Economic Analysis for Business

1. Economic Analysis for Business Chapter 5 Factors of Production, Finance and the Role of the Entrepreneur

2. Factors of production Inputs used in the production process are called the factors of production Traditional list: • Land • Labour • Capital – NOT MONEY, NOT SHARES, NOT BONDS

3. Other factors Other less traditional factors • Entrepreneurial ability • Finance • Skills, knowledge and know-how And some people even include • Time

4. Land A metaphor for all of the natural resources used in the production process: land includes water In essence “land” is made up of various natural resources In their natural state usually very very far from being usable for productive purposes But everything we possess is based on a reshaping of natural resources into a form that suits human purposes

5. Labour Labour represents the human effort in the production process Vast ranges in age, talent, skills, abilities, experience, knowledge and application Located in different places, can be near or far from where work needs doing Different combinations of personal characteristics embodied in every individual Major task of economic system is to bring together different workers who bring different abilities to a productive process

6. Capital Capital made up of inputs into the production process that have themselves been an output from the production process Comprised of that part of value adding activity used to produce other forms of capital Production of capital is a drawing down of the productive capabilities of an economy in the present for the purpose of adding to the economy’s productive capabilities in the future

7. Capital is anything used in production to earn an income Capital is any and every form of previously accumulated wealth used by its owner to earn an income The decision to use an item in some form of commercial activity turns it into an item of capital Example of an automobile • A car can be used to go for personal transport OR can be used as a taxi • Non-profit organisations and governments make use of capital: a car may be used by a charity or by the police

8. What capital is not Capital is not money Capital does not include stocks, shares or bonds Think tools. Think machines. Capital are forms of production used in production – can be either tangible [a computer] – or intangible [ a computer program]

9. John Stuart Mill: Fundamental Propositions Respecting Capital Mill’s four “fundamental propositions respecting capital”: • Industry is Limited by Capital • Capital is the Result of Saving • What is Saved is Spent • The Demand for Commodities is Not Demand for Labour

10. First proposition: Industry is limited by capital Industry is limited by its capital base: an economy cannot produce more output than the amount of capital in existence will allow it to produce Corollary: it is not possible to produce so much capital that production would overwhelm the willingness of the community to buy every last bit of the extra production the additional capital allowed an economy to supply

11. The nonsense role of unproductive spending Mill: “there is not an opinion more general among mankind than this, that the unproductive expenditure of the rich is necessary to the employment of the poor.” Today: there is not an opinion more common than this, that the unproductive expenditure of governments is good for the economy, especially during recessions Mill again: “The limit of wealth is never deficiency of consumers, but of producers and productive power.”

12. Second proposition: Capital is the result of saving Mill’s second proposition: “all capital, and especially all addition to capital, is the result of saving” If capital is to be produced, saving must take place. Without saving the stock of capital cannot grow Only if those who earned incomes do not spend all they receive on current consumption but save at least a portion, that there is something left over to improve the productive capabilities of an economy Investment comes from not consuming everything we produce

13. Third proposition: What is saved is spent Mill’s third proposition states that capital “although saved, and the result of saving, it is nevertheless consumed” To consume meant to put something to use whether it is by consumers or investors Consumption meant to use up, as in a house was “consumed” by a fire The use of our productive resources in production deprives society of all the other ways those resources might have been used

14. Mill on saving Those who save have limited current purchases to less than what they earned – the remainder of those resources is transferred The very fact incomes had been earned means something has been produced and sold to the market Saving allows the resources not employed unproductively to be used in productive activity

15. Saving and economic growth Without saving an economy cannot grow This is the choice every community must face: how much of its resources to use up in day-to-day living and how much to use in adding to its productive capabilities Saving is not an absence of production, a void to be filled RMIT University

16. Saving is investment

17. Fourth proposition: Demand for commodities not demand for labour Mill’s fourth proposition: “the demand for commodities is not demand for labour” When someone buys goods they are not themselves employing the labour or paying the wage By the time the good is bought, the work has already been done and workers have already been paid Employment of labour is an entrepreneurial decision made in advance of production and sale – employment is not the consequence of someone having finally bought the product

18. A community lives off its accumulated capital • When you buy a product in a shop you are not paying the wages of the person who made the product • Those wages were paid by the manufacturer even before the product was sold to the retailer never mind to you, its final buyer • Wages are paid out of savings – they are paid from the accumulated capital of an economy RMIT University

19. The entrepreneur Fourth factor of production the most important The entrepreneur rents, hires and purchases the other three and then directs them towards their productive use Economies cannot work in anything other than the most primitive way without free, private, individual decision makers who makes their living based on the success of the businesses they own and run

20. Movies and the entrepreneur • Movies • Land → the location • Labour → actors • Capital → cameras, lights • Entrepreneur → The Director [?]

