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Factors of production: Capital and Labour.
Factors of production are resources used by firms as inputs for a good or service to be produced. Factors of production are as follows: capital, labour and natural resources.
In economic theory the term “capital” refers to goods and money used to produce more goods and money. Classifications of capital vary with the purpose of the classifications. The most general distinctions is the one made between physical, financial and human capital.
Physical capital is land, buildings, equipment, raw materials. Bonds, stocks, available bank balances are included in the financial capital. They both make a great contribution to production.
Human capital is knowledge that contributes “know-how” to production. It is increased by research and disseminated through education. Investment in human capital results in new, technically improved, products and production processes which improve economic efficiency. Like physical capital, human capital is important enough to be an indicator of economic development of a nation.
It is common in economics to understand labour as an effort needed to satisfy human needs. It is one og the three elements of production. Ladour has a variety of functions: production of raw materials, manufacturing of final products, transferring things from one place to another, management of production and services like the ones rendered by physicians and teachers.
One classify labour into productive and unproductive. The first produces physical objects having utility, the latter is useful but doesn’t produce material wealth. Labour of the musician is an example.
Demand for labour is influenced by the demand for goods produced by workers, the proportion of wages in total production costs, etc. the supply of labour depends upon the size of population, geographic mobility, skills, education level (human capital), etc. If demand for and supply of labour are not in equilibrium, there is unemployment.
Factors of production are combined together in different proportions in order to produce output. It is assumed in economics that one should choose the combinations of factors which minimizes the cots of production and increases profits.
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Circular Flow of Payment and National Income.
In every economy there are lots of households to supply labour and capital to firms that use them to produce goods and services. Firms provide incomes for households, who in turn use this money to purchase the goods and services produced by firms. This process is called the circular flow of payments.
The gross domestic product (GDP) is the total money value of all final goods produced in the domestic economy over a one-year period. The GDR can be measured in three ways: (a) the sum of the value added in the production within a year, (b) the sum of incomes received from producing the year’s output, (c) the sum to spend on the year’s domestic output of goods and services.
The total money value of all final goods and services in an economy over a one-year period, that is the GDR, plus property income from abroad (interest, rent, dividends and profits) make the gross national product (GNR). The GNR is an important measure of a country’s economic well-being, while the GMR per head provides a measure of the average standard of living of the country’s people. However, this is only an average measure of what people get. The goods and services available to particular individuals depend on the income distribution within the economy.
We now recognize that assets wear out the production process either physically or become obsolete. This process is known as depreciation. There has to be part of the economy’s gross output to replace existing capital and this part of gross output is not available for consumption, investment, government spending, exports. So we subtract depreciation from the GNR to arrive at national income.
National income measures the amount of money the economy has available for spending on goods and services after setting aside enough money to replace resources used up in the production process.
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Taxes and Public Spending
In most economies government revenues come mainly from direct taxes on personal incomes and company profits as well as indirect taxes levied on purchase of goods and services such as value added tax (VAT) and sales tax. Since state provision of retirement pensions is included in government expenditure, pension contributions to state-run social security funds are included in revenue too. Some small component of government spending is financed through government borrowing.
Government spending comprises spending on goods and services and transfer payments.
Government mostly pays for public goods, that is, those goods that, even if they are consumed by one person, can still be consumed by other person. Clean air, national defense, health service are examples of public goods. Government also provides such services as police, fire-fighting and administration of justice.
A transfer is a payment, usually by the government, for which no corresponding service is provided in return. Examples are social security, retirement, unemployment benefits and in some countries food stamps.
In most countries there are campaigns for cutting government spending. The reason for it is that high levels of government spendings are believed to exhaust resources that can be used productively in the private sector. Lower incentives to work are also believed to result from social security payments and unemployment benefits.
Another reason for reducing government spending is to make room for tax cuts.
The most progressive tax structure is the one in which the average tax rate rises with a person’s income level. As a result of progressive tax and transfer system most is taken from the rich and most is given to the poor.
