) is held fixed, the proportion of labour to the fixed factor rises; productivity initially improves as the fixed factor is used more fully, but beyond a point there is too little of the fixed factor for each extra worker to use effectively.
2. Technology. Better technology raises the maximum output obtainable from any given combination of inputs, so it raises productivity at every level of employment.
3. Skills and training. A better-trained, more experienced worker produces more per hour than an untrained one using the same equipment.
4. Capital per worker. Giving each worker more or better machinery to work with usually raises the output each worker can produce.

What are the advantages of labour-intensive and capital-intensive production?

Each method of production suits a different combination of circumstances, so each has advantages that make it the better choice in particular situations.

Advantages of labour-intensive production

Labour-intensive production needs less money tied up in machinery, so it suits firms or countries with limited capital but an ample supply of workers. This matters most where capital is expensive to borrow or buy, and where a large pool of willing workers is available at a relatively low wage.

It is also more flexible than capital-intensive production, since output can often be adjusted by hiring or laying off workers rather than buying or scrapping expensive machines; a firm facing uncertain or seasonal demand can expand and contract its workforce more easily than it can expand and contract a factory.

Labour-intensive production also tends to create more employment for a given level of output, which matters where unemployment is high, since using relatively more workers to produce the same output spreads income to more households.

Finally, some goods, particularly handmade or craft products, depend on the skill and judgement of individual workers in a way that machinery cannot easily replace, so labour-intensive methods can also preserve the quality and individuality of the product.

Advantages of capital-intensive production

Capital-intensive production can usually produce a much larger volume of output and often produces it more consistently, because a machine repeats the same task the same way each time, reducing variation between units of the product.

Once the machinery is installed, the cost of producing one extra unit is often lower, so large-scale, standardised output becomes cheaper per unit; this is one reason mass-produced goods tend to be made with capital-intensive methods rather than labour-intensive ones.

Capital-intensive production also reduces a firm's dependence on finding, training and managing a large workforce, which can be an advantage where suitable labour is scarce, expensive, or difficult to supervise across a large site.

Worked example 2. A firm compares two ways of producing 100 units of a good: Method A uses 20 units of labour and 5 units of capital; Method B uses 5 units of labour and 20 units of capital.

Answer: Method A uses relatively more labour than capital, so it is the labour-intensive method; Method B uses relatively more capital than labour, so it is the capital-intensive method. Which method the firm actually chooses depends on the relative price of labour and capital: if labour is cheap relative to capital in that economy, Method A is likely to be the lower-cost way to produce the 100 units, and the firm should choose it; if capital is the cheaper factor, the firm should choose Method B instead.

What are the disadvantages of labour-intensive and capital-intensive production?

Alongside their advantages, each method also has drawbacks that a firm must weigh before choosing between them.

Disadvantages of labour-intensive production

Labour-intensive production can be slower than capital-intensive production, since human workers generally cannot match the speed at which machinery repeats a task.

Output quality can also vary more between workers, because different individuals have different levels of skill, concentration and experience, whereas a machine performs the same operation identically each time.

Labour-intensive methods can need continuous spending on recruiting and training staff, particularly where workers leave or where the firm expands, and a firm relying heavily on labour is also more exposed to rising wage costs or to disputes between workers and management.

Disadvantages of capital-intensive production

Capital-intensive production requires a large amount of money to buy the machinery before any output is produced at all, which can be a major barrier for a firm or a country without access to sufficient funds.

The equipment can become outdated as technology changes, so a firm may need to replace or upgrade machinery well before it has worn out, adding further cost.

Breakdowns can stop production entirely until the equipment is repaired, unlike labour-intensive production where one worker's absence has a much smaller effect on total output.

Introducing machinery in place of workers can also cause job losses, which affects household incomes and can create opposition from the workforce or from government, particularly in an economy where unemployment is already high.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

What are the short run and the long run?

In the short run, at least one factor (usually capital, such as the size of the factory) cannot be changed and is called the fixed factor; the firm can only vary the other factor, the variable factor.

In the long run, all factors, including capital, can be varied, so there is no fixed factor and the firm can change the whole scale of its operations.

What are total, average and marginal product?

Economists call total output the total product of the variable factor and output per worker its average product. The marginal product is the extra output produced by one more unit of an input, with all other inputs held constant.

Marginal product = change in total product ÷ change in labour

The law of variable proportions

This pattern of productivity first rising and then falling as more of a variable input is added, while other inputs stay fixed, is called the law of variable proportions (also called the law of diminishing marginal returns): the marginal product of a factor initially rises as its employment increases, but after a certain level of employment it starts falling.

Consider a farmer with a fixed amount of land who can choose how many workers to employ.

With only one worker, there is too much land for that worker to cultivate alone, so adding a second and third worker lets each one specialise and work more effectively, and marginal product rises.

Once the land becomes crowded with workers, each additional worker has insufficient land to work on efficiently, and the output added by each extra worker falls.

Plot labour on the horizontal axis and output per worker on the vertical axis.

