One of the pioneers of the subject we call economics today, Adam Smith, named his most influential work – An Enquiry into the Nature and Cause of the Wealth of Nations. What generates the economic wealth of a nation? What makes countries rich or poor? These are some of the central questions of economics. It is not that countries which are endowed with a bounty of natural wealth – minerals or forests or the most fertile lands – are naturally the richest countries. In fact the resource rich Africa and Latin America have some of the poorest countries in the world, whereas many prosperous countries have scarcely any natural wealth. There was a time when possession of natural resources was the most important consideration but even then the resource had to be transformed through a production process. The economic wealth, or well-being, of a country thus does not necessarily depend on the mere possession of resources; the point is how these resources are used in generating a flow of production and how, as a consequence, income and wealth are generated from that process. Let us now dwell upon this flow of production. How does this flow of production arise? People combine their energies with natural and manmade environment within a certain social and technological structure to generate a flow of production. In our modern economic setting this flow of production arises out of production of commodities – goods and services by millions of enterprises large and small. These enterprises range from giant corporations employing a large number of people to single entrepreneur enterprises. But what happens to these commodities after being produced? Each producer of commodities intends to sell her output. So from the smallest items like pins or buttons to the largest ones like aeroplanes, automobiles, giant machinery or any saleable service like that of the doctor, the lawyer or the financial consultant – the goods and services produced are to be sold to the consumers. The consumer may, in turn, be an individual or an enterprise and the good or service purchased by that entity might be for final use or for use in further production. When it is used in further production it often loses its characteristic as that specific good and is transformed through a productive process into another good. Thus a farmer producing cotton sells it to a spinning mill where the raw cotton undergoes transformation to yarn; the yarn is, in turn, sold to a textile mill where, through the productive process, it is transformed into cloth; the cloth is, in turn, transformed through another productive process into an article of clothing which is then ready to be sold finally to the consumers for final use. Such an item that is meant for final use and will not pass through any more stages of production or transformations is called a final good.

Why do we call this a final good? Because once it has been sold it passes out of the active economic flow. It will not undergo any further transformation at the hands of any producer. It may, however, undergo transformation by the action of the ultimate purchaser. In fact many such final goods are transformed during their consumption. Thus the tea leaves purchased by the consumer are not consumed in that form – they are used to make drinkable tea, which is consumed. Similarly most of the items that enter our kitchen are transformed through the process of cooking. But cooking at home is not an economic activity, even though the product involved undergoes transformation. Home cooked food is not sold to the market. However, if the same cooking or tea brewing was done in restaurant where the cooked product would be sold to customers, then the same items, such as tea leaves, would cease to be final goods and would be counted as inputs to which economic value addition can take place. Thus it is not in the nature of the good but in the economic nature of its use that a good becomes a final good. Of the final goods, we can distinguish between consumption goods and capital goods. Goods like food and clothing, and services like recreation that are consumed when purchased by their ultimate consumers are called consumption goods or consumer goods. (This also includes services which are consumed but for convenience we may refer to them as consumer goods.) Then there are other goods that are of durable character which are used in the production process. These are tools, implements and machines. While they make production of other commodities feasible, they themselves don’t get transformed in the production process. They are also final goods yet they are not final goods to be ultimately consumed. Unlike the final goods that we have considered above, they are the crucial backbone of any production process, in aiding and enabling the production to take place. These goods form a part of capital, one of the crucial factors of production in which a productive enterprise has invested, and they continue to enable the production process to go on for continuous cycles of production. These are capital goods and they gradually undergo wear and tear, and thus are repaired or gradually replaced over time. The stock of capital that an economy possesses is thus preserved, maintained and renewed partially or wholly over time and this is of some importance in the discussion that will follow.
We may note here that some commodities like television sets, automobiles or home computers, although they are for ultimate consumption, have one characteristic in common with capital goods – they are also durable. That is, they are not extinguished by immediate or even short period consumption; they have a relatively long life as compared to articles such as food or even clothing. They also undergo wear and tear with gradual use and often need repairs and replacements of parts, i.e., like machines they also need to be preserved, maintained and renewed. That is why we call these goods consumer durables. Thus if we consider all the final goods and services produced in an economy in a given period of time they are either in the form of consumption goods (both durable and non-durable) or capital goods. As final goods they do not undergo any further transformation in the economic process. Of the total production taking place in the economy a large number of products don’t end up in final consumption and are not capital goods either. Such goods may be used by other producers as material inputs. Examples are steel sheets used for making automobiles and copper used for making utensils. These are intermediate goods, mostly used as raw material or inputs for production of other commodities. These are not final goods. Now, to have a comprehensive idea of the total flow of production in the economy, we need to have a quantitative measure of the aggregate level of final goods produced in the economy. However, in order to get a quantitative assessment – a measure of the total final goods and services produced in the economy – it is obvious that we need a common measuring rod. We cannot add metres of cloth produced to tonnes of rice or number of automobiles or machines. Our common measuring rod is money. Since each of these commodities is produced for sale, the sum total of the monetary value of these diverse commodities gives us a measure of final output. But why are we to measure final goods only? Surely intermediate goods are crucial inputs to any production process and a significant part of our manpower and capital stock are engaged in production of these goods. However, since we are dealing with value of output, we should realise that the value of the final goods already includes the value of the intermediate goods that have entered into their production as inputs. Counting them separately will lead to the error of double counting. Whereas considering intermediate goods may give a fuller description of total economic activity, counting them will highly exaggerate the final value of our economic activity. At this stage it is important to introduce the concepts of stocks and flows.Often we hear statements like the average salary of someone is Rs 10,000 or the output of the steel industry is so many tonnes or so many rupees in value. But these are incomplete statements because it is not clear whether the income which is being referred to is yearly or monthly or daily income and surely that makes a huge difference. Sometimes, when the context is familiar, we assume that the time period is known and therefore do not mention it. But inherent in all such statements is a definite period of time. Otherwise such statements are meaningless. Thus income, or output, or profits are concepts that make sense only when a time period is specified. These are called flows because they occur in a period of time. Therefore we need to delineate a time period to get a quantitative measure of these. Since a lot of accounting is done annually in an economy, many of these are expressed annually like annual profits or production.Flows are defined over a period of time.

