Basic Economic Activities: Capital Formation

Capital Formation is one of the basic economic activities that determine a country's economic development. The other three factors are Production, Distribution, and Consumption, which eventually lead to the capital formation stage.

  

The four basic economic activities are interlinked, and each activity leads to the next stage of the economy.

• The production of goods and services leads to the distribution of goods that are ultimately either consumed or stocked.
• Distribution of goods to all corners of the economy results in the streamlined consumption of those goods and services.
• Consumption can be controlled at a certain state of satiety, and the excess portion can be diverted into investment for future stocks and capital formation.

So, each economic activity leads to the next stage, and thereby they are interlinked with one another.

Capital Formation

Now, coming to capital formation, there are two types of capital: either working capital or fixed capital.

Working capital is used for running the business. It includes stores and stocks, semi-finished goods, cash and bank balances, etc.

Fixed capital is the foundation of a business. It consists of land, buildings, plant and machinery, etc.

Note:

The creation of capital, or capital formation, refers to the net worth of assets. It is the net value of capital, calculated by deducting all liabilities from assets.

Capital Formation Process

A decrease in expenses and present consumption leads to excess income and excess stocks of produced goods and services. 

Whenever there is more production and less consumption, it leads to capital formation. 

Therefore, restraint on present consumption and the generation of savings are the major sources of capital formation. Overall, production is either consumed or used to create capital.

Consumption plays an important role in capital formation.

• Whenever you refrain from present consumption and save your money, it is generally deposited in banks.
• The banks, in turn, lend that money to producers or invest it in shares and equity funds.
• This investment is again used by producers and businesspeople to purchase machinery and equipment and to start new ventures or increase current production levels. Increased production is possible because of this extra income or savings, which producers use positively.
• This will again boost the economy and can increase both workers' income and consumption levels.
• Increased consumption is a sign of an elevated standard of living and symbolizes a developed economy.

Increased consumption does not always imply that whatever you are producing is consumed entirely.

When the production of goods and services greatly exceeds initial requirements, and since you have more money to spend in developed economies, it is possible to consume more goods at relatively affordable prices and still save sufficient money. 

These savings, in turn, create capital formation.

Capital formation occurs when these savings are deposited in banks and used to invest in shares or to finance producers. 

If the savings are kept idle at home, no capital formation can occur. 

Therefore, idle funds must be used to produce more goods and services, which is considered part of the capital formation process.

Basic Economic Activities: Consumption of Goods and Services, Limitations and Bad Effects on Economy

Consumption is the 3rd basic economic activity that follows after Production and Distribution of goods.

In some cases, consumption may not necessarily go through the intermediary process of distribution, as in the case of a roadside eatery, where food is produced and consumed immediately with no intermediary.

Consumption is the act of using up something. Economically, it is the usage or utilisation of goods and services that are being produced. 

Whatever goods and services get produced, we use them up to satisfy our needs - let it be our immediate need or some future need. Either way, it is the act of consumption. 

So, whenever we eat food, or purchase groceries, clothes, and other household and electronic goods, all these are counted as acts of consumption. 

Similarly, consulting a Doctor, availing hospital services, legal services, or salon services - all these acts also add to the concept of consumption function.

Types of Consumption

Not every consumption leads to immediate satisfaction of wants.

• A portion of consumption adds to storage and future utilisation of those goods. For example, purchasing a bag of rice and other monthly or weekly purchases. These items are consumed throughout the month or week.
• Some items of consumption are used for longer periods of life, like electronic goods, furniture, and other equipment which are utilised for years.
• Many items of goods and resources are procured for using them in manufacturing other end products. This consumption can be termed as industrial consumption. 
• Industrial consumption leads to production of many goods and products that are again utilised by end users or intermediaries. So, it is a chain of consumption.
• Then, there are the types of physical goods, professional services, and digital content (Spotify, YouTube, OTT platforms, etc), and movies, dramas, TV shows, books, and other multiple forms of consumption.

Limitations of Consumption

There are some limitations to consumption as it is dependent on other circumstances that are interlinked with it. 

