3.6 Firms & Production
Firms choose how to produce goods using labour, capital, and land — and how efficiently they use these resources determines whether they can compete and grow.
What You Need to Know
- Derived demand: Firms demand factors of production (land, labour, capital) only because consumers demand the final goods or services.
- Three influences on factor demand: demand for goods/services, price of different factors, and their availability and productivity.
- Labour-intensive vs capital-intensive: A choice firms make based on wages, technology costs, and the nature of the product.
- Production ≠ Productivity: Production is total output; productivity is efficiency (output per unit of input).
- Key drivers of productivity: innovation, investment, training, competition, and entrepreneurial freedom.
1. Demand for the Factors of Production
What is Derived Demand?
Firms don't buy factors of production for their own sake. They buy them because customers want the final product. This is called derived demand.
Think of it this way: If a tyre manufacturer sees demand for their tyres increase, they'll suddenly need more rubber, more workers, and possibly more machinery. The demand for rubber, labour, and capital is derived from the demand for tyres.
Derived Demand
Demand for a factor of production that exists only because there is demand for the final good or service that uses that factor.
The Three Main Influences on Factor Demand
Influence 1: Demand for Goods & Services
When consumer demand for a product increases, firms need more raw materials, more labour, and possibly more capital to meet that demand.
Example: During summer, demand for ice cream rises. Ice cream makers will demand more:
- Raw materials (milk, sugar, flavourings) — land/natural resources
- Workers for production and sales — labour
- Refrigeration equipment — capital
Influence 2: The Price of Alternative Factors
Firms constantly monitor whether it's cheaper to buy a new machine or hire more workers. If wages rise sharply in a country, firms are more likely to invest in capital (machinery) to replace labour.
Key principle: Firms substitute expensive factors with cheaper ones when it makes financial sense.
Real-world example: A clothing factory in a wealthy country might shift production to a poorer country where wages are lower. Or it might invest in automation to replace high-wage workers entirely.
Influence 3: Availability & Productivity of Factors
If a factor becomes harder to find or more expensive to access, firms demand less of it. Conversely, if a factor becomes more productive, demand for it increases.
Example — Supply shock: COVID-19 reduced the availability of both labour (workers absent) and raw materials (supply chain disruptions). Firms scrambled to find substitute factors or local alternatives, even at higher prices.
Example — Productivity increase: A government training scheme improves car mechanic skills. Repair garages will now hire more mechanics because each worker is more productive, increasing overall profits.
📌 Practice Question
A smartphone manufacturer sees demand for its phones fall sharply. Explain how this will affect the firm's demand for labour.
2. Labour & Capital-Intensive Production
What's the Difference?
Labour-Intensive Production
Capital-Intensive Production
Real examples:
- Labour-intensive:
- Capital-intensive:
What to Memorise