0455 · 3.5Firms and production

Factors of production and derived demand

0:00A bakery can make more bread by hiring extra workers, or by giving its existing staff better equipment. Both approaches raise output, but they change the business in different ways. Extra workers add to the resources used, while better equipment helps each worker make more. Understanding that difference helps explain how firms choose their production methods. In this video, we will connect demand for factors of production with the choice between labour-intensive and capital-intensive production.

0:26We will also distinguish production from productivity. A bakery will help us follow the reasoning through to investment decisions. By the end, you should understand why the best method varies between firms. A firm is a business organisation that produces goods or services. Factors of production are the resources used to produce them. These are land, labour, capital and enterprise. Land includes natural resources, labour is human effort, and enterprise organises production and bears business risks.

0:54Capital means human-made resources used in production, such as tools, machinery and buildings. Money can purchase these resources, but it is not itself productive equipment. Our bakery combines ingredients, workers and ovens under the direction of its owner. Its output depends on how effectively those resources work together. Demand for factors of production is derived demand because it arises from demand for the goods and services they produce. A bakery wants workers because customers want bread.

1:21If demand for its product increases, the business has a reason to expand output. It may therefore hire more staff or purchase another oven. That response is not automatic for every resource. If the existing oven has unused capacity, extra workers might be enough to increase production. A fall in demand for bread could instead reduce the need for staff or equipment. The important connection is that customers’ purchases influence the resources firms want to employ.

1:46The price of different factors of production also matters. Wages are payments for labour, while machinery involves purchase or hire charges and running expenses. If wages rise relative to the cost of capital, machinery becomes more attractive where it can replace workers, so demand for labour falls. However, a machine must perform the required task before it becomes a useful alternative. Availability can limit the choice even when a resource looks affordable.

2:11A bakery might struggle to recruit skilled bakers, while an imported machine could take months to arrive. Limited land, unreliable electricity or shortages of ingredients can also restrict production. Firms must consider resources they can actually obtain, rather than only their advertised prices. The productivity of each factor is another influence on demand. Productivity is output per unit of input. A skilled baker who produces more usable loaves per hour may justify a higher wage than an inexperienced worker.

2:39Similarly, a reliable oven can be more attractive than a cheaper model that frequently breaks down.

Labour-intensive and capital-intensive production

2:43Labour-intensive production uses a relatively high proportion of labour compared with capital. Hairdressing, handmade crafts and tea picking are typical examples. Car assembly and oil refining work the other way, with machinery and equipment doing most of the work. That approach is capital-intensive production, which uses a relatively high proportion of capital compared with labour. The distinction concerns the relative use of resources, not the complete absence of either factor.

3:09A hairdresser still needs scissors, chairs and other equipment. A highly automated factory requires workers to supervise operations and maintain machines. Counting employees alone cannot tell us which method a firm uses. Labour-intensive production is attractive when tasks require personal attention, judgement or detailed handwork. A customer may want a particular hairstyle that requires discussion and adjustments. Workers can respond flexibly to individual requests and unusual situations. Where suitable labour is available at relatively low wages, this approach can also be economical.

3:41Another advantage is that a firm may avoid a large initial expenditure on machinery. This can help a small business begin operating with limited finance. However, employing many workers creates substantial wage costs, especially when pay rises. Output can also vary with skill, tiredness, absence and the quality of supervision. Capital-intensive production is especially useful for large quantities of standardised products. Machines can repeat the same task quickly and consistently.

4:08Greater output from each worker can lower labour cost per item. This gives a firm a reason to use machinery when customers demand many similar products. The disadvantages include a high initial purchase cost and continuing maintenance expenses. A breakdown can interrupt a large part of production if several stages depend on one machine. Specialised equipment may also be difficult to adapt when customers want a different product. Staff often need training before they can operate it effectively.

4:34Neither approach is always cheaper or environmentally better. Efficient equipment can reduce energy use and wasted materials per item, but other machines consume substantial electricity. Careful handwork may save materials, although it can take longer. The sensible choice reflects product demand, relative factor prices, availability and productivity together.

Production and productivity

4:53Production is the total output of goods and services. We measure it over a stated period, such as loaves produced during a working day. Productivity tells us how much output comes from each unit of a resource. Labour productivity could be measured as loaves per worker per hour. These measures answer different questions. Production tells the owner how much bread the bakery makes altogether. Productivity indicates how effectively its resources are being used.

5:17Hiring more workers can raise total output while each worker makes no more than before. Greater production therefore does not necessarily mean higher productivity. Labour productivity equals total output divided by the number of worker hours used. A worker hour represents one person working for one hour. To find the worker hours, multiply the number of workers by the hours each one works. The division then gives output per worker per hour.