21. Role of the entrepreneur Organisational role of the entrepreneur comes with many motivations, the desire for personal gain being only one In the commercial world, however, where production for profit predominates, the role of the entrepreneur is not only guided by personal gain, but the forces of competition Competition will ensure attention paid to ensuring costs are contained, and the products sold are as good as can be found for the price

22. Profit and loss Loss making firms draw on resources of the community but without returning at least as much in value adding production Because they are unable to pay their way, must let those resources go to others who will then to try to make a better use of the capital and labour made available Market system succeeds by putting resources under the direction of those able to cover all costs through sales revenues while taking resources from those who cannot This is the role of the entrepreneur

23. Production and innovation Entrepreneurs decide what, how and where to produce and at what prices to sell Entrepreneurs decide on what inputs to use Every major innovation is the product of an entrepreneurial decision by someone Goods and services do not end up in our possession through magic They are the result of business decisions

24. Finance The fifth factor of production A fifth factor of production different from the others Finance not normally included Without ability to pay for costs incurred before returns are earned, large scale productive activity cannot occur Financial instruments (and money) are not capital but necessary in the overall structure of business activity Entrepreneurs organising a business secure lines of credit so that in conjunction with normal business cash flow, payments can be made as bills come due

25. Financing activity Finance is a specialised area of the economy Finance transfers purchasing power from those who wish to save to those who wish to spend Interest is the payment made for the use of part of one’s property; can be seen as a form of rental One lends out one’s savings in the same way one might rent out one’s house

26. Major skill in lending money is to get it back Easy to find people who wish to borrow money Difficult to find borrowers who will repay the funds received along with their interest payments The skill in lending is to know who will pay the money back with interest

27. Productive lending Two general classes of recipients of transferred savings The first, and economically most important, are businesses which intend to repay debts with receipts out of business returns Institutional structures which direct savings to their potentially most productive are amongst the most crucial determinants of whether an economy will or will not prosper

28. Lendingfor non-income earning reasons A second class of borrowers do not intend to use the funds in a money making operation but intend to finance their loans from other income earning activities Examples are housing and personal loans The role of the financial institution is to ensure the money is likely to be repaid

29. Other forms of finance There are other forms of finance for business besides direct lending All of these are forms of saving which are transferred to a business from those who do not wish to spend at the present time Include shares, corporate bonds and other financial instruments designed to finance the activities of firms

30. Skills, knowledge and know-how RMIT University

31. Innovation RMIT University

32. Time The most abstract of the possible factors of production – the time required to bring products to completion Time must be paid for – time is not a free good and tying up one’s finance in some project must be repaid Many processes – fermenting wine, growing forests – require time as an actual ingredient in the process RMIT University

33. Incomes from factors of production Each factor of production has an associated name for the income generated but not capital or time land → rent labour → wages capital → ? entrepreneur → profit finance → interest, dividends time → ?

34. Stocks and flows Stock represents and amount and a flow is the change in that amount A crucial distinction that needs to be made An economy is prosperous to the extent that it has a stockof already existing capital, skilled labour and natural resources that are directed towards productive value adding activities The flow of new additions of capital, labour market skills, natural resources and entrepreneurial talent is always minuscule in comparison with the existing stock

35. Stocks If in an economy there are a number of buildings – this is the stock of buildings in that economy Maintaining those buildings at some level does nothing more than maintain that stock – it restores what wear and tear has allowed to deteriorate Maintenance only keeps what already exists Not to maintain causes the stock of wealth to deteriorate The stock of capital is the list of what exists

36. Flows In some economy suppose one new building is added each year to all of the other buildings that already exist This new building is thus added to the stock of existing buildings Additions to the stock of assets is called investment Investment is a flow which is defined as the change in a stock

37. Stocks, flows and economic prosperity Economies are prosperous to the extent that there already is in existence a stock of productive capital and skilled labour that are available for use in value adding ways Living standards are dependent on this stock of productive capital and skilled labour Maintaining living standards depends on maintaining this stock of capital and labour Raising living standards depends on increasing this stock of capital and labour

38. The standard of living is different from economic growth Much of the productive effort in an economy is aimed at maintaining the existing stock of capital as well as training and re-training workers New capital investment in an economy adds only a tiny amount to the stock of existing capital just as education adds only a tiny fraction to the existing stock of labour market skills and capabilities

39. Employment and value adding activity Investment both for maintenance and to produce additions to the stock of capital assets may create employment but it is the stock of productive assets and skilled labour that create prosperity All other things being equal, an economy with more capital will be richer than an economy with less capital Only jobs that add more to output than they use up resources are value adding – non-value adding jobs inevitably reduce living standards and lower real incomes