Cuts in tax usually reduce the deadweight tax burden and reduce amount of taxes raised but might increase eventual revenue.
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Money and its Functions.
Money has four function^ a medium of exchange or means of payment, a store of value, a unit of account and a standard of deferred payment. When used as a medium of exchange, money is considered to be distinguished from other assets.
Money as a medium of exchange is believed to be used in one half of almost all exchange. Workers exchange labour for money people buy or sell goods in exchange for money es well.
People do not accept money to consume it directly but because it can subsequently be used to buy things they wish to consume.
The unit of account is the unit in which prices are quoted and account are kept. In the USA for instance prices are quoted in US dollars. In Japan – in yen. It is usually convenient to use the same unit to measure the medium of exchange as well as to quote prices and keep accounts in.
Money is a store of value, for it can be used to make purchases in future. For money to be accepted in exchange, it has to be a store of value. Unless suitable for buying goods with tomorrow, money will not be accepted as payments foo the goods supplied today. But money is neither the only nor necessarily the best store of value.
Finally money serves as a standard of deferred payment or a unit of account over time. When money is borrowed the amount to be repaired next year is measured in units of national currency.
The key feature of money is its use as a medium of exchange. For money to be used successfully as a means of exchange it must be a store of value as well. And it is usually though not always convenient to make money the unit of account and standard of deferred payment.
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Monetary System and Monetary Policies.
Today every has a Central Bank. It acts as a lender to commercial banks and it acts as a banker to the government, taking responsibility for the funding of the government’s budget deficit and the control of the money supply which includes currency outside the banking system plus the sight deposits of the commercial bank against which the private sector can write cheques. Thus, money supply is partly liability of the Central Bank (currency in private circulation) and partly liability of commercial banks (chequing accounts of the general public). The Central Bank controls the quantity of currency in private circulation and the one held by the banks through purchases and sales of government securities. The Control Bank can impose reserve requirements on commercial banks, that is, it can impose minimum ratio of cash reserves to deposits that banks must hold. The Control Bank also sets discount rate which is the interest rate commercial banks have to pay when they want to borrow money. Having set the discount rate, the Central bank controls the money market.
Thus the central bank is responsible for the government’s monetary policy. Monetary policy is the control by the government of a country’s currency and its system for lending and borrowing money through money supply in order to control the level of spending in the economy.
The demand for money is a demand for real money, that is, nominal money deflated by the price level to undertake a given quantity of transactions.
The quantity of real balances demanded falls as the interest rate rises. Interest rates are a tool to regulate the market for bonds. Being sold and purchased by the Central Bank bonds depend on the latter foe their supply and price. Interest rates affect household wealth and consumption. Consumption is believed to depend both on interest and taxes. Higher interest rates reduce consumer demand. There also exist a close relationship between interest rates and incomes. With a given money supply higher income must be accompanied by higher interest rates to keep money demands unchanged.
A given income level can be maintained by an easy monetary police and a tight ficcal policy or by the converse.
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Inflation
Inflation is a steady rise in the average price and wage level. The rise wages being high enough to raise costs of production, prices grow further resulting in a higher rate of inflation and finally in an inflationary spiral. Periods when inflation rates are very large are referred to as hyperinflation.
The causes of inflation are rather complicated and there is a number of theories explaining them. Monetarists such as Milton Friedman say that inflation is caused by too rapid increase in money supply and the corresponding excess demand for goods.
Therefore monetarists consider due government control of money supply to be able to restrict inflation rates. They also believed the high rate of unemployment to be likely to restrain claims for higher wages. People having jobs accept the wages they are being paid, the inflationary spiral being kept under control. This situation also accounts for rather slow increase in aggregate demand.
On the other hand Keynesians, that is, economists following the theory of John Keynes, suppose inflation to be due to processes occurring in money circulation. They say that low inflation and unemployment rates can be ensured by adopting a tight income policy.