Topic 1: The Nature of Economic Activity

All discussions of basic economic concepts must begin with what we mean by the term "the economy". This term, which is loosely used in popular discussion, needs a proper definition before analysis can proceed. We can visualize the economy as a collection of resources together with the set of institutions that govern their use. The resources include human skills, land, buildings, machinery, houses, and so forth. Added together, they compose the economy's capital stock and, given appropriate institutions, produce the flow of commodities and services that the public enjoys. The institutions within which these resources are organized and managed are the business firms, corporations, government agencies, non-profit organizations, cooperatives, etc. that appear everywhere we look. These organizations function within a legal framework, created and managed by government through the political process, that establishes their rights and obligations along with those of private individuals and provides, when the situation demands, regulation of particular activities. The size of the flow of commodities and services that can be produced with the capital stock will thus depend on the social and political institutions through which the people who live in this economy organize themselves. An important aspect of this institutional framework is the process by which tasks are assigned to government, the extensiveness of the tasks so assigned, and the procedures by which government collects taxes and allocates its expenditures and manipulates the private sector.

Economic activity is the process by which the stock of resources or stock of capital produces a flow of output of goods and services that people utilize in partial satisfaction of their unlimited wants. This process involves not only the production of goods and services but their distribution among the various members of the community. Since output is the flow of goods and services produced by the economy's capital stock, we must be clear about what we mean by the terms stock and flow if we are to understand the nature of capital and its relationship to output and income.

The levels of certain variables at a point in time can be viewed as stocks---for example, the stock of automobiles in Ontario on some particular date was, say, 1.2 million. A process occurring over an interval of time can be viewed as a flow. For example, the flow of liquor drank by the townsfolk per month in the past year was 320 quarts.

One interpretation of a flow is as a change in a stock---the stock of liquor on the shelf was 700 quarts on the first of June and the stock was 380 quarts on the first of July so, since none was added, the flow consumed during the month was therefore 320 quarts. But a flow need not necessarily imply a change in a stock. Suppose, for example, that the distillery produced 640 quarts of liquor during the month of June and the public drank all of them. The stock of liquor on the shelf did not change during the month. Of course, had nothing been consumed, the stock on the shelf would have risen by 640 quarts---had none been produced the stock would have declined by 640 quarts. The important insight here about capital and output is that the distillery (representing a stock of human and physical capital) produced a flow of output at the rate of 640 quarts per month, independently of whether this liquor was consumed or added to inventory. More broadly, the stock of capital provides services to the community taking the form of a flow of consumables.

The stream of output yielded by a stock of capital is often referred to as the services of capital, or the services yielded by capital. For example, the stock of a capital good, say cars, represents the source of a flow of income---car services---which might be thought of as the ability to get quickly and comfortably from point A to point B. If one owns a car, one can indefinitely obtain a steady flow of services from it as long as one feeds it a flow of gasoline and pays the necessary sequence of repair bills. To take another example, consider an electronics technician who has the necessary stock of skills (human capital) to be able to repair radios and TV sets. That technician can produce through time a flow of repair jobs per month (per year), providing a stream of services to others who, in return, will pay him a flow of income per month (per year). Alternatively, of course, like everyone else the technician can utilize his whole range of personal characteristics to produce a flow of leisure for himself. Note that flows are always defined per unit time---they occur at some rate through time.

Every consumable or absorbable good in the economy represents a flow of output from some stock of human and/or physical capital and/or natural resources that produces it. Apples represent the flow of output from a stock of apple trees. Lumber represents the flow of wood obtained by cutting down trees and sawing them into appropriate lengths. This may be associated with either an increase or decline in the stock of standing timber, depending on how fast the trees are growing.

Note also that the flow of lumber obtained from cutting down trees may be used to increase the stock of lumber on hand in the form of inventories. These inventories are capital just like trees are but the flow of services they yield are not tangible like the flow of lumber yielded by the stock of trees. The stock of lumber in inventory yields a flow of intangible services that are very valuable to people in the economy---the services of not running out of stock if there is an unusually large flow of lumber demanded for house construction during a period of time. The lumberyard owner is willing to pay for these services by giving up the interest she could otherwise earn on the funds invested in the inventories because she can pass this cost on to the consumer in the form of a higher markup of selling price over cost. Consumers of lumber are willing to pay this higher price because they find it a costly waste of time to shop at establishments that have lower prices but too frequently run out of stock.

You should now be ready to take a test on your understanding of what an economy is and of the distinctions between income and capital and stocks and flows. Detailed answers are available on-screen for all questions. But you should always think about the question and construct your own answer before going to the one here provided.

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