Factors of Production and Circular Flow of Income - Coursework Example

? Topic: Lecturer: Presentation: Introduction In our everyday lives we are faced with various choices we have to make and in most cases we have to forego one option in favour of the other. This is what economics is all about; making choices among alternatives bearing in mind the scarcity of resources. In other words, economics is about efficient allocation of scarce resources (Wessels, 2006). Since resources (factors of production) are very scarce and human wants are unlimited, we have to allocate them efficiently for the welfare of all citizens thus the need for economics. According to Samuelson (2010) the central concern of economics is solving three vital problems: what to produce, how to produce and for whom and the solution lies in making choices between inputs and outputs. The aim of this paper is thus to discuss the factors of production and the circular flow of income. To achieve this, the paper will be divided into various sections. The first section will be discussion on what economics is and the problems it seeks to address. It will also cover the importance of economics and brief explanation of different economies such as the market, command and mixed economy as mechanisms of allocating scarce resources. The second section will address the factors of production: land, labour, capital and enterprise. It will discuss their functions, qualities and how their productivity can be improved. The third section will discuss the circular flow of income which shows flow of inputs and outputs between firms and households or at microeconomics level. Lastly, a brief summary of the main points will be given. What is economics and why study economics? Samuelson (2010: 4) defines economics as “the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.” It aims at producing the highest combination of quality and quantity of goods and services thus enhancing efficiency. Efficiency according to Samuelson is achieved when no individual’s economic welfare can be improved unless someone else is made worse off (p. 5). When efficiency is achieved the welfare of the whole society is improved. Many people might think that it is not essential to study economics but it has a lot of benefits. According to Lipsey and Chrystal (2011) economics is important in helping to understand the world in which we live and to become astute participants in the economy. It helps us to understand business cycles in relation to credit, unemployment and policies put in place to deal with such crises. It also helps people to understand international trade and the effects of globalisation especially in modern era where production has gone global. Government policies to promote economic growth, use of resources, full employment and price stabilisation are also the product of economic analysis. Economics takes a scientific approach to analysis of issues in the economy and also applies econometrics to economic problems. It is based on the principle of holding other things constant when analysing variables (Gitman and McDaniel, 2008). Economics is divided into two categories: micro and macroeconomics. Microeconomics deals with markets, firms and households while macroeconomics deals with the whole economy but we shall concentrate on microeconomics. Human wants are numerous or unlimited and as stated earlier, resources are scarce. As such, it is difficult to satisfy the unlimited wants thus choices have to be made that would lead to efficient allocation of resources. For example, if a firm decides to produce household items, it foregoes the opportunity or alternative of producing industrial items or any other product. The benefits the firm could have gotten by dealing with industrial items (the next best alternative) are what Samuelson (2010) calls opportunity cost. Economics is all about making choices on what to produce, how to produce and for whom given technology and scarce resources (Wessels, 2006). Whatever choice is made, there is an opportunity cost foregone as the limited resources cannot satisfy all wants. This needs an understanding of the mechanisms that allocate scarce resources such as the market mechanism, command and mixed economy. In market economy, resources are allocated by forces of demand and supply (Marshall, 2007). It is the consumers through their demand who determine what is to be produced and for whom. For example, if consumers demand pizzas then the producers have no option but to produce enough pizza to satisfy existing demand. If the pizzas cost a high price, then demand for it might fall and as such the producers have to find ways of producing efficiently (low cost and low prices) thus answering the question of how to produce. In a command economy, it is the government who owns the means of production thus directs the operations of the enterprise (Samuelson, 2010). Between the two extremes is the mixed economy where decisions are made by the market forces and the government intervenes to correct market failures. The factors of production are used in the production process to produce output and comprise of land, labour, capital and enterprise. The demand for these factors is derived demand from firms that use the factors to produce goods and services. The factors are also interdependent in that it requires them to be used together for production process to commence and not in isolation. For example, land cannot be used in production unless labour is applied on it and on the other hand, labour can only be utilised in land and capital for production otherwise it would not be required. For Mankiw (2011: 25) the marginal product of one factor depends on quantities of all factors available and a change in supply of one factor alters the equilibrium earnings of all the factors. He also notes that the value of marginal product of a factor is equal to its price. Land refers to all the natural resources below or above the surface including hills, forests, water and minerals (Marshall, 2007: 133). Land as a factor possesses various characteristics. First of all, it is a gift of nature hence man does not contribute in its creation. This means that there is nothing man can do to increase its size or alter its properties and this leads us into the next characteristic; land is limited or fixed in nature. One can develop the productive power of the land by applying capital and labour but its supply cannot be curtailed. As such, the rise in demand of land automatically leads to a high price in terms of rent (p. 139). Land is also immobile. One cannot move a piece of land or natural resources from one place to another since area is fixed. This is unlike labour and capital which can be transferred anywhere. Land also differs in variety and this can explain its different uses: agriculture, building residential areas, mining, putting up factories and other infrastructures such as roads, railways and transport useful for driving the economy (Marshall, 2007). Land is also passive in that it requires other factors such as labour to function without which nothing can be produced. Land productivity can be determined by many factors such as ownership and size, government policy, improved production techniques as well as human and natural factors. Sometimes land can be degraded by overuse especially in agriculture thus its productivity needs to be improved. This can be done by adding fertiliser to the soils, avoiding water and land pollution, and proper planning. Labour refers to “all physical and mental activity