Both the marginal product curve and the average product curve rise, reach a peak, and then fall, giving them an inverted-U shape.

The marginal product curve crosses the average product curve from above exactly at the point where average product is at its maximum, because average product can only be rising while marginal product is above it, and can only be falling once marginal product has dropped below it.

Worked example 3. For the workshop in the production and productivity table (marginal product 10, 14, 16, 10, 6, 1 as each worker is added), at 2 units of labour average product is 12, and at 3 units of labour average product rises to 13.33 before falling at 4 units of labour to 12.5.

Answer: average product is rising between 2 and 3 units of labour because marginal product (14, then 16) is above the current average product; once marginal product drops to 10 at 4 units of labour, which is below the average product of 13.33, average product starts to fall, confirming that marginal product pulls average product up or down depending on whether it is above or below it.

What is a production function?

The relationship between the quantities of inputs a firm employs and the maximum output it can produce from them is its production function. If either labour or capital increases while the other stays the same, output rises, but the rate at which it rises changes as more of one factor is added while the other is held fixed.

What are returns to scale?

In the long run, a firm can change every factor, including the fixed factor from the short run, and may increase all its inputs by the same proportion.

If output then increases by exactly that proportion, the production process shows constant returns to scale; if output increases by a larger proportion, it shows increasing returns to scale; if output increases by a smaller proportion, it shows decreasing returns to scale.

These long-run patterns are a separate idea from the law of variable proportions, because they only apply when every factor is free to change, not when one factor is held fixed.

For example, if a firm doubles both its labour and its capital, constant returns to scale means output also exactly doubles; increasing returns to scale means output more than doubles, perhaps because a larger scale lets workers specialise more; and decreasing returns to scale means output less than doubles, perhaps because a much bigger operation becomes harder to organise and coordinate.

A firm choosing its long-run scale of production therefore has to weigh these effects: expanding scale can lower average cost where increasing returns apply, but it can also raise average cost if the firm grows past the point where it is managed efficiently.

Glossary

• Factors of production: the inputs a firm uses to produce output: land, labour, capital and enterprise.
• Derived demand: demand for a factor of production that arises only because of demand for the product it helps make.
• Labour-intensive production: a method of production using a relatively large amount of labour compared with capital.
• Capital-intensive production: a method of production using a relatively large amount of capital compared with labour.
• Factor proportions: the ratio in which two or more inputs are combined to produce output.
• Production: the total amount of output a firm makes in a period.
• Labour productivity: output per worker, calculated as total output divided by the number of workers.
• Land: natural resources used in production, such as farmland, minerals and water.
• Capital: man-made goods used to produce other goods, such as machinery, tools and buildings.
• Enterprise: the risk-taking and organising ability that brings the other factors together.
• Productivity: output per unit of input used, for example output per worker.

Common errors and misconceptions

• Misconception: production and productivity mean the same thing. Correct: production is total output, while productivity is output per unit of input; total output can rise even while output per worker falls.
• Misconception: capital-intensive methods are always better than labour-intensive methods. Correct: which method suits a firm depends on relative factor prices, availability of factors, the scale of output and the nature of the product.
• Misconception: capital means money. Correct: in economics, capital is a factor of production meaning man-made equipment such as machinery, tools and buildings, not money itself.
• Misconception: a firm demands labour or machinery for its own sake. Correct: a firm's demand for a factor is a derived demand, arising only because of the demand for the product it helps produce.
• Misconception: higher productivity always means a firm produces more in total. Correct: productivity is output per unit of input; a firm that cuts its workforce can raise output per worker while its total production falls.
• Misconception: once a firm becomes more capital-intensive, employment in that firm can never be high. Correct: a capital-intensive firm can still employ many workers; it is the proportion of capital to labour that is relatively high, not the absolute number of workers.

Exam-style questions with model answers

Q1. Define 'productivity'. [2 marks]

1. Productivity is output per unit of input used, for example output per worker or output per hour of labour.
2. It measures how much each unit of a factor produces, not the total amount produced.

Q2. Identify two influences on a firm's demand for a factor of production. [2 marks]

1. The price of that factor relative to other factors it could use instead.
2. The availability of that factor, for example whether enough skilled labour can be found locally.

Q3. Explain two reasons why a firm might choose capital-intensive production rather than labour-intensive production. [4 marks]

1. If the price of labour is high relative to the price of capital, it becomes cheaper for the firm to use machinery rather than workers to produce the same output.
2. This is because the firm minimises its cost of production by using more of the relatively cheaper factor and less of the relatively more expensive one.
3. If the firm needs to produce a large, standardised volume of output, machinery can produce it more consistently than a large workforce.
4. Once installed, machinery often has a lower cost per extra unit produced, so large-scale production becomes cheaper per unit than relying mainly on labour.

Q4. Explain two influences on the productivity of labour in a factory. [4 marks]

1. Better training and skills make each worker produce more output per hour using the same equipment, so productivity rises.
2. Giving each worker more or better machinery to work with usually raises the output each worker can produce.
3. Better technology raises the maximum output obtainable from any given combination of inputs, so it raises productivity at every level of employment.
4. If too many workers are added while the amount of machinery stays fixed, each worker has less equipment to work with and productivity falls.

