The Economy of the World | Chapter 5: Making More with What We Have — Firms, Productivity and Economic Growth

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A repair shop has three technicians, a crowded cupboard and a growing queue of unfinished jobs. Every morning, someone searches for a tool. Sometimes a replacement part arrives after the customer has gone elsewhere. The technicians work hard, but the shop completes less than it could.

Now imagine that the owner reorganises the storage, improves the booking system and keeps a small stock of frequently used parts. The staff work the same hours. They spend less time waiting and more time repairing. More customers collect working appliances at the end of the week.

No one has become more valuable as a human being. The system around their work has become more useful.

That distinction sits at the heart of productivity. An economy’s ability to provide for people depends partly on how much useful output it can obtain from its resources. Understanding that ability requires looking inside firms, beyond the simple instruction to work harder.

A firm brings resources together to produce goods or services. It may be a sole trader, a partnership, a cooperative, a family enterprise or a company with many shareholders. Different forms distribute ownership, control and risk differently.

Markets coordinate many exchanges between firms. Inside a firm, however, much work is coordinated through plans, roles and instructions. The workshop does not hold an auction every time somebody needs to use a screwdriver. People agree on responsibilities and organise repeated tasks together.

This can save effort. A team that works together regularly can develop shared knowledge, establish quality standards and respond to problems without renegotiating every detail. But internal organisation has costs too. Information can get lost as it moves through layers of management. Rules can become rigid. A decision-maker may misunderstand work performed far away.

The boundary of a firm therefore presents choices. Should the repair shop employ a delivery driver or buy delivery services from another company? Should it hold parts itself or rely on a supplier? The answer depends on reliability, scale, flexibility, cost and the importance of close coordination.

There is no rule that bigger is always better. A large firm may spread some costs across more output and invest in specialised systems. A small firm may adapt quickly and understand particular customers. Both can be well or badly managed, and both operate within conditions they do not control.

Public services and organisations without shareholders also face production questions. A library must organise staff, buildings, books and access. A hospital must coordinate many activities whose quality cannot be reduced to the number completed. Understanding production is useful wherever people try to achieve something together.

A business receives revenue when it sells goods or services. Revenue is not profit. Producing what was sold requires resources, and some of the apparent gain may disappear once all relevant costs are considered.

Consider a fictional sole-trader business over one year. All figures are in illustrative currency units, or CU. Revenue is CU200,000. Its recognised expenses, including materials, hired staff, overheads and depreciation, are CU160,000. On these simplified assumptions, accounting profit is CU40,000.

The owner has not recorded a salary for their own work. Suppose the best realistic alternative employment would have paid CU30,000. The owner also uses premises they own; those premises could have earned CU15,000 after relevant costs if rented out instead. The additional opportunity costs total CU45,000.

Subtract those from the accounting profit and economic profit is minus CU5,000. The business covers its recorded expenses but produces less financial value than these specified alternatives. This example assumes the alternatives are genuinely available and comparable; changing that assumption changes the conclusion.

Accounting and economic profit answer different questions. Economic profit includes relevant opportunity costs, while accounting follows its own rules for recognising income and expenses. OpenStax explains this distinction between explicit and implicit costs. Source: OpenStax, Explicit and Implicit Costs.

The owner may still choose to continue. Independence, flexibility, satisfaction or future prospects may matter. A monetary calculation is evidence for a decision, not a complete description of a life. It should, however, be clear about what has been counted.

Cash flow is another question. A profitable sale may remain unpaid for weeks. Buying equipment may require a large payment now while its cost is recognised over several years. A firm can therefore appear profitable and still struggle to pay wages on Friday. This connects the production decisions in this chapter with the liquidity problems we met in Chapter 4.

Productivity compares output with the inputs used to produce it. Labour productivity commonly measures output per worker or per hour. It can rise because of better skills, equipment, technology, organisation or other inputs, rather than because people simply expend more effort. The Reserve Bank of Australia distinguishes labour productivity from measures that consider several inputs together. Source: RBA, Productivity.

Suppose a fictional food-preparation business produces 600 identical meal portions using 60 hours of labour. Labour productivity is ten portions per hour. After redesigning the kitchen, it produces 900 portions in the same 60 hours. Labour productivity becomes fifteen portions per hour, a 50 per cent increase.

We still need to ask what else changed. Did the kitchen use more expensive equipment? Did it consume more energy? Did food quality fall? Were unpleasant tasks transferred to an unpaid family member? A measure involving only labour cannot answer questions about all other inputs or consequences.

This is why productivity is not a score for individual merit. Two equally skilled people may produce different measured amounts because one has reliable equipment and the other faces power cuts. A new employee may appear slower while learning a process that will later improve the whole team.

The US Bureau of Labor Statistics explains that changes in labour productivity can reflect capital, technology, organisation, workforce skill and scale, among other factors. The output attributed to an hour depends on the conditions surrounding that hour. Source: BLS, Why does productivity change?.

The measure is particularly delicate where quality is difficult to observe. A teacher who gives less attention to each learner may appear to handle more students. A repair technician who skips checks may finish more jobs today and create failures tomorrow. Faster activity is not necessarily better production.

Good measurement therefore asks what the output is meant to accomplish. It may require quality adjustments, several indicators and judgement. The goal is to understand improvement, not to reward whatever is easiest to count.

