Firms that fail to operate efficiently seldom survive. They are dominated by their competitors because the latter produce more efficiently and can sell at a lower price. The drive for profitability is everywhere present in the modern economy. Companies that promise more profit, by being more efficient, are valued more highly on the stock exchange. For example: In July of 2015 Google announced that, going forward, it would be more attentive to cost management in its numerous research endeavours that aim to bring new products to the marketplace. This policy, put in place by the Company's new Chief Financial Officer, was welcomed by investors who, as a result, bought up the stock. The Company's stock increased in value by 16% in one day – equivalent to about $50 billion.
The remuneration of managers in virtually all corporations is linked to profitability. Efficient production, a.k.a. cost reduction, is critical to achieving this goal. In this chapter we will examine cost management and efficient production from the ground up – by exploring how a small entrepreneur brings his or her product to market in the most efficient way possible. As we shall see, efficient production and cost minimization amount to the same thing: Cost minimization is the financial reflection of efficient production.
Efficient production is critical in any budget-driven organization, not just in the private sector. Public institutions equally are, and should be, concerned with costs and efficiency.
Entrepreneurs employ factors of production (capital and labour) in order to transform raw materials and other inputs into goods or services. The relationship between output and the inputs used in the production process is called a production function. It specifies how much output can be produced with given combinations of inputs. A production function is not restricted to profit-driven organizations. Municipal road repairs are carried out with labour and capital. Students are educated with teachers, classrooms, computers, and books. Each of these is a production process.
Production function: a technological relationship that specifies how much output can be produced with specific amounts of inputs.
Economists distinguish between two concepts of efficiency: One is technological efficiency; the other is economic efficiency. To illustrate the difference, consider the case of auto assembly: the assembler could produce its vehicles either by using a large number of assembly workers and a plant that has a relatively small amount of machinery, or it could use fewer workers accompanied by more machinery in the form of robots. Each of these processes could be deemed technologically efficient, provided that there is no waste. If the workers without robots are combined with their capital to produce as much as possible, then that production process is technologically efficient. Likewise, in the scenario with robots, if the workers and capital are producing as much as possible, then that process too is efficient in the technological sense.
Technological efficiency means that the maximum output is produced with the given set of inputs.
Economic efficiency is concerned with more than just technological efficiency. Since the entrepreneur's goal is to make profit, she must consider which technologically efficient process best achieves that objective. More broadly, any budget-driven process should focus on being economically efficient, whether in the public or private sector. An economically efficient production structure is the one that produces output at least cost.
Economic efficiency defines a production structure that produces output at least cost.
Auto-assembly plants the world over have moved to using robots during the last two decades. Why? The reason is not that robots were invented 20 years ago; they were invented long before that. The real reason is that, until recently, this technology was not economically efficient. Robots were too expensive; they were not capable of high-precision assembly. But once their cost declined and their accuracy increased they became economically efficient. The development of robots represented technological progress. When this progress reached a critical point, entrepreneurs embraced it.
To illustrate the point further, consider the case of garment assembly. There is no doubt that engineers could make robots capable of joining the pieces of fabric that form garments. This is not beyond our technological abilities. Why, then, do we not have such capital-intensive production processes for garment making, similar to the production process chosen by vehicle producers? The answer is that, while such a concept could be technologically efficient, it would not be economically efficient. It is more profitable to use large amounts of labour and relatively traditional machines to assemble garments, particularly when labour in Asia costs less and the garments can be shipped back to Canada inexpensively. Containerization and scale economies in shipping mean that a garment can be shipped to Canada from Asia for a few cents per unit.
Efficiency in production is not limited to the manufacturing sector. Farmers must choose the optimal combination of labour, capital and fertilizer to use. In the health and education sectors, efficient supply involves choices on how many high- and low-skill workers to employ, how much traditional physical capital to use, how much information technology to use, based upon the productivity and cost of each. Professors and physicians are costly inputs. When they work with new technology (capital) they become more efficient at performing their tasks: It is less costly to have a single professor teach in a 300-seat classroom that is equipped with the latest technology, than have several professors each teaching 60-seat classes with chalk and a blackboard.