CHAPTER 3
3.2 Production, Income and Spending
The economy is concerned with what to produce, how to produce it and how to distribute
products between the various participants in the economy. Production is important because
goods and services are ultimately produced to satisfy human wants.
Production, income and spending are closely connected. Production creates income because the
factors of production earn income during the production process. This income is then used to
purchase goods and services, which creates spending. Production, income and spending
therefore occur continuously and simultaneously, creating a circular flow in the economy.
Stocks and Flows
Production, income and spending are all flows because they are measured over a period of time.
STOCK
A stock has no time dimension and can only be measured at a particular point in time.
STOCK VARIABLE
Can only be measured at a particular point in time.
FLOW
A flow has a time dimension and can only be measured over a period.
FLOW VARIABLE
Can only be measured over a period
Examples of Stocks (WALCPU)
Wealth.
Assets.
Liabilities.
Capital.
Population.
Unemployment.
Examples of Flows (IPITSD)
Income.
Profit and loss.
Investment.
The number of births and deaths.
Saving.
Demand for labour.
Stocks and flows are related because stocks can only change as a result of flows. For example,
the capital stock can increase through investment, while the population stock can change
through births and deaths.
The Mixed Economy
In a mixed economy, households, firms, government and the foreign sector all participate in the
production process. They contribute towards total production, earn income and spend their
incomes.
Exchange links the different sectors of the economy and usually takes place in markets.
Goods markets are where goods and services are exchanged.
Factor markets are where the factors of production are exchanged.
3.3 Sources of Production: The Factors of Production
There are four main factors of production: natural resources or land, labour, capital and
entrepreneurship.
Natural resources and labour are primary factors of production.
Capital and entrepreneurship are secondary factors of production.
Labour and entrepreneurship are human resources.
Natural resources and capital are non-human resources.
Natural Resources (Land)
DEFINITION
Natural resources, also called land, consist of all the gifts of nature.
Example: new mineral deposits are still being discovered and exploited every day, but once they
have been used, they cannot replace it.
Remuneration: Rent
Natural resources include mineral deposits, water, arable land, vegetation, natural forests.
Natural resources are generally fixed in supply, meaning that their availability cannot simply be
increased when more are required. Some natural resources, particularly minerals, are non-
renewable assets because once they have been used, they cannot be replaced.
Both the quantity and quality of natural resources are important. The rate at which natural
resources are exploited is an important economic concern because excessive exploitation can
lead to their depletion and destruction.
Labour
DEFINITION
Labour can be defined as the exercise of human mental and physical effort in the production of
goods and services. It includes all human effort exerted with a view to obtaining reward in the form
of income.
Example: Employees working in a clothing factory use their physical skills and knowledge to operate
sewing machines, cut fabric and assemble clothing that will be sold to customers.
Remuneration: Wages or salaries
The quantity of labour depends mainly on the size of the population and the proportion of the
population that is able and willing to work. The available quantity of labour is referred to as the
labour force.
Specialisation and the Division of Labour
DEFINITION: DIVISION OF LABOUR
Division of labour occurs when a production process is broken up into different steps or parts, each
of which is performed by an individual worker or group of workers.
Advantages of Division of Labour
It saves time because workers do not have to repeatedly move between different tasks, tools or
work positions.
It enables workers to develop specific skills and makes training easier.
Disadvantages of Division of Labour
Workers may feel less responsible because they cannot appreciate their individual contribution to
the final product. This can result in worker alienation.
It creates greater interdependence because a problem at one stage of production can affect other
workers and stages of production.
Specialisation vs Division of Labour
SPECIALISATION
Specialisation refers to the tendency of people, businesses and countries to concentrate on
different activities to which they are best suited.
DIVISION OF LABOUR
Division of labour refers to the act of assigning individual workers to different tasks which form
part of a production process.
Specialisation can create wealth, but its benefits can only be achieved if there is exchange or
trade. Without exchange, specialised producers cannot obtain all the goods and services they
require from their own production.
Capital
DEFINITION
Capital comprises all manufactured resources, such as machines, tools and buildings, which are
used in the production of other goods and services.
Example: A manufacturing company uses machinery, computers, factory equipment and vehicles
to produce and distribute its products. These resources help the business produce goods more
efficiently.
