6. Intermediate Microeconomics
During most of our discussion of consumer decisions and the production decisions of firms, we have focused on only labor and the decisions that individuals make about whether or not to work. We know from our study of production functions that firms also use capital to produce output. Where does capital come from? Not surprisingly, it is the result of another consumer decision, the decision of whether or not to save. This lecture analyzes the decisions consumers and firms make in the capital market.
Once we understand what the cost and benefits are of different consumption and investment decisions over time, we can understand how both firms and individual consumers make decisions about how much to invest in different types of opportunities.
In finance and accounting, capital generally refers to financial wealth, especially that used to start or maintain a business. In classical economics, capital is one of three factors of production, the others being land and labor.
Goods with the following features are capital:
It can be used in the production of other goods (this is what makes it a factor of production).
It is made by humans, in contrast to "land," which refers to naturally occurring resources such as geographical locations and minerals.
It is not used up immediately in the process of production, unlike raw materials or intermediate goods.
Capital: Meaning, Characteristics, Function and Importance of Capital:
Meaning of Capital:
Capital has been defined as that part of a person’s wealth, other than land, which yields an income or which aids in the production of further wealth.
Obviously, if wealth is left unused or is hoarded, it cannot be considered capital.
Capital serves as an instrument of production.Anything which is used in production is capital.
Is Money Capital?
In the ordinary language, capital is used in the sense of money. But when we talk of capital as a factor of production, it is quite wrong to confuse capital with money. There is no doubt that money is a form of wealth and it yields income, when it is lent out. But it cannot be called capital. Capital is a factor of production, but money as such does not serve as a factor of production. It is another thing that with money we can buy machinery and raw materials which then serve as factors of production.
Are Securities and Shares Capital?
There is no doubt that securities, bonds, stocks, shares, etc., possessed by a man yield income to him. But they cannot be called capital, because they represent only titles of ownership rather than factors of production. Capital has also been defined as “produced means of production”. This definition distinguishes capital from land and labour, because both land and labour are not produced factors. Land and labour are often considered as primary or original factors of production. But capital is not a primary or original factor it is a ‘produced’ factor of production.
Capital has been produced by man working with nature. Hence, capital may also be defined as man-made instrument of production. Capital, thus, consists of those physical goods which are produced for use in future production. Machines, tools and instruments, factories, canals, dams, transport equipment, stocks of raw materials, etc., are some of the examples of capital. All of them are produced by man to help in the production of further goods.
Characteristics of Capital:
The following are the main characteristics of capital:
(i) Capital is man-made. It is, therefore, possible to increase its supply when the situation requires.
(ii) It involves the element of time, as it renders its service over a period of time. That is why payment for capital is calculated in terms of so much per cent per annum.
(iii) The use of capital makes roundabout methods of production possible. Its application increases efficiency and the productive power of all the factors with which it is combined and used.
Fixed Capital and Working Capital:
Capital may be divided into fixed capital and working capital. Fixed capitals are the durable-use producer goods which are used in production again and again till they wear out. Machinery, tools, railways, tractors, factories, etc., are all fixed capital. Fixed capital does not mean fixed in location.
Capital like plant, tractors and factories are called “fixed” because if money is spent upon these durable-use goods it becomes “fixed” for a long period in contrast with the money spent in purchasing raw materials which is released as soon as the goods made with them are sold out.
Working capital, on the other hand, includes the single-use producer goods like raw materials, goods in process, and fuel. They are used up in a single act of consumption. Moreover, money spent on them is fully recovered when goods made with them are sold in the market.
Wealth and Capital:
From the definition of capital, it is clear that capital consists of valuable economic goods which are scarce. Such goods are called wealth in Economics. All capital, therefore, is wealth. But all wealth is not capital. Only that part of wealth, which is used productively, is called capital. The car which is used for personal enjoyment is wealth but not capital. Wealth and capital are, therefore, not synonymous.
Capital and Income:
Capital and income should be distinguished from each other. The factory that a man owns is his capital, but the profit that he gets out of it every year is his income. Capital is a fund (or stock) and income a flow. Income flows in at regular intervals. It is calculated per week, per month or even per year.
Is land Capital?
Land is nature’s free gift to man; it is limited in area, and is of infinite variety. On the other hand, capital is man-made, and can be increased at will Land lacks mobility, whereas capital is fairly mobile. Land has no supply price, i.e., its supply does not depend on the price for its use (i.e., rent). If, therefore, rent falls, its supply cannot be withdrawn. But the supply of capital varies with its price. For all these reasons, land can be distinguished from capital and is not regarded as capital.