Q5. A firm employs 4 workers who produce 200 units a day. It hires a fifth worker and output rises to 230 units a day. Calculate labour productivity before and after the new worker is hired, and state what has happened to production and to productivity. [4 marks]

1. Labour productivity with 4 workers = 200 ÷ 4 = 50 units per worker.
2. Labour productivity with 5 workers = 230 ÷ 5 = 46 units per worker.
3. Production has risen, from 200 to 230 units a day.
4. Productivity has fallen, from 50 to 46 units per worker, so the extra worker added less output than the average of the first four.

Q6. Analyse the difference between production and productivity, using an example of a factory that increases its workforce. [6 marks]

1. Production is the total quantity of output the factory makes in a period, while productivity is output per unit of input, such as output per worker.
2. If the factory doubles its workforce but output less than doubles, total production rises, showing that production has increased.
3. However, output per worker falls, because each additional worker is adding less extra output than before, showing that productivity has fallen.
4. This can happen because the amount of machinery or floor space stays the same, so each new worker has less of the fixed factor to work with.
5. It follows that production and productivity can move in opposite directions at the same time, so a rise in total output does not guarantee a rise in output per worker.
6. The firm can raise productivity again by training workers or giving them more or better machinery, so that each worker produces more.

Q7. Discuss whether or not a government should encourage firms in an economy with high unemployment to adopt labour-intensive production methods. [8 marks]

1. Labour-intensive production uses relatively more workers for a given output, so encouraging it could create more jobs and reduce unemployment, which also raises household incomes and tax revenue.
2. Labour-intensive methods generally need less upfront capital, so they may suit firms, or an economy, with limited funds for expensive machinery.
3. Some goods, particularly handmade or craft products, depend on the skill and judgement of individual workers, so labour-intensive methods can preserve the quality and individuality of the product.
4. However, labour-intensive production can be less efficient and produce lower output per worker than capital-intensive methods, which may make the firm's goods more expensive or less able to compete with firms abroad that use machinery.
5. Forcing firms to use more labour than is cost-effective for them could reduce their profits and their ability to invest in future growth, including future job-creating investment.
6. Labour-intensive methods can be slower and give less consistent quality, and a firm relying heavily on labour is more exposed to rising wage costs.
7. The best choice also depends on the type of good being produced and the skills available locally; a policy that works for one industry may not suit another.
8. On balance, encouraging labour-intensive methods can help with unemployment in the short term, but a government also needs to weigh the effect on firms' efficiency and competitiveness before giving this encouragement to every industry.

Q8. Explain two reasons why a firm's demand for labour may fall. [4 marks]

1. Demand for the firm's product may fall; because the demand for labour is a derived demand, the firm then needs fewer workers to produce the smaller output.
2. The wage may rise relative to the price of machinery, so the firm replaces some workers with capital, becoming more capital-intensive.
3. A fall in the productivity of labour, for example because workers lack the skills a new process needs, also makes labour less attractive to employ.
4. Any one of these reduces the quantity of labour the firm wishes to employ at each wage.

Key takeaways

• A firm's demand for a factor of production is a derived demand, depending on demand for the product, factor prices, availability and productivity.
• Production is total output and rises when more factors are employed or when factors become more productive; productivity is output per unit of input.
• Labour-intensive production uses relatively more labour; capital-intensive production uses relatively more capital, for the same output.
• Choosing between the two methods depends on relative factor prices, availability, the scale of output and the nature of the product.
• Labour-intensive methods need less upfront capital and create more jobs; capital-intensive methods usually give higher, more consistent output but need heavy upfront spending.
• Production is total output; productivity is output per unit of input, so the two can move in different directions.
• Labour productivity is total output divided by the number of workers; it rises with training, better technology and more capital per worker.
• Adding workers while machinery stays the same can raise production but lower output per worker.

Test yourself

What is meant by a factor of production?

An input a firm uses to produce output, grouped into land, labour, capital and enterprise.

Why is a firm's demand for labour described as a derived demand?

Because the firm wants labour only because of the output and sales it helps the firm achieve, not for its own sake.

Give one reason a firm might switch from labour-intensive to capital-intensive production.

If the relative price of labour rises compared with capital, machinery becomes the cheaper way to produce the same output.

How is labour productivity calculated?

Total output divided by the number of workers (or worker-hours), giving output per worker.

Can production rise while productivity falls? Explain briefly.

Yes; total output can keep rising as more workers are added, while output per worker falls because each extra worker has less machinery to use.

State one advantage and one disadvantage of capital-intensive production.

Advantage: higher, more consistent output once installed. Disadvantage: high upfront cost and possible job losses when machinery replaces workers.

State two influences on production.

The quantity of factors of production employed and their productivity; better technology and the availability of factors also change total output.

Give two reasons a firm might choose labour-intensive production.

Labour is cheap relative to machinery, and the product (such as a handmade craft item) needs individual skill.