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So far, in the A-equals-A.com Fundamental Economic Concepts series, we've discussed
1 - Scarcity and Subjective Value
2 - Production, Time Preference, and Opportunity Cost
3- Incentives and Margin

Today's topic concerns production and consumption. We will discuss the importance of capital goods and savings - two concepts that are essential to understanding how an economy works.
 
The goal of all production is to make or obtain goods of value for consumption. Goods produced by an individual directly for consumption are referred to as consumer goods. Goods that are used as part of an individual's plan to produce a consumer good are referred to as capital (or production) goods. Like consumption goods, capital goods do not appear in nature in effortless abundance. They must be produced. Since every action incurs the cost of foregone alternatives, effort spent in producing consumer goods cannot be spent producing capital goods. Effort spent producing capital goods cannot be spent producing consumer goods. Therefore, for an individual to continue to enjoy a desired level of present consumption without disruption, the individual must amass a certain value of real savings in order to invest in the formation of capital goods. Savings is the exchange of present consumption for consumption in the future. Capital investment requires real savings; either a postponement of current consumption or a consumption saved goods.

The classic deserted island scenario depicts a survivor initially surviving on berries (consumer goods). Most all of the survivor's waking time is spent picking and eating berries. Eventually, the survivor decides to increase output or decrease berry consumption in hopes of generating enough real savings to last a few days. Once the savings level is sufficient to satisfy his need for berries, the survivor takes time off of picking berries and uses his mind and his effort to build a harvesting tool (capital good). After the tool is built, the survivor now only needs half a day to satisfy his consumption needs and uses the other half of the day to build hunting tools. The process continues. His standard of living is increased by the creation of capital goods, made possible by real savings.

This example shows that there is a difference between producing for consumption and producing for capital formation. Real savings is a requirement for investment in capital production. All other things equal, it is not possible to increase consumption and increase investment in capital production with a finite pool of resources. The magicians in Washington
disagree.

This article by Bob Murphy gives an excellent explanation of production, consumption, capital goods, and savings. If you haven't read this article about the "Sushi Economy", I strongly suggest checking out this article by Bob Murphy.


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