An economy can produce more by employing more people, adding equipment or using more land and materials. It can also produce more by improving how inputs are combined. In practice, these changes often occur together.

A second oven may increase a bakery’s output, but workers may need training and space to use it well. New software may save time only after a business changes its process. Investment is therefore more than purchasing an object. It often involves learning how to make the object useful.

Some improvements spread slowly. A successful technique has to be understood, adapted and maintained. A business may know a method exists but lack finance, skills or a reliable supplier. Innovation includes invention, but it also includes the less visible work of adoption.

Growth compounds over time. Consider an imaginary output index beginning at 100. If output rises by 2 per cent, the index becomes 102. Another 2 per cent increase takes it to 104.04, because the second increase applies to the larger base. The arithmetic explains why sustained improvements can make a substantial difference over many years.

It does not establish that any particular growth rate will continue. Output can fall, the population can change and additional production can carry costs. A forecast should never be smuggled into an illustration of compound arithmetic.

Total output also differs from output per person. If production grows by 3 per cent while population grows by 2 per cent, output per person rises by approximately 1 per cent, or more precisely by 1.03 divided by 1.02 minus one. A country can have a larger economy without an equally large improvement in resources available per resident.

And a higher average does not mean every person is better off. The gains may be concentrated. More working hours may account for part of the increase. Environmental damage or reduced leisure may matter. Chapter 7 will examine how to read the figures without asking one measure to answer every question.

Suppose the reorganised repair shop completes more work with the same staff. Several things can happen. It may reduce prices, increase wages, shorten hours, retain profits, invest in further improvements or combine these choices.

The technical improvement does not dictate the distribution. Competition influences what prices the firm can charge. Labour-market conditions, contracts and bargaining affect pay. Ownership and governance influence how surplus is used. Public policy affects taxes, standards and the services available outside employment.

Productivity growth can make higher material living standards more feasible, but feasibility is not a guarantee that the gains will be shared. We must follow the improvement through the institutions that distribute it.

There can also be adjustment costs. If each technician can complete more jobs, the shop may need fewer workers for a fixed amount of demand. Alternatively, lower prices and better service may attract enough customers to expand employment. Which effect dominates depends on demand, competition, costs and the time allowed for adjustment.

At the economy-wide level, new tasks and industries may develop while others shrink. The people who lose work are not automatically the people who obtain the new opportunities. Location, age, skills, family obligations and access to support influence their ability to move.

The phrase “the economy will adjust” can conceal a great deal of human experience. Adjustment requires actual training, vacancies, transport, housing and income while change takes place. Treating those needs seriously is part of economic analysis, not an objection to it.

A useful policy question is therefore how to support productive improvement while making transitions workable. That question admits several approaches and involves trade-offs. It should be judged through evidence about particular conditions rather than a promise that change will be painless.

Imagine two ways to increase a firm’s sales. It could make a product that lasts longer and reaches customers who need it. Or it could make an existing product harder to repair so that customers must replace it sooner. Both may increase revenue under some conditions. Their contribution to people’s lives is different.

This is why growth and development should not be treated as synonyms. Economic growth concerns an increase in measured production, usually after adjusting for price changes. Development is a broader improvement in people’s capabilities, living conditions and opportunities. The relationship matters, but one number cannot settle it.

A productive system must also maintain the resources on which future production depends. Equipment wears out. Skills need updating. Soil and water can be damaged. Infrastructure can be neglected. Consuming these foundations can raise apparent activity temporarily while reducing later possibilities.

Resilience belongs in the calculation too. Holding spare parts or maintaining a second supplier may look costly during an uninterrupted year. It may preserve output when something fails. The cheapest arrangement under one set of assumptions is not always the best arrangement across a wider range of possible conditions.

Return to the repair shop at the start. A better system allows staff to turn effort into useful results. Yet we would judge the change differently if the faster pace caused injuries, if repairs failed sooner or if the gain depended on unpaid overtime hidden from the records.

The right questions are concrete. What output improved? Which inputs were needed? Was quality maintained? What did the change cost? Who gained, who had to adjust and what remains sustainable over time?

These questions carry us from the firm’s organisation to the people who work within it. In Chapter 6, we examine how skills and effort become an income, why wages differ and why much of the work that sustains economic life receives no wage at all.

• Firms organise repeated cooperation as well as buying and selling in markets.
• Revenue, accounting profit, economic profit and cash flow answer different questions.
• Productivity depends on equipment, skills, organisation and conditions; it does not measure a person’s worth.
• More productive capacity creates possibilities, while institutions influence how gains and adjustment costs are shared.

Revenue: Income from sales before the relevant costs are deducted.

Accounting profit: Revenue minus expenses recognised under the applicable accounting approach.

Economic profit: Revenue minus explicit costs and relevant implicit opportunity costs.

Labour productivity: Output per worker or per hour worked.

Depreciation: The reduction in a productive asset’s value through use, wear or obsolescence, represented in accounts under specified rules.

Economic growth: An increase in an economy’s real output over time.

Development: Broader improvement in people’s capabilities, opportunities and living conditions.

• OpenStax — Explicit and Implicit Costs, and Accounting and Economic Profit.
• Reserve Bank of Australia — Productivity.
• US Bureau of Labor Statistics — Why does productivity change?.

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