In contrast, capital goods or consumer durables once produced do not wear out or get consumed in a delineated time period. In fact capital goods continue to serve us through different cycles of production. The buildings or machines in a factory are there irrespective of the specific time period. There can be addition to, or deduction from, these if a new machine is added or a machine falls in disuse and is not replaced. These are called stocks. Stocks are defined at a particular point of time. However we can measure a change in stock over a specific period of time like how many machines were added this year. Such changes in stocks are thus flows, which can be measured over specific time periods. A particular machine can be part of the capital stock for many years (unless it wears out); but that machine can be part of the flow of new machines added to the capital stock only for a single year. To further understand the difference between stock variables and flow variables, let us take the following example. Suppose a tank is being filled with water coming from a tap. The amount of water which is flowing into the tank from the tap per minute is a flow. But how much water there is in the tank at a particular point of time is a stock concept. To come back to our discussion on the measure of final output, that part of our final output that comprises of capital goods constitutes gross investment of an economy1. These may be machines, tools and implements; buildings, office spaces, storehouses or infrastructure like roads, bridges, airports or jetties. But all the capital goods produced in a year do not constitute an addition to the capital stock already existing. A significant part of current output of capital goods goes in maintaining or replacing part of the existing stock of capital goods. This is because the already existing capital stock suffers wear and tear and needs maintenance and replacement. A part of the capital goods produced this year goes for replacement of existing capital goods and is not an addition to the stock of capital goods already existing and its value needs to be subtracted from gross investment for arriving at the measure for net investment. This deletion, which is made from the value of gross investment in order to accommodate regular wear and tear of capital, is called depreciation. So new addition to capital stock in an economy is measured by net investment or new capital formation, which is expressed as

