Micro‑economic Decision‑Makers: Firms and Production
Objective
Explain how different types of investment affect a firm’s productivity in the short‑run and long‑run, and link these effects to the production function, the Production Possibility Frontier (PPF), and average‑cost concepts. Relate the analysis to the Cambridge IGCSE 0455 syllabus (sections 3.5‑3.7).
Key Definitions
- Production (Y): total quantity of goods and services produced by a firm.
- Productivity: output per unit of a given input.
- Labour productivity = Y/L
- Capital productivity = Y/K
- Investment: expenditure that increases the stock of capital or improves skills, e.g. purchase of machinery, building extensions, training, research & development (R&D).
- Physical capital: tangible assets such as machinery, equipment and buildings.
- Human capital: knowledge, skills and health acquired through education and training.
- R&D investment: spending on research to develop new products or production techniques.
- Demand for factors of production: the quantity of labour, capital and other inputs that a firm wishes to purchase at given input prices. It is derived from the marginal revenue product of each factor and is influenced by product demand, input prices, technology and productivity.
- Labour‑intensive production: output is produced mainly with labour; capital input is relatively small. Typically associated with higher variable costs and lower fixed costs.
- Capital‑intensive production: output relies heavily on machinery and equipment; labour input is relatively small. Usually involves higher fixed costs and lower variable costs.
- Cost concepts (IGCSE 3.6):
| Cost | Definition |
|---|
| Total Cost (TC) | Sum of all costs of production (TC = FC + VC). |
| Fixed Cost (FC) | Cost that does not vary with output (e.g., rent, machinery). |
| Variable Cost (VC) | Cost that varies directly with output (e.g., wages of hourly workers, raw materials). |
| Average Total Cost (ATC) | TC divided by output (ATC = TC/Q). The curve shows the cost per unit at each level of output. |
| Average Fixed Cost (AFC) | FC divided by output (AFC = FC/Q). Falls as output rises. |
| Average Variable Cost (AVC) | VC divided by output (AVC = VC/Q). Typically U‑shaped. |
Demand for Factors of Production
- Derived from the marginal revenue product (MRP) of each input: MRP = MP × MR, where MP is marginal product and MR is marginal revenue.
- Higher productivity (greater MP) raises MRP, leading firms to demand more of that factor at a given input price.
- Investment that raises productivity therefore shifts the factor‑demand curve to the right.
Labour‑Intensive vs. Capital‑Intensive Production
| Characteristic | Labour‑intensive | Capital‑intensive |
|---|
| Primary input | Labour | Physical capital |
| Typical industry | Textiles, hospitality | Automobile manufacturing, chemicals |
| Cost structure | Higher variable cost, lower fixed cost | Higher fixed cost, lower variable cost |
| Effect of investment | Training → large productivity gains | Machinery upgrade → large productivity gains |
How Investment Influences Productivity
- Physical‑capital investment
- More or better machinery raises the amount each worker can produce → higher labour productivity.
- Short‑run: capital may be under‑used because labour is fixed and workers need time to learn the new equipment.
- Long‑run: workers become familiar, maintenance improves, and complementary training occurs, giving a larger productivity boost.
- Human‑capital investment
- Training or education improves the effective quality of labour (skilled labour).
- Productivity gains appear quickly and are sustained, also enhancing the returns from existing capital.
- R&D and technological innovation
- Creates new production techniques or products that make existing inputs more efficient.
- Impact is small while the innovation is being trialled, then large once it is fully adopted.
- Scale effects
- Investment that allows larger output can generate economies of scale – a fall in ATC as output rises.
- If the firm expands beyond its optimal size, diseconomies of scale may appear, causing ATC to rise.
Short‑run vs. Long‑run Effects of Investment
| Type of Investment | Short‑run effect on productivity | Long‑run effect on productivity |
|---|
| Additional machinery (physical capital) | Modest increase; limited by fixed capital and workers’ learning curve. | Significant rise as workers adapt, maintenance improves and complementary training occurs. |
| Worker training (human capital) | Immediate improvement in labour efficiency. | Sustained higher productivity; also raises the marginal product of other inputs. |
| R&D for a new process | Little impact until the new process is trialled and installed. | Potentially large jump in productivity (higher total‑factor productivity) once fully adopted. |
| Expansion of factory space (fixed capital) | Little effect until new equipment is installed. | Enables larger‑scale production; may generate economies of scale and lower ATC. |
Effect of Investment on Cost Curves
- Short‑run: With at least one factor fixed, investment mainly shifts the variable component. AVC may fall slightly, but ATC falls only if the increase in output outweighs any rise in fixed cost.
- Long‑run: All inputs become variable. An investment that raises productivity shifts the entire ATC curve downwards (lower cost per unit at every output level) and can move the minimum‑ATC point to a higher output level, illustrating economies of scale.
- When the firm expands beyond the efficient scale, the ATC curve bends upward, showing diseconomies of scale.
Diagrammatic Representation (what to sketch in the exam)
- Production function (Y = f(K,L)) – draw the original curve and a second curve shifted upward/rightward to show higher output for the same inputs after investment.
- Production Possibility Frontier (PPF) – an outward (right‑hand) shift represents the firm’s increased capacity to produce after productivity‑raising investment.
- Average Total Cost (ATC) curve – illustrate the original ATC and a new ATC curve lower at every output level (economies of scale) or higher after diseconomies of scale.
- Factor‑demand curve (optional) – show a rightward shift when productivity rises, indicating higher demand for the factor at each price.
Market Types (IGCSE 3.7)
Although not required for diagrammatic work, the syllabus expects a brief description of the two main market structures:
- Perfect competition: many buyers and sellers, homogeneous product, free entry and exit, price‑taker behaviour. Firms maximise profit where P = MC = MR. In the long‑run, economic profit is zero.
- Monopoly: single seller, unique product, high barriers to entry, price‑setter. Profit‑maximising output is where MR = MC, but P > MC, leading to a dead‑weight loss.
Examples
- Machinery upgrade: A bakery buys a new oven that can bake twice as many loaves per hour. Short‑run output rises only slightly because staff need to learn the new controls. After a month, labour productivity doubles and the ATC curve shifts downwards.
- Staff training: A software firm funds a coding boot‑camp for its programmers. Productivity (lines of code per hour) improves immediately and stays higher, raising the marginal product of the firm’s computers and reducing AVC.
- R&D breakthrough: A car manufacturer develops a lightweight alloy. Once the new chassis is produced, each car uses less material and the assembly line works faster, causing a large upward shift of the production function and a marked fall in ATC.
- Factory expansion: A beverage company builds a larger bottling plant. In the short‑run the new space is idle; in the long‑run it allows the firm to double output, generating economies of scale and moving the ATC curve down.
Key Takeaways
- Production is total output; productivity measures output per unit of input.
- Investment can be in physical capital, human capital or R&D – all raise productivity, but the timing differs.
- Short‑run gains are limited by fixed inputs and adjustment periods; long‑run gains are larger as all inputs become variable.
- Higher productivity shifts the production function and the firm’s PPF outward, and moves the ATC curve downwards (economies of scale) or upward (diseconomies of scale).
- Factor demand rises when productivity improves because the marginal revenue product of the factor increases.
- Understanding these links helps firms decide where to allocate resources for maximum efficiency, profit and competitive advantage.