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Using Financial Markets to Allocate Capital in Economic Systems

Using Financial Markets to Allocate Capital in Economic Systems
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  • 0:03 What is Capital?
  • 0:43 Uses of Capital
  • 2:40 Vehicles of Capital
  • 4:48 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Every company wants to make money, but sometimes it takes money to make even more money. Just like many students use student loans instead of saving for years to go to college, firms have a number of ways to raise capital.

What is Capital?

As you've probably learned by now, everything produced in the economy requires contributions from a few general classes of resources. One of the most important of these is capital, or the money necessary to start and expand businesses. Frankly, one of the reasons that it is so important is because it is next to impossible to do anything without money in the economy. Think about it - would you work for free? Sure, you might volunteer, but I mean do a job for free. Probably not. Do you think that your bank or landlord would let you live in your house without paying your mortgage or rent? Definitely not. Needless to say, the environment is about the same for business.

Money Makes the World Go Round

Rather than provide a bunch of examples, it's really more convenient in this case to look at one of the most important economic models, the circular flow chart. This model shows how goods and services move through an economy. As you can see in this simplified version that only includes households, firms, and markets, money is vital. (By the way, this chart uses the term 'factor service,' but the word capital works here, too.) However, if you look at what households provide firms, you'll see specifically where capital falls into play. Again