Functions of Capital:
Capital is valued for the very useful functions it performs in the production of wealth. In fact, production would almost come to a stand-still without adequate and suitable supply of capital.
The following are its main functions:
Supply of Raw Materials:
Capital supplies raw materials. Every businessman must have on hand a sufficient supply of raw-materials of a good quality. A cotton mill must have cotton ready in its godown; a paper mill must keep straw or bamboo cuttings; a sugar mill must buy large quantities of sugarcane, and so on. This is undoubtedly very essential, otherwise how is production to go on?
Supply of Appliances and Machinery:
Another equally necessary function that capital performs is the supply of tools, implements and appliances. It is clear that these things are essential for production. Without their aid large-scale production is impossible. Tools are needed even in the most primitive stage of economic development.
But they are all the more necessary today when production has become capitalistic. Modern industry is highly mechanized. Even agriculture employs all sorts of machines like tractors, threshers, harvester-combines, etc., All these are obtained with capital.
Provision of Subsistence:
Capital provides subsistence to the labourers while they are engaged in production. They must have food, clothes and lodging. Production today is a long-drawn-out affair, and has to pass through many stages. It may be after years that the goods reach the market and bring income to the manufacturer. Means must be found in the mean time to bridge this gap, and this is the function which capital performs. It provides means of subsistence for the workers when they are engaged in the work of production.
Provision of Means of Transport:
Goods have not only to be produced, they have also to be transported to the markets and put into customers’ hands. For this purpose, means of transport, like railways and motor-trucks, are essential. A part of the capital must be devoted to the supply of this need.
Provision of Employment:
In modern times, capital is performing another very important function, viz., to provide employment. This function is of special importance to underdeveloped or developing economies. Among the determinants of employment in a country, probably the most important is the saving and its investment in the form of capital.
Application of capital to agriculture, trade, transport and industry creates work on the farms, in the factories, in commercial houses and on roads, railways, ships, etc. It is the lack of capital which is responsible for unemployment, or underemployment in backward countries. A sure way to tackle the problem is to create more and more capital.
Importance of Capital:
Capital plays a vital role in the modern productive system:
(i) Essential for Production:
Production without capital is hard for us even to imagine. Nature cannot furnish goods and materials to man unless he has the tools and machinery for mining, farming, foresting, Ashing, etc. If man had to work with his bare hands on barren soil, productivity would be very low indeed. Even in the primitive stage, man used some tools and implements to assist him in the work of production. Primitive man made use of elementary tools like bow and arrow for hunting and fishing-net for catching fish. But elaborate and sophisticated tools and machines are required for modern production.
(ii) Increases Productivity:
With the growth of technology and specialization, capital has become still more important. More goods can be produced with the aid of capital. In fact, greater productivity of the modern economy likes that of the U.S.A. is mainly due to the extensive use of capital, i.e., machinery, tools or implements in the productive process. Capital adds greatly to the productivity of worker and hence of the economy as a whole.
(iii) Importance in Economic Development:
Because of its strategic role in raising productivity, capital occupies a central position in the process of economic development. In fact, capital accumulation is the very core of economic development. It may be free enterprise economy like the American or a socialist economy like that of Soviet Russia or a planned and mixed economy of India, economic development cannot take place without capital formation.
Much economic development is not possible without the making and using of machinery, construction of irrigation works, the production of agricultural tools and implements, building of dams, bridges and factories, roads, railways, airports, ships and harbors which are all capital. Broadening and deepening of capital are mainly responsible for economic development.
(iv) Creating Employment Opportunities:
Another important economic role of capital is the creation of employment opportunities in the country. Capital creates employment in two stages.
First, when the capital is produced. Some workers have to be employed to make capital goods like machinery, factories, dams and irrigation works.
Secondly, more men have to be employed when capital has to be used for producing further goods. In other words, many workers have to be engaged to produce goods with the help of machines, factories, etc.
Thus, we see that employment will increase as capital formation is stepped up in the economy. Now if the population grows faster than the increase in the stock of capital, the entire addition to the labour force cannot be absorbed in productive employment, because not enough instruments of production are there to employ them. This results in unemployment.
The rate of capital formation must be kept sufficiently high so that employment opportunities are enlarged to absorb the additions to working force of the country as a result of population growth. In India, the stock of capital has not been growing at a fast enough rates so as to keep pace with the growth of population.
That is why there is huge unemployment and underemployment in both urban and rural areas. The fundamental solution to this problem of unemployment and underemployment is to step up the rate of capital formation so as to enlarge employment opportunities.
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