Remuneration: interest
Capital goods experience wear and tear and may become outdated because of technological
progress. Resources must therefore be provided for their replacement. This is known as
provision for depreciation or a depreciation allowance.
Entrepreneurship
Entrepreneurship refers to the ability to organize and combine the other factors of production,
make business decisions and take risks in order to produce goods and services.
Example: An entrepreneur identifies an opportunity to open a restaurant, invests money into the
business, hires employees, purchases equipment and ingredients, and takes the risk that the
restaurant may succeed or fail.
Remuneration: Profit
Technology
Technology is sometimes regarded as a fifth factor of production. When new knowledge is
discovered and applied to production, more goods and services can be produced.
INVENTION
Invention refers to the discovery of new knowledge.
INNOVATION
Innovation refers to the incorporation of this knowledge into actual production techniques and
products.
The Choice of Technique
CAPITAL-INTENSIVE
Capital-intensive production occurs when production is dominated by machines and uses relatively
little labour.
LABOUR-INTENSIVE
Labour-intensive production occurs when production places greater emphasis on labour.
3.4 Sources of Income: Remuneration of the Factors of
Production
For the economy as a whole, total income can only be increased by increasing production.
TOTAL INCOME = RENT + WAGES AND SALARIES + INTEREST +
PROFIT
3.5 Sources of Spending: The Four Spending Entities
There are four basic sources of spending in the economy: households, firms, government and
the foreign sector.
Role of Households and Firms in the Circular Flow of Production, Income and
Spending
The two main participants in the economy are households and firms. Households are the
smallest decision making units in the economy. They consume goods and services
(consumption) and decide what should be produced. Households also own the factors of
production and sell these factors to the firms.
The firms are the productive units in the economy. They are responsible for investment
spending and capital formation. They use the factors of production to produce goods and
services. Firms pay income to the households for their factors of production. Households use the
income they receive from the firms to purchase the goods and services that are produced by
the firms
Households are responsible for spending on consumer goods (C), while firms are responsible for
spending on capital goods (I).
Government
Government purchases factors of production, mainly labour, from households in the factor
market. It also purchases goods and services from firms in the goods market and provides
households and firms with public goods and services such as law and order, education, health
services.
Government expenditure (G) refers to government spending on goods, services and factor
services.
Taxes (T) are payments levied on and paid by households and firms.
Transfer payments involve the transfer of income from certain individuals or groups to others.
The Goods Market
The goods market refers to the collection of markets in which goods and services are bought
and sold. In macroeconomics, individual markets for different goods and services are
aggregated and treated as one goods market. In microeconomics, individual goods and services
markets are analysed separately.
The Factor Market
Factor markets are markets where the factors of production are bought and sold. They include
the labour market and markets for capital goods. In macroeconomics, individual factor markets
are aggregated and treated as one factor market. In microeconomics, we examine the individual
markets in detail.
The Foreign Sector
EXPORTS (X)
IMPORTS (Z)
TOTAL EXPENDITURE = C + I + G + X − Z
3.7 Circular Flows of Production, Income and Spending
Government in the Circular Flow
The government collects taxes from households and firms, which is a leakage from the circular
flow, and spends money on goods, services and infrastructure, which is an injection.
Government spending provides public services, creates income and employment, and social
grants help households spend more on goods and services.
Foreign Sector in the Circular Flow
The foreign sector consists of all countries and organizations outside the country's borders.
Exports and imports affect the circular flow in opposite ways. Exports are an injection because
spending originates from the rest of the world and enters the domestic economy. Imports are a
leakage because domestic spending is used to purchase goods and services produced outside
the domestic economy.
Financial Institutions in the Circular Flow
Financial institutions include banks, insurance companies, pension funds and the JSE. They act
as a link between participants who have surplus funds and participants who require funds.
Households save money in banks instead of spending all of their income. Financial institutions
collect these savings and make the funds available as loans. Firms borrow money from financial
institutions to invest in things such as machinery, buildings and equipment. This investment
increases production and can create employment and income in the economy. Financial
institutions therefore help move money from savers to borrowers, keeping the circular flow of
income and spending moving.