• An individual's income determines his consumption. Because income is limited for any one person, he can spend only a certain amount of money to purchase goods or services. So, his consumption is limited by his income.
• The availability of goods also determines or affects the consumption function. You may want to buy something, but it is not available in your region or is not in stock. So, you are unable to buy it and should look at other options or go without it.
• Ignorance of knowledge also affects consumption, as you are unaware of some goods in the market and so do not consider purchasing them.

Bad Effects of Consumption

Consumption, if uncontrolled, can lead to many worst situations in the economy.

• Consumption can leave goods and services out of stock at times.
• Consumption can deplete the economy's resources, thereby depriving future generations of them.
• Consumption can make governments depend on other countries for goods and resources, thereby tilting the balance of payments position negatively.

To sum up:

Consumption is a major indicator of the progress of an economy. But there are some limitations and negative effects of the consumption process. So, it requires much planning and management to develop a country's growth.

Basic Economic Activities: Distribution of Goods and Services

Distribution of goods and services plays an important role in the economy. It is the activity that comes after production, and its job is to distribute the goods and services to their points of consumption.

Goods produced do not get consumed in their local markets when production is on a large scale. 

So, they need to be transported to all corners of the market depending upon their requirements. First of all, you may need to create awareness in the market about your produce so that people come to know of it and demand it for their requirements. This involves publicity and advertisement. Then, you need transportation and storage facilities for the goods until they get consumed.

So, distribution of goods and services involves the following major activities:

Publicity:

To acquire demand for your goods, the public should be aware that you are producing so-and-so goods and/ or services. But, how can they know if you are doing your business in a confined zone? Only your neighbours and acquaintances could be aware of your activities.

So, you need publicity for your produce.

This can be achieved through advertisements in all leading newspapers or broadcasts on Radio and TV. 

Information about your products, including their quality and functions, also needs to be publicized through pamphlet distribution and TV advertisements. 

This will encourage interested people to demand your products.

Transportation

Upon receiving a goods requirement, you need to transport them to their designated locations. 

The destination can be either your godown, an agency, or directly to the customer's address.

This can be done either with your own fleet of vehicles or through public transportation facilities, such as carriers, couriers, railway freight services, cargo services, etc.

Storage

Distribution of goods may require storage space and facilities for storing them at destination points or even at intermediary points till actual consumption takes place, to protect them from heat and rain. 

You can't ship each and every requirement separately, since it will not be economical and may delay the supplies. So, storage occupies an important role in the distribution of goods.

So, from the above analysis, you can see that distribution of goods is a very complex economic activity involving publicity, transportation, and storage of goods.

Note:
There can be exceptions, in which case this distribution activity may not be necessary. 

For example, food consumed directly at small roadside eateries, a haircut at the salon, etc., where there is no involvement of distribution activities. It is a case of direct production and consumption.

Basic Economic Activities: Production and Factors of Production

Production is one of the four basic economic activities.

 

Production can be defined as the conversion of resources or raw materials, with the help of other inputs, into usable goods and services. It turns raw materials into finished goods with other inputs.

It is the process of manufacturing, producing, or developing user-friendly goods and services, employing various means and resources that are available in an economy.

Man can not consume goods in their raw form in most of the cases. Even the food grains and other foods require some form of processing to be edible. 

The raw materials and resources need to be processed, tanned, and tamed to be utilised by markets. 

For example, production of cars, buses, trains, etc. requires the steel to be first mined in its raw form, then melted, and moulded to build their frames and shapes. It requires engineering skills, labour force, and financial capital (for purchasing the raw iron/steel, machines and tools for moulding, and for payments to labour, etc). 

Further, it requires the skills of efficient management for the controlling and overseeing of various processes as well as efficient usage of inputs.

So, production implies utilisation of resources as well as the other input factors of production. 

Here one should notice that only those inputs which become a part of the output, or are consumed and used up during the production process, or help in producing those goods are to be treated as the real factors of production.