Calculating labour productivity

5:41For example, four bakers each do a six-hour shift and together produce four hundred and eighty loaves. Four workers multiplied by six hours gives twenty-four worker hours. Dividing four hundred and eighty loaves by twenty-four worker hours gives twenty loaves per worker per hour. This is an average for the whole team, not the output of any particular employee. After a new oven is installed, the four bakers produce six hundred loaves in their usual six-hour shifts.

6:06Six hundred loaves divided by twenty-four worker hours gives twenty-five loaves per worker per hour. Subtracting twenty from twenty-five gives an increase of five loaves per worker per hour. Production has also risen from four hundred and eighty to six hundred loaves with no extra labour input. Now go back to the original bakery and suppose the owner hires a fifth baker instead of buying the oven. Five workers multiplied by six hours gives thirty worker hours.

6:31With the old oven now crowded, the team bakes five hundred and seventy loaves. Five hundred and seventy loaves divided by thirty worker hours gives nineteen loaves per worker per hour. Production has risen from four hundred and eighty loaves, yet productivity has fallen from twenty to nineteen. Production can increase when a firm employs more resources or uses existing ones for longer. Additional workers, extra ovens and longer opening hours can all raise total output.

6:56Better supplies of materials and fewer interruptions also help. However, a firm needs sufficient product demand to make additional output worth producing. Education and training can improve productivity by helping workers complete tasks accurately and quickly. Better technology allows equipment to perform tasks that previously required more time or effort. Motivation matters because engaged employees are more likely to work carefully and consistently. Effective management coordinates people, materials and machinery so fewer working hours are wasted.

7:26Working conditions and reliable equipment also influence the result. A well-organised workspace reduces unnecessary movement, while maintenance prevents avoidable stoppages. Access to suitable materials helps workers produce usable output rather than defective goods. Productivity improves through better methods and support, not simply through pressure to work faster.

Investment and productivity

7:46Investment is expenditure on capital goods. A bakery might purchase a dough mixer that allows each worker to prepare more batches in an hour. With suitable training, this can increase labour productivity. If output grows faster than production costs, the cost of making each loaf falls. Lower costs make the firm more competitive because it can charge lower prices or earn more profit on each sale. Investment in efficient equipment may also reduce energy use and material waste per item.

8:12However, productivity gains require equipment that suits the task. Expensive machinery provides little benefit if it sits unused or repeatedly fails. A fall in investment has the opposite effect, because worn equipment is not replaced. Breakdowns then become more frequent, so workers spend longer waiting and productivity falls. Yet investment does not guarantee an immediate increase in productivity. Installation, training and adjustment can temporarily interrupt output before the expected benefits appear.

Exam technique and recap

8:40Examiners often see answers that mix up the two measures. Keep production as total output and productivity as output per unit of input, and always name the resource and time period. Classify a production method by its proportion of labour to capital. When judging investment, look at whether the equipment suits the task and is reliable. In Paper One Multiple Choice, look for the proportion of labour to capital, such as reliance mainly on handwork or on machines.

9:05For numerical questions, check whether the denominator should be workers or worker hours. Paper Two Structured Questions can ask you to connect a change in demand, wages or investment to a firm’s decisions. Follow the cause through to the specific outcome requested. The command word define asks for a precise meaning, while state requires an answer expressed in clear terms. For explain, set out why or how something happens. An analyse response examines relationships in detail, so develop the economic links between cause and outcome.

9:34Discuss requires a structured examination of the issue in depth, including both sides. Consider this question: Explain how investment in a new oven could increase labour productivity at a bakery. Labour productivity is output per worker per hour. A new oven can bake a larger batch in the same time, so workers spend less time waiting for each batch to finish. Total output rises while the number of staff and their hours stay unchanged.

9:57Output per worker per hour therefore rises, so labour productivity increases. For a discuss question, consider whether a bakery should adopt capital-intensive production. Machinery can produce standard loaves quickly and consistently, which can reduce cost per item at high output. However, expensive equipment may be underused when sales are low, and skilled workers can adapt more easily to customised orders. On balance, it usually suits a bakery with large, stable demand, because busy machines spread their cost over many loaves.

10:27The central idea is that firms choose resources to meet demand using a suitable production method. Their demand for factors depends on product demand, relative prices, availability and productivity. Labour-intensive methods emphasise human effort, while capital-intensive methods rely relatively more on equipment. Each offers benefits and limitations that vary with the task. Keep the final distinction clear: production measures total output, while productivity measures output per unit of input. More resources can increase production without improving productivity.

10:57Suitable investment, training, motivation and management can help existing resources achieve more. These connections explain why a firm’s decisions matter, rather than simply giving us definitions to memorise.