Net Investment = Gross investment – Depreciation

Let us examine this concept called depreciation a little more in detail. Let us consider a new machine that a firm invests in. This machine may be in service for the next twenty years after which it falls into disrepair and needs to be replaced. We can now imagine as if the machine is being gradually used up in each year’s production process and each year one twentieth of its original value is getting depreciated. So, instead of considering a bulk investment for replacement after twenty years, we consider an annual depreciation cost every year. This is the usual sense in which the term depreciation is used and inherent in its conception is the expected life of a particular capital good, like twenty years in our example of the machine. Depreciation is thus an annual allowance for wear and tear of a capital good.2 In other words it is the cost of the good divided by number of years of its useful life. Notice here that depreciation is an accounting concept. No real expenditure may have actually been incurred each year yet depreciation is annually accounted for. In an economy with thousands of enterprises with widely varying periods of life of their equipment, in any particular year, some enterprises are actually making the bulk replacement spending. Thus, we can realistically assume that there will be a steady flow of actual replacement spending which will more or less match the amount of annual depreciation being accounted for in that economy. Now if we go back to our discussion of total final output produced in an economy, we see that there is output of consumer goods and services and output of capital goods. The consumer goods sustain the consumption of the entire population of the economy. Purchase of consumer goods depends on the capacity of the people to spend on these goods which, in turn, depends on their income. The other part of the final goods, the capital goods, are purchased by business enterprises either for maintenance or addition to their capital stock so that they can continue to maintain or expand the flow of their production. In a specific time period, say in a year, the total production of final goods can thus be either in the form of consumption or investment and there is thus a trade-off. If an economy, out of its current production of final goods, produces more of consumer goods, it is producing less of investment goods and vice-versa. We will soon see, however, that this simple additive relation is more complex in more than one way. The relation, in fact, is that of a basic circularity expressing the self-feeding nature of the production process. Consumption goods sustain the basic objective of any economy – the need to consume. Consumption may range from basic life sustenance to luxurious lifestyles. Human beings must consume to survive and work and it is consumption of the basic necessities of life – food, clothing, shelter that make us function. But as human societies advance and progress, their consumption needs become much more wide ranging and complex. Not only are newer consumption needs perceived and correspondingly new consumer goods and services produced, but also the meaning of basic necessities may now include not only food and clothing but such essentials like basic education and health care. If consumption is the ultimate objective, these consumables – goods and services – are to be both produced and purchased. Whereas it is possible, in different social or economic arrangements, for goods to be produced and distributed to members of the society without being purchased or sold, we are not considering an economy like that. In the economy under consideration all goods and services are produced by the entrepreneur for sale and the enterprise intends to make a profit through the act of selling. So the act of production makes this consumption feasible in two ways – by producing these consumption goods and simultaneously generating the income for those who are involved in the production process. The entrepreneur buys machines and employs people to make this production feasible. The objective of the entrepreneur is to sell the commodities produced and earn profits. The act of employment, in turn, generates income for those who are employed. The income that the employed earn and the profit that the entrepreneur earns become the basis for purchase of consumption goods that are being produced for sale. But the production of consumption goods would not be feasible without capital goods. Human labour is combined or applied on the stock of capital goods to produce the consumables and the capital goods. More sophisticated the capital goods are, more will be the productivity of labour. The traditional weaver would take months to weave a sari but with modern machinery thousands of pieces of clothing are produced in a day. Decades were taken to construct the great historical monuments like the Pyramids or the Taj Mahal but with modern construction machinery one can build a skyscraper in a few years. One of the signs of progress in our modern society is both the qualitative and quantitative enhancement that has happened to capital stock. The larger and more sophisticated the capital stock, the more numerous and more varied will be the output of commodities and, consequently, more numerous and varied will be the production of consumption goods. But aren’t we contradicting ourselves? Earlier we have seen how, of the total output of final goods in an economy, if a larger share goes for production of capital goods, a smaller share is available for production of consumer goods. Here we have to bring in the relevance of the time period in our discussion. Given a stock of capital goods with which production commences in a year, of the total output produced at the end of the year, if more of capital goods are produced then less of consumption goods are produced. But the more the capital goods produced now, more will be the productive capacity of the system in the future. Hence a larger volume of consumption goods can be produced in the future. If, at present, the economy sets aside a greater fraction of its output for investment purpose, its capacity to produce more output in the future rises. This phenomenon becomes possible because capital goods, unlike non-durable consumer goods, do not get immediately exhausted with their use – they add to the stock of capital in quantitative terms. The new stock may also be qualitatively superior to the existing stock (just as a modern textile mill is more productive than the old handlooms). In both cases the capacity of the economy to produce more output in the future rises. Now if we concentrate on production in a given time period, say a year, we can observe the basic circularity. Total output of final goods and services produced in an economy in a year has two different parts – the consumer goods and services, and the capital goods. The consumer goods and services sustain the consumption of the total population of the economy. From the population of the economy is derived its workforce, people who contribute to production either by providing their labour and skill or by supplying their capital or entrepreneurship. Such human effort is combined with existing stock of capital goods – tools, machines, infrastructure etc. to form the basis for production of output. Of this a part of the final output comprises of this year’s capital goods production, which replaces or adds to the existing capital stock, and the resultant capital stock, in interaction with human labour and entrepreneurship, will be the basis for production of output in the next cycle of production i.e. next year. Thus the economic cycle rolls on, making a continuous process of consumption and production possible. We can also observe here that unless the current production of capital goods is entirely used up for replacement of old capital stock, which in most instances is rather unlikely, i.e. if there is a net addition to capital stock at the end of this year’s production cycle, next year’s production commences with a larger stock of capital. This can thus become the basis for larger production of output. Thus the economic cycle not only rolls on, it also has a strong tendency to expand. We can also locate another view of the circular flow inherent in the discussion we have made had so far. Since we are dealing with all goods and services that are produced for the market, i.e. to be sold, the crucial factor enabling such sale is demand for such products backed by purchasing power. One must have the necessary ability to purchase commodities. Otherwise one’s need for commodities does not get recognised by the market. We have already discussed above that one’s ability to buy commodities comes from the income one earns as labourer (earning wages), or as entrepreneur (earning profits), or as landlord (earning rents), or as owner of capital (earning interests). In short, the incomes that people earn as owners of factors of production are used by them to meet their demand for goods and services. So we can see a circular flow here which is facilitated through the market. Simply put, the firms’ demand for factors of production to run the production process creates payments to the public. In turn, the public’s demand for goods and services creates payments to the firms and enables the sale of the products they produce. So the social act of consumption and production are intricately linked and, in fact, there is a circular causation here. The process of production in an economy generates factor payments for those involved in production and generates goods and services as the outcome of the production process. The incomes so generated create the capacity to purchase the final consumption goods and thus enable their sale by the business enterprises, the basic object of their production. The capital goods which are also generated in the production process also enable their producers to earn income – wages, profits etc. in a similar manner. The capital goods add to, or maintain, the capital stock of an economy and thus make production of other commodities possible.

1 Comment:

  1. nmatthews said...
    Great information!!
    Thanks for sharing.

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