Understanding goods and service production
WITHIN ANY economy, there are three main groups of agents - households, firms and the government, operating within three main markets - the market for inputs in the production process including labour and capital, the market goods and services, and the financial market.
What determines the total amount of goods and services produced in Jamaica?
The amount of goods and services produced in Jamaica depends on the quantity of inputs used in the production process. These are referred to as factors of production. The two most familiar factors of production are labour and capital. Labour is the amount of time and effort we put into our work while capital represents the tools we use to apply our labour. For example, the computer that I use to write The Briefing is capital, the calculator that the accountant uses or the motorcycle that the delivery man uses to deliver pizza is capital. The production process also depends on our ability to turn inputs into outputs.
The technology available for production helps to determine the rate at which inputs (labour and capital) turn into output (gross domestic product) this relationship is given by a production function. Additively, the factors of production and the production function determine the quantity of goods produced and supplied in the economy. The aim of the firm is to maximise profits and they will choose the optimal amount of capital and labour in an attempt to do so.
What are the optimal amounts of capital and labour used by the firm?
The amount of labour used depends on the productivity of each additional unit employed, referred to as marginal productivity of labour. This is the extra amount of output the firm produces from using an extra unit of labour. Most production processes encounter diminishing marginal returns after a certain point. For example, a bakery will produce more bread if it employs more bakers, but as the bakery hires new bakers, there becomes a maximum limit on the number of bakers who can fit in the kitchen, and there is also a limit on the amount of bread each oven can bake at a time since the owners of the bakery cannot automatically expand the kitchen to facilitate more bakers.
At what point do owners decide that they have hired enough bakers? They will stop hiring bakers when they have maximised profits when the revenue received from selling the bread produced by the additional baker is less than or equal to the wage they have to pay the extra baker. In other words, the firm will stop hiring additional workers when it becomes unprofitable to do so. The same holds true for the amount of capital employed.
What determines the demand for goods and services?
In the circular flow of income, the household consumes some of the goods and services produced, the household and the firm use some of these goods and services for investment, and the government buys some to use for public consumption, the rest is exported, and what we do not produce is imported. Households receive wages for the labour they sell to firms, from these wages, they pay taxes and the remainder is either consumed or saved. The income remaining after paying all taxes is called disposable income. The proportion of the disposable income that is consumed is called the marginal propensity to consume (MPC). This MPC shows how our consumption changes when disposable income changes.
What about investment?
Firms and households buy investment goods; firms buy these goods to produce other goods, while households buy houses as investment. The quantity of investment goods purchased depends on the cost of these goods given by the interest rate. The higher the interest rate, the higher the cost of these investment goods, which means less investment will take place. Over the last couple of years, under the supervision of the International Monetary Fund, Jamaica has been making some effort to reduce interest rates to boost investment. Economics distinguishes between nominal and real interest rates. Nominal interest rates are given while real interest rates take inflation into consideration.
The government competes with other agents in the economy for capital goods. If the government, for example, wants to increase consumption via borrowing, they will increase the demand for funds which will lead to an increase in interest rates, this increase in interest rates will have a negative effect on firms and the household which borrows. This is the typical crowding out effect where increase in government spending results in a fall in private investment
Dr Andre Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton; or email firstname.lastname@example.org.