performed for earning money or transforming resources into goods and services” (Marshall, 2007: 147). This means that if an activity is not performed with a goal of earning money then it is not labour. For example, working in own farm to produce crops for consumption is not labour unless the produce is sold in the market. Labour possesses various characteristics. Unlike land, it is mobile. This is due to the fact that labour cannot be separated from the individual thus he/she moves with it in different professions or sectors of the economy (Samuelson, 2010). It is also active in that other factors cannot function without it. Labour has varied efficiencies based on knowledge, skills and abilities of individuals thus accounting for the differences in wages in the economy. Labour can be skilled, semiskilled or unskilled allowing labourers to get involved in different occupations. The kinds of skills also influence the productivity of labour and contribution to the economy. It is therefore, essential to improve labour productivity through training and development and offering high quality education (Marshall, 2007). Offering better health care can also go a long way in improving the quality of labour as a healthy nation is a productive nation. Job enrichment also enhances labour productivity by making sure labourers engage in variety of jobs. Capital is the third factor of production and refers to “all kids of wealth other than free gifts of nature which yield income” (Marshall, 2007: 177). It is the money used to acquire human and natural resources as well as assets for production. Many people use capital and wealth or income interchangeably but they mean different things. Capital is a form of wealth but wealth is not capital unless it is made to produce income. Income is the output of capital thus capital is not income unless the income is saved and accumulated for investment thus producing more earnings (Samuelson, 2010). It has several characteristics: it is man-made in that it is a result of investment unlike land which is given. Unlike land, wealth can be produced without capital although not easily (Mankiw, 2011). Capital is also mobile and transferable but it must use labour so as to produce. However, in modern era where technology has advanced, machines can function automatically thus replacing labour. Most importantly it is a result of savings. Capital can be fixed or working capital whereby fixed capital includes machinery, buildings and equipments. These machines and equipment age and depreciate if used for long time and thus can slow the production process. As such replacements need to be made and damaged equipments repaired for production to run smoothly and efficiently (Marshall, 2007). To improve the productivity of machines, various measures can be taken. First, the firm should engage in continuous research and development to find out new machines that work better in other places or ways of improving existing machines. Technology keeps advancing and as such innovations are vital in improving productivity. Hiring qualified labour who can handle machines effectively is essential if their life is to be prolonged; some machines get damaged due to poor handling. Enterprise or entrepreneur is the last category. An entrepreneur is the one who initiates a business idea and ensures its objectives are realised. He is different from a labourer in that he does all jobs in the company, has a lot of risks, it is not as mobile as labour and entails responsibility (Marshall, 2007: 191). The enterprise organises and co-ordinates all the other three factors of production to ensure efficiency in production process. The entrepreneur does a lot of other things such as choosing the business, product, innovating, determining location for production and distributing rewards. As such, entrepreneurs should have leadership skills, be conversant with the business, be able to organise, and ensure other factors are efficient. He should be a risk taker as most businesses entail taking risks. An entrepreneur is the one who decides what is to be produced and is confronted with other business decisions to make. As such he should be a good decision maker and have problem solving skills (Gitman &McDaniel, 2008). The success or failure of the business depends on the entrepreneurs hence it is vital for him to have the knowledge, skills and abilities required to perform the role effectively. The relationship between the different factors of production is manifested in the circular flow of income. The circular flow diagram according to Mankiw (2011: 24) shows how the economy is organised and how participants interact through the markets for goods and services and markets for factors of production. It comprises of two players: firms and households but in macroeconomics it also involves international trade and government activities. In the market for goods and services, the households are buyers while firms are sellers but in the markets for production factors household are sellers who earn rent, interest, wages whereas firms are buyers. The circular flow of income diagram is as shown in figure 1 below. The inner loop shows flow of inputs and outputs while the external loop shows flow of dollars or income as a result of decisions made by firms and households. Figure 1: The Circular flow of Income. Adapted from Mankiw N Gregory, 2011:25 The income of households and firms circulates through the two markets. The inner loop shows flow of inputs and outputs .In the market for goods and services firms sell goods and buyers buy the goods and consume. They offer the factors of production to firms in the market for factors and get wages, rent which they use to buy goods and services. Firms use these factors to produce and sell more goods and services in the goods market. In the outer loop, households spend their income to buy goods and the firms use the revenue obtained to pay for factors of production and also gain profit from sales (Mankiw, 2011). Conclusion Economics is the study of mankind in ordinary business of life and it helps us to understand how the economy works and how government policies work. It also helps us to allocate scarce resources efficiently through the market. Economics is concerned with three problems which include what to produce, how and for whom and the markets as the mechanisms of allocating resources help us to answer these questions. The production process requires inputs such as labour, capital, land and enterprise to produce output for sale in the markets. The relationship and interactions between the inputs and outputs are represented in the circular flow of income. It has two markets: markets for goods and services and market for factors of production which enable exchange and circulation of income in economy. Households sell factors of production to firms and earn income which they use to buy goods and services from firms after which they get revenue to buy factors and the process continues. This is in the micro economy which consists of firms and households. References Gitman, L.J and McDaniel, C.D. 2008. The future of business: the essentials. Mason, OH: Cengage Lipsey, R and Chrystal, A. 2011. Economics. 12th edn. Oxford: Oxford University Press Mankiw, N.G. 2011. Principles of economics. 6th edn. Mason, OH: Cengage. Marshall, A. 2007. Principles of economics. New Delhi: U.K Publications. Samuelson, P.A. 2010. Economics. 19th edn. New York: Tata McGraw-Hill. Wessels, W.J. 2006. Economics. 4th edn. New York: Barron’s Educational Series, Inc. Read More