Production and efficiency

Production and efficiency describes how and explains why businesses and individuals specialise rather than being jacks of all trades.  It also outlines how productivity can be measured and concept of economies of scale.


Specialisation and the Division of Labour

It is possible for economic agents to specialise on the production of a particular good or service, for example:

  • Individuals – specialise in particular jobs.
  • Areas – for example Torquay specialises in tourism and London specialises in financial services.
  • Countries – for example Saudi Arabia specialises in oil production and Columbia specialises in coffee growing.


Specialisation by individuals is called the division of labour. In 1776 Adam Smith described how division of labour would enable pin workers to increase their output.  He stated that one worker would be able to make 20 pins a day, but if division of labour occurred and 10 workers each specialised in a different task they could make 48,000 pins.

Benefits of Division of Labour

There are a number of benefits for the business and workers of division of labour.

  • Workers can focus upon a narrow range of tasks that they can become experts in.
  • It becomes cost effective to provide workers with specialist tools if they are only working on a narrow task.
  • Time is saved as workers don’t have to move between different stations as they change tasks.
  • Workers are able to specialise in the tasks that they are best suited to.


Disadvantages of specialisation

There are a variety of disadvantages of specialisation as well:

  • Jobs that are specialised can be quite narrow and therefore become very boring.  This can reduce the productivity of workers.
  • If a business in a small town or village tries to specialise in one good or service, it might find that the market isn’t big enough to keep the business going in such a narrow area.
  • If regions are too dependent on a particular good or sector, a downturn in demand will have a great impact.
  • Some nations have also suffered from relying too heavily on a single crop.

What would the effect on a country be if there was a particularly bad harvest?


Specialisation and Exchange

Before specialisation, individuals and families would be self-sufficient; they would try to grow and produce everything they required.  This required a jack of all trades approach to life.


Specialisation requires that exchange can take place between individuals. Farmers will only specialise in producing food if they know that they can exchange their produce for other goods such as shelter and clothing.  Bartering was used for the most part of our history – that is exchanging goods or services for other goods and services.


Money allows more complex exchanges to take place.  Without money the economy we know today would not be able to exist.

Production and Productivity

Production is the process that converts raw materials and components into finished goods that are demanded by consumers.



Productivity measures the rate of output – if productivity rises then the business or economy is able to

  • produce more using the same factors of production
  • produce the same quantity using the fewer factors of production



There are two main ways of measuring productivity.  The easiest method is to measure the output per worker.  This is calculated using the following formula:


Output per worker = total output per timer period / number of units of labour


It is also possible to calculate the productivity per hour worked using the following formula:


Productivity per hour worked = labour productivity / number of hours worked


The simpler output per worker measure has the disadvantage that it can be affected by changes in how people are employed.  For example, in the UK there has been a shift towards part-time employment, this could lead to a situation where employment has increased, but total hours worked in the economy remained unchanged. Calculating productivity using output per worker would show that output per worker had fallen, this is clearly misleading.


Measuring productivity using the per hour worked measure would show that productivity had remained unchanged.


The benefits of increased productivity

The economy will benefit from higher productivity in a number of ways:

  • The average cost of producing a good or service will be reduced if productivity increases.  Lowering costs will enable businesses to either lower their price and maintain their profit margin or keep the price the same and increase their profit margin.
  • The competitiveness of the UK will be affected by the change in costs.
  • Changes to the real wages paid to employees.
  • Changes to profit levels of UK firms.
  • Impact upon the UK’s growth rate shifting the country’s PPF outwards.



Productive Efficiency

Productive efficiency is achieved when the output is produced at the minimum average cost.  This is shown on the diagram below.


Productive efficiency can also be shown using a production possibility boundary.  An economy will be productively efficient if it produces on the production possibility boundary, any point inside it will be productively inefficient.


On the diagram below point Y is productively efficient whilst point X is not.


Economies of Scale

As businesses grow they are able to take advantage of lower average costs – this is known as exploiting economies of scale – and is demonstrated on the diagram below as the quantity produced by a business increases from Q1 to Q2.


Businesses will grow in one of two ways:

  • Internal growth – this will occur when a firm buys and uses more factors of production (CELL), this should lead to an increase in its output and level of sales.
  • External growth – this will take place when a business merges with or takes over another one.


Businesses will continue to grow in the hope of exploiting economies of scale.  The minimum efficiency scale (MES) is the point at which average costs stop falling (productive efficiency).  If the MES output is similar to the total size of the market a monopoly may emerge.



Internal economies of scale

Internal economies of scale will occur when there is an increase in the firm’s level of output.  There are a number of different types:

  • Technical economies – large firms are able to buy expensive equipment that will make tasks easier.  It would not be economical for small businesses to buy expensive specialised machinery as it would be left unused for long periods of time.
  • Increased specialisation – small businesses are not able to take advantage of division of labour in the same way that a large business is able to as it doesn’t have enough workers to divide the tasks amongst.
  • Increasing dimensions – by doubling the height and width of a warehouse or ship the volume will increase by a greater amount.


This shows that an increase in surface area from 6 to 24, a four fold increase will lead to an eight fold increase in volume, from 1 to 8.

  • Managerial economies – large businesses are able to employ specialist managers to carry out narrow tasks, whereas smaller one will have to employ staff that are able to carry out a number of different roles.
  • Marketing economies – large businesses are able to spread the cost of its marketing campaigns over a large volume of output.  A large business will be able to spend significantly more on marketing than a smaller competitor, but the cost of advertising per unit sold will be lower
  • Purchasing economies – large businesses are able to negotiate discounts as they will purchase huge volumes directly from the manufacturer.  Smaller rivals may have to buy from a wholesaler and consequently pay a higher price.
  • Financial economies – larger businesses will usually be deemed to be more credit worthy and they will be lent money at a lower rate of interest than a smaller one.  If the business sells it shares on the stock exchange it can raise extra funds by selling more shares – something that have a very low cost.  Smaller businesses, who are statistically more likely to go bankrupt, will struggle to borrow money and if they persuade a bank to lend them money it will usually be at a higher rate of interest.


External economies of scale

External economies of scale occur due to factors the business is unable to control.  There are a number of different types:

  • Growth of industry – if other firms locate nearby better roads and other facilities may be built.  The business may be able to poach workers that have been trained by rival firms.  It is possible that suppliers will move to the area as well and that will reduce transportation costs.
  • Research and development – universities and other businesses will spend significant amounts of money of research and development.
  • New technology –technology may become available that can reduce average costs.


Diseconomies of scale

Diseconomies of scale are an increase in the average costs and they may occur if the business gets too large.  The causes of diseconomies of scale are often bundled together and called X-inefficiency; it is made up of the following problems:

  • Control – monitoring the activity, productivity and quality of thousands of workers spread over many countries can be difficult and costly.
  • Co-ordination – efficiently co-ordinating many suppliers, customers, wholesalers, transporters etc. is very difficult and expensive.
  • Motivation – workers can feel alienated as don’t feel part of the business.
  • Communication – can be difficult with so many employees in a variety of locations.


Diseconomies of scale may discourage the growth of businesses as they will not want to face increasing costs.  Economies of scale and diseconomies of scale are highlighted on the chart below.


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