Reasons for adopting labour-intensive and capital-intensive production

Micro‑economic Decision‑makers – Firms and Production (IGCSE 0455 Topic 3.5)

Learning Objective

Explain why a firm may adopt a labour‑intensive or a capital‑intensive production technique, linking the choice to:

• Factor‑price changes (wages, interest/ rental rates)
• Availability of labour and capital
• Productivity of each factor and the role of investment
• Government policies
• Market structure (competitive vs. monopoly/dominant‑firm)

All points are required for the IGCSE Economics exam.

Key Definitions

• Labour‑intensive production: A technique that uses a relatively large amount of labour compared with capital.
• Capital‑intensive production: A technique that uses a relatively large amount of capital compared with labour.
• Productivity: Output per unit of input.
  Formula: $$\text{Productivity}=\frac{Q}{L\;{\rm or}\;K}$$ where \(Q\) = output, \(L\) = labour input, \(K\) = capital input.
• Fixed cost (FC): Costs that do **not** vary with output (e.g., rent, depreciation of machinery).
• Variable cost (VC): Costs that vary directly with output (e.g., wages, raw materials).
• Total cost (TC): \(TC = FC + VC\).
• Average cost (AC): \(AC = \dfrac{TC}{Q}\).
• Marginal cost (MC): The extra cost of producing one more unit of output.
  Formula: $$MC=\frac{\Delta TC}{\Delta Q}$$
• Derived demand for factors: The demand for labour and capital is derived from the demand for the final product. It depends on the marginal revenue product (MRP) of each factor:
  $$MRP_{L}=MP_{L}\times P_{D} \qquad\text{and}\qquad MRP_{K}=MP_{K}\times P_{D}$$ where \(MP\) = marginal product and \(P_{D}\) = price of the product.

3.5.1 Demand for Factors of Production

The firm’s demand for labour and capital is a **derived demand**:

• Higher consumer demand → higher marginal revenue product (MRP) of both factors → greater factor demand.
• Factor‑price changes: a rise in wages makes labour‑intensive techniques relatively more expensive; a rise in interest or rental rates makes capital‑intensive techniques relatively more costly.
• Factor availability: abundant cheap labour or readily available machinery pushes the firm toward the cheaper factor.
• Productivity: more productive labour or capital raises its MRP, encouraging its use.
• Investment: spending on new machinery raises the marginal product of capital, shifting the firm’s production possibilities outward (see diagram suggestion below).

3.5.2 Reasons for Adopting Labour‑Intensive Production

1. Cheap, abundant labour – low wages or high unemployment keep variable costs low.
2. Flexibility – workers can be re‑allocated quickly to new tasks or product lines.
3. Low initial capital outlay – avoids large fixed‑cost investment and the need for borrowing.
4. Skill‑intensive or handcrafted products – quality, design or creativity depends on manual skill that machines cannot replicate (e.g., fashion, artisanal foods).
5. Technological constraints – unreliable electricity, lack of spare‑parts services or suitable machinery.
6. Government policies favouring labour – minimum‑wage subsidies, tax credits for hiring, or restrictions on imports of machinery.
7. Uncertainty or low demand forecasts – firms prefer lower fixed costs when future sales are uncertain.

3.5.3 Reasons for Adopting Capital‑Intensive Production

1. Higher productivity – machines can produce more output per unit of time, lowering average cost.
2. Consistency and quality control – automation reduces defects and ensures uniform standards.
3. Economies of scale – high fixed costs are spread over a larger output, reducing AC.
4. Reduced dependence on labour markets – firms are less vulnerable to wage inflation or labour shortages, stabilising unit costs.
5. Technological advancement – newer, faster equipment can give a competitive edge.
6. Government incentives for capital – subsidies, tax relief on machinery, accelerated depreciation.
7. Long‑run cost advantage – once capital is installed, the marginal cost of additional output is low.

3.5.4 Influence of Investment on Productivity and the PPF

• Investment in modern machinery raises the **marginal product of capital (MP_K)**.
• Higher MP_K increases the **marginal revenue product of capital**, shifting the firm’s derived demand for capital outward.
• On a **Production Possibility Frontier (PPF)** for the firm, investment moves the curve outward, allowing a higher maximum output for the same amount of labour (or the same output with less labour).

Diagram suggestion: Draw two PPFs – PPF₀ (before investment) and PPF₁ (after investment) – both with labour on the horizontal axis and output on the vertical axis. Show the outward shift.

3.5.5 Market‑Structure Considerations

• Competitive markets – firms are price‑takers; profit maximisation pushes them toward the lowest‑cost technique. If economies of scale are achievable, a capital‑intensive method is often preferred.
• Monopoly or dominant‑firm markets – firms have price‑setting power and may invest in capital to:
  • protect market share (barriers to entry)
  • differentiate products through higher quality or innovation
  • stabilise costs against wage pressures.

