Production, consumption and capital formation are called the basic economic activities of an economy. Scarce resources are used in the production of goods and services with the objective of satisfying needs and wants.

The process of production of goods and services is carried by combining the factors like land, labour, capital and entrepreneurship. Factors are paid rent, wages, interest and profits for their productive services. The consumption activity consists of the use of goods and services for the direct satisfaction of individual or collective human wants. A part of current production is saved for future to add to existing capital stock like, plant, machinery, building, etc. every year in order to expand production potential in future. So whatever is produced is disposed of either for consumption or for capital formation or both.

1. Production

The scarce resources are used in the production of goods and services. The goal of production is to satisfy wants. These goods and services produced can be sold in markets or can be provided by the government to public at nominal charge. Therefore, Production is defined as creation of utility.

Production activities involve making of goods and services. People who make and sell these goods and services are known as producers. The producers combine the factors like land, labour, capital and entrepreneurship along with raw materials in order to transform them into various goods and services. Land, labour, capital and entrepreneurship are called the factors of production. The producers try to produce maximum amount of goods and services by using various combination of factors of production.

1. Land

Land is a gift of nature. It includes plain region, mountains and plateau region. The plain region is useful for agriculture and industrial activities. Mountains ensure flow of rivers into the plain region and provide facilities for tourism. Plateau region possesses reserves of minerals, fossil fuels and forests. Production of food grains, vegetables, fruits, etc require agricultural land in the plain region.

Along with this people also carry out animal husbandry, fisheries and forestry which are called allied activities. In India, rural area is known for carrying out agricultural and allied activities. Some amount of land in the plain region is specially developed to establish industries and urban areas such as towns and cities.

2. Labour

In general, labour implies the human effort through physical and mental exertions in the production of goods and services. A person working on the agricultural field is said to provide his physical labour while a writer of a book is said to provide his mental labour. People who provide labour are known as human resources.

Production activities require both skilled and unskilled labour. Purely physical labour such as loading and unloading, ploughing on the field, etc do not require special skill. But to become an engineer, doctor, teacher, lawyer, mechanic, electrician or tailor, one must acquire skill through education and training.

3. Capital

Capital means all man-made appliances and all types of wealth used in production. Capital consists of machinery, tools, buildings, materials, etc. Whereas land is a natural resource, capital is a man made resource. Capital is used to increase the efficiency of other factors of production like land or labour. The efficiency of land can be increased by use of better irrigation facilities and machines.

However, capital is a passive factor of production and cannot be used without employing labour to work. Capital has a limited span of life, and becomes obsolete after a certain period. Small tools like, screwdrivers, calculators to heavy machines like engines, tractors, ships are all examples of fixed capital, as they can be used in production for many years. Fixed capital also includes the buildings and heavy machines. The working capital includes raw materials like cotton yarn, clay, seeds, fertilizers, which are used up in the process of production.

4. Entrepreneurship

Somebody must take the initiative to start the process of production of goods or services by bringing land, labour and capital together in right proportion. He will be responsible for choosing the right type of land, labour and capital and take important decisions with respect to quantity to be produced, money to be spent to buy the factors and raw materials, marketing the output produced, etc.

Entrepreneurship is the art of organising the production activity. The person who makes the decisions and controls the production process and bears the risks and uncertainties involved in production is called an entrepreneur. He or she should be knowledgeable, courageous and should possess leadership qualities.

The objective of an entrepreneur is to get maximum production by using the given resources and make arrangements for the sale of the finished products. He or she is also responsible to make payments to other factors of production, pays wages to the labourers, rent to the landlords and interest to the owner of capital in return for their productive services. Similarly, they earn profit for their productive activity.

Since these payments, rent, wages, interest and profits are received by the factors for their productive services, they are termed as factor incomes.

Factor Incomes

The factors of production are owned by people. Land is owned by the landlord, labour is owned by labourer, capital is owned by people who acquire capital goods, entrepreneurship is owned by the entrepreneur. The owners of factors of production are paid in return for their productive services.

When you hire a piece of land, you pay rent to the landlord for using the services of land. Thus, the tenant pays rent for the services of land. Labour refers to the services rendered by the workers. It refers to the all types of workers, manual labour, technical workers and so on. When an employer requires the services rendered by a worker, he or she is ready to pay for his services.

By hiring a worker, actually his services are hired. When a loan is taken from a bank to buy a tractor, seeds, machinery, etc. interest is paid to bank. Thus, rent is paid to the landlords, wages to the labourers, interest to the owners of capital resources and profit to the entrepreneurs. Since they are paid in return to their productive services, they are called factor payments and their incomes are called factor incomes. 

2. Consumption

The objective of production is to produce goods and services for consumption. The consumption activity consists of the use of goods and services for the direct satisfaction of individual or collective human wants or needs. To satisfy their wants the households purchase a large variety of goods and services like cycles, furniture, television set, car, refrigerator, food grains, milk, oil, soap, etc. and services like barber, teacher, doctor, bank and insurance companies, etc.

There is no time gap between the production and consumption of services. In case of services production and consumption take place simultaneously. They are consumed as soon as they are produced, such as the services of doctors, lawyers, teachers, etc. As you visit a doctor to take medical advice, you consume his service.

This is not the case with regard to goods. There is a time gap between the production and consumption of goods. Goods are considered to be consumed when they are purchased. However, certain durable goods like furniture, cycles, etc. continue to provide services for many years, still they are considered to be consumed as soon as they are purchased.

3. Capital Formation

The third important activity of an economy is capital formation. Factor owners get factor incomes in return for their productive services. They spend a large part of their incomes on goods and services such as food articles, cloth, furniture, housing, bicycles, education, health care, etc. However, they do not spend their entire income on these goods and services. They also save some income and deposit it in bank for future.

For example, if an individual has an income of Rs. 500 all of which she consumes, there is no saving. Instead if she restricts her consumption to Rs.300, she saves Rs.200 and may use this money to deposit in bank for future use. The bank, in turn, may use this money to lend an industrialist to invest in the expansion of his business.

Capital formation is done by refraining from present consumption. Saving, if kept idle, cannot constitute capital formation. If a person saves money and locks up in the house, no capital formation takes place. If only the saved money is invested in capital goods it leads to capital formation by facilitating production and consumption in future.

Thus, current consumption is forgone and used towards adding to existing capital stock like, plant, machinery, building, etc. every year in order to expand production potential in future. This increase in the stock of capital goods in a year is called capital formation or investment. Similarly, a part of nation’s output is devoted not to immediate satisfaction of consumer wants but to the provision of plants and equipments by which production is maintained and expanded.

To sum up, whatever is produced is disposed of either for consumption or for capital formation or both.

Interrelation of Economic Activities

The three activities, production, consumption and capital formation are interrelated. An increase in the production of goods and services increases the level of consumption and capital formation. Increase in consumption is an indicator of rising standard of living of people and increase in capital formation is very important as the growth of the country depends on it.

More consumption is possible if there is more production and more production is possible if there is more capital formation. Thus, the three economic activities have their impact on one-another to take the economy forward to the path of development.