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Meaning and Functions of an Economy

Updated on November 11, 2013

Meaning of an Economy

As per Professor A G Brown, "Economy is a system by which people get their living." Just like a machine, made up different parts that perform specific functions, an economy is made up of a system which has different functions. Some people provide labour, some people provide land and others provide capital or entrepreneurship. All these parts which perform different functions work together and form the economy of the country. Remember, production generate income. It doesn't matter whether it is agricultural, manufacturing, mining, fishing or service industry, all these activities produce income for the people involved. For every dollar's worth of service and goods produced, income of a dollar is generated. There are different ways to produce goods and services. Production is taking place at schools, hospitals, factories, mines, shops, banks, cinema houses, ships, railways, roads, workshops, government and private offices, farms, airlines, spas etc.

All the above institutions which produce goods or services provide livelihood to the individuals or organization involved. All the income produced by all these institutions are collectively known as an economy. In other words, an economy is a collection of all the producing units located with in a geographical area of a country. Thus, we have American economy, Chinese Economy, Indian Economy, British Economy, Japanese economy, African economy, Russian economy etc. This means the collection of producing units of goods and services located within the geographical limits of the country concerned is called the economy of that country.

Activities/Functions of an economy.

For the survival and growth of an economy there must be some activities which needs to be repeated or continued for a long time. These activities satisfy the want an individual and provide a living for the people involved. All those activities, which provide a living to the people, for satisfaction of their wants can be grouped into the following three heads:

  1. Production.
  2. Consumption
  3. Capital Formation or investment.

Production: is defined as an activity which produces material goods and services or which increases the value of commodities already produced. A fisherman is extracting fishes from the sea or river can be called a producer. A farmer producing wheat or vegetables are producing goods, just like miners who extract goods from the earth.

There are other vocations which adds value to the existing goods. A shoe maker who buys leather from the market for $ 100 makes shoes and sell it for $ 200 at the market is adding value to leather. Here he added some value to the existing goods i.e. leather. We can say he added value of $100 ($200-$100=$100) to the leather. Thus he has done the production which has a value of $100.

A goldsmith who makes bangles from gold or a carpenter who convert wood in to furniture or a miller who converts wheat in to flour or a weaver who makes cloth from raw cotton are adding value in their respective area of work. Value added to goods are also comes under the head production. Just like physical goods, services can also satisfy human wants. For example, transporters, consultants, doctors, brokers, mechanics, insurance agents, accountants, judges, office clerks, electricians, teachers, guides, caretakers, security offices, policeman, postman etc. who earns an income by providing services can be treated as producers of service.

Consumption: Another activity which helps the economy to survive and grow is consumption. Consumption is the process of using up of goods and services for direct satisfaction of individual or collective human wants". An individual or a household purchase a large number of goods and services such as milk, food grains, oil, cloths, detergents, TV sets, computer, mobile phones, fridges, shoes, cars, cycles etc., and services like transport, doctors, banks, teachers, insurance, courier etc., to satisfy individual wants. All purchases of goods and services, except that of houses, by the household are comes under the household consumption and are called consumer goods.

Please note, houses are treated as capital goods instead of consumer goods because it provides housing service almost throughout the life of an individual.

Another form of consumption is collective consumption. Parks, hospitals, roads, schools, defense, law and order services are some examples of collective consumption. Government provides these services either free of cost or for a nominal price. Such consumptions can be called government consumption or collective consumption.

Gifts received in the form of goods by an household are treated as consumed, the moment they received. All goods, durable or non-durable are treated as consumed the moment they are acquired or purchased.

Capital Formation or Investment: The third and important function of an economy is capital formation. "Capital formation is the net addition to the capital stock of an economy during a given period." Usually all the goods produced by an economy in a year are not consumed in the same year. The excess goods produced are set apart for the consumption of the coming year. The excess of production over consumption is called investment or capital formation. Goods like transport equipment, machines, factories, buildings which can be used for further production for many years are called capital goods. Capital formation involves making capital goods.

As consumption increases, there arise the need of capital goods to increase the production which meet the demand for more goods. So capital formation or investment is the vital function of a growing economy. If there is no capital formation, the production decrease over a long period and the demand increases. To meet the growing demand, it is important for an economy to set aside a portion of its production as capital goods. Excess of production over consumption can be set aside and use for the capital formation.

It is evident from the above discussion that the production, consumption and capital formation or investment are inter related and are important functions of a growing economy.


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    • profile image

      danielabram 5 years ago

      Very informative and thoughtful hub. Glad to read the work of a fellow economist!

    • INDIAN DIAMOND profile image

      INDIAN DIAMOND 5 years ago

      A Simple and well written article. Good Work.

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      Shirin 5 years ago

      Great posts - informative, educational, and very simple. Thanks for sharing.