Factors of Production

There are four important factors of production without which production may not be possible. They are as follows:

• Land,
• Labour,
• Capital and
• Entrepreneurship. 

Now, let me give a brief account of these factors of production as to their importance in production.

1. Land

Land is one important factor of production. Land is used for building plants and factories, offices, and for the cultivation of food grains, vegetables, and plantations, as well as for trees. So, land provides the foundational base for businesses. 

Furthermore, soil fertility is used for agricultural production. Again, land contains rivers and lakes that provide water for production units, besides serving fisheries and internal transportation. 

Land is the base for all our minerals, oils, and other production activities.

2. Labour

Labour is required to perform all physical tasks as well as other skilled operations in order to produce something.

Purely physical labour includes lifting of heavy materials, ploughing of soil for agriculture, construction work, and other unskilled jobs like helpers and servants.

Skilled labour requires special talents in the field through education and training, like engineers, technicians, and draughtsmen.

All of these professionals aid in the production of goods and services as their time and energy are consumed in the process.

3. Capital
Capital is one more important factor of the four factors of production. 

You can't do any business without capital. 

Production requires the accumulation of resources, which are procured by paying money or equivalent before starting any production. So, you have to invest capital before starting production or establishing any kind of business.

Even after accumulating the required resources, you have to pay for the services utilised for land, labour, and other intermediary activities before you may start earning income or profits from the business. 

So, capital is one important factor of production.

4. Entrepreneurship
Even after all your resources and inputs have been procured to start your production, you still need some managerial skills and talents to run your production process. 

You need to organise everything in a planned and systematic manner to enable production. 

You need to know what to produce, how much to produce, and the inputs required for the planned output. 

You should be able to calculate and predict things prudently and efficiently to produce maximum output with the available limited resources.

So, entrepreneurship plays an important role in production, and you can't ignore it. 

Four Basic Economic Activities: An Introduction

When we talk about an economy (say the US economy or the Indian economy), we are referring to its structure, institutions, activities, and development. We think of its standards and position in the world.

Coming to economic activities, there are four basic activities involved:

• Production,
• Distribution,
• Consumption and
• Capital formation.

These are the backbone of any economy. These economic activities create the wealth and purchasing power for the economy. They lead to capital formation also. 

Production

Production refers to the manufacturing of goods or services. 

Though services are not produced, they are created. They are part of projects devised through plans and creativity. So, they can also be treated as a form of production, producing services.

Coming to the point of the manufacturing of goods, most of them are produced from the processing of Raw Materials. It requires processing, refining, shaping, mixing, tanning, manufacturing, cultivating, and many other procedures to make the resources consumable by human beings. All these are done through production. 

Production uses available resources to produce the required outputs to meet people's needs. We always need the production of finished products for sustenance.

Distribution 

Distribution refers to the passage of goods and services from one point to another, or from the producer to the consumer through exchange or transfer. 

It involves intermediary agents also in the process, like distributing agents and courier services. It can also include the bequeathing of assets, transfer of charity funds, subsidies, and free social welfare services, all of which imply economic values.

Consumption

Consumption refers to the activities of buying goods and services for one's needs.

It is the result of our desires and wants, which can be satiated through possession and use of those produced goods or services. So, consumption implies production in most cases. 

Consumption is an unending activity. We always need something to satisfy most of our recurring wants on a daily basis. So, there will be an everlasting consumption activity in any economy at any given point in time. It is a continuous process requiring continuous production of goods and services.

Capital Formation

Large quantities of goods and services produced result in accumulation of stocks and wealth. Further, production uses the factors of land, labour and capital, resulting in wealth distribution to the providers of these factors in return for their use or services, mostly in the form of rent, wages, interest, etc. 

This income again gets used for consumption of goods and services, and the balance income gets reinvested in assets and stocks to form capital for future usage. 

It becomes a recurring circle of production, distribution, consumption, and capital formation, repeatedly, again and again.

So, we see that there are four basic economic activities in a society that impact the economic position and development of any economy.

Let us have a deeper look into each of these activities in our next chapters.