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4.2: Costs and Productivity

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    Many treat cost control as a matter of production. To a certain extent, this is true. If a business produces less or hires fewer workers, costs can, and often do, fall. But these actions are only a temporary fix to a high-cost problem. If the cost-cutting firm ever tries to increase output to meet an increase in demand, costs will again rise to their lofty levels.

    A longer-term solution to cost control must deal with input productivity. When existing levels of labor, capital, and land become more productive than output can rise without upward pressure on costs.


    Business efficiency has two parts: productive and allocative.

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    A business which achieves only one kind of efficiency never really becomes efficient.

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    For example, let’s say a factory has a maximum production capacity of 2,000 units per day. If the factor’s manager organizes her workers and machines in such a way that the factory produces 2,000 units per day then we can confidently say that the company is productively efficient. However, let’s also assume that the 2,000 units of daily production are inferior to consumers and not one unit coming from this factor is ever sold. Would you still call this company efficient? This company achieved productive, but not allocative, efficiency.

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    Let’s look at another possible scenario. This company took the time to survey potential consumers and used this information to design a well-crafted product. As a result, this research consumer demand was strong. But what if the production process was not as well planned as the product design? If the company was hampered by temporary plant closings and production-line breakdowns one would expect an increase in production costs. This company achieved allocative, but not productive, efficiency.

    Module 2 Supply and Demand focused on allocative efficiency. When a market is in equilibrium, allocative efficiency is achieved. After all, when supply equals demand, firms produce what the consumers want.

    This session focuses on productive efficiency. We will also examine how changes in output affect costs.

    Measuring Productivity

    Productive efficiency (i.e., productivity) can be measured but keep in mind that it is easier to measure in the manufacturing sector (e.g., steel, auto, computer chips, etc.) than in the service sector (e.g., retail, banking, education, etc.).

    The most common way of measuring productivity by output per hour worked (or output per worker). This can be measured at the firm level (micro) and on the national level (macro). The Bureau of Labor statistics publishes U.S. productivity data on a quarterly basis (i.e., four times a year). Figure 1 shows the annual percent change in output per hour worked.

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    Figure 1

    When the percentage change is increasing, then worker productivity is increasing. This situation is like what happened in the U.S. during the late 1990s. During this time the rate of productivity growth went from 0% in 1995 to a high of 4% in 2000. Since workers were more productive, this meant that worker compensation could increase and not cause an increase in cost per unit. For management and labor this is a win-win situation. Workers can receive more pay without hurting company profits.

    In this session we will not focus on the macro (i.e., national) but on the micro (i.e., firm) productivity analysis.

    This page titled 4.2: Costs and Productivity is shared under a not declared license and was authored, remixed, and/or curated by Martin Medeiros.

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