3.5.6 Cost Concepts Summary

Cost Concept	Definition	Relevance to Production Choice
Fixed Cost (FC)	Costs that do not vary with output (e.g., rent, depreciation).	High in capital‑intensive methods; spreads over output → economies of scale.
Variable Cost (VC)	Costs that vary directly with output (e.g., wages, raw materials).	High in labour‑intensive methods; rises quickly with output.
Total Cost (TC)	FC + VC.	Basis for calculating average and marginal cost.
Average Cost (AC)	\(AC=\dfrac{TC}{Q}\).	Used to compare overall efficiency of two techniques.
Marginal Cost (MC)	\(MC=\dfrac{\Delta TC}{\Delta Q}\).	Guides the decision of how much to produce; intersect with marginal revenue determines profit‑maximising output.

3.5.7 Break‑Even Output Between Two Techniques

When a firm has a labour‑intensive (A) and a capital‑intensive (B) method, the output at which the two have the same average cost is:

$$Q_{BE}= \frac{FC_{B}-FC_{A}}{VC_{A}-VC_{B}}$$

Below \(Q_{BE}\) the method with lower fixed cost (usually labour‑intensive) is cheaper; above \(Q_{BE}\) the capital‑intensive method becomes cheaper because its lower variable cost is spread over more units.

3.5.8 Illustrative Example – Cost‑Benefit Analysis

A shoe manufacturer can produce 100 pairs per day using two alternative methods.

Method A – Labour‑Intensive

• 20 workers × 5 pairs per worker = 100 pairs.
• Wage = £10 per worker per day → VC = 20 × £10 = £200.
• Fixed cost (factory rent, utilities) = £150.
• Total cost = £350 → AC = £3.50 per pair.

Method B – Capital‑Intensive

• 2 stitching machines (each 50 pairs) + 4 supervisors.
• Machine rental = £200 per day; depreciation of owned machines = £50 per day (both fixed).
• Supervisors’ wages = 4 × £10 = £40 (variable).
• Fixed cost = £150 (factory) + £200 + £50 = £400.
• Variable cost = £40.
• Total cost = £440 → AC = £4.40 per pair.

Cost comparison and break‑even analysis

Item	Method A (Labour‑intensive)	Method B (Capital‑intensive)
Fixed cost	£150	£400
Variable cost	£200	£40
Total cost (100 pairs)	£350	£440
Average cost per pair	£3.50	£4.40

Using the break‑even formula:

$$Q_{BE}= \frac{400-150}{200-40}= \frac{250}{160}\approx 1.56\text{ (hundreds of pairs)}$$

Thus, when output exceeds roughly 156 pairs, the capital‑intensive method becomes cheaper per unit.

3.5.9 Decision‑Making Framework for Firms

1. Compare **relative factor prices** (wages vs. interest/ rental rates).
2. Assess **availability and skill level** of the local workforce and the reliability of capital equipment.
3. Forecast **product demand** (customised vs. standardised, short‑run vs. long‑run).
4. Evaluate **technological infrastructure** (electricity, maintenance services, spare parts).
5. Consider **government policies** – subsidies, tax incentives, import duties.
6. Identify the **market structure** – competitive pressure favours the lowest‑cost technique; monopoly/dominant‑firm may justify higher capital investment for barriers or differentiation.
7. Analyse **cost structure** (FC, VC, AC, MC) and calculate the **break‑even output** between techniques.
8. Weigh **long‑run strategic goals** – export orientation, product diversification, cost leadership.

Suggested Classroom Diagrams

• Derived‑demand diagram: Show product demand curve → marginal revenue product of labour and capital curves.
• PPF before and after investment: Two outward‑shifting curves illustrating how capital investment raises maximum output.
• Average‑cost curves for two techniques: Plot AC_A (labour‑intensive) and AC_B (capital‑intensive) with the break‑even output where they intersect.
• MC vs. AC: Briefly illustrate that MC cuts AC at its minimum – useful for exam questions on cost behaviour.

Summary

• Firms choose a labour‑intensive technique when labour is cheap, flexible, and capital is scarce or expensive.
• Capital‑intensive techniques are preferred when technology is available, economies of scale can be realised, and the firm can absorb high fixed costs.
• The decision is driven by **derived factor demand**, **factor prices**, **availability**, **productivity gains from investment**, **government policy**, and **market structure**.
• Understanding fixed vs. variable costs, marginal cost, and the break‑even output equips students to analyse real‑world production choices – a core skill for the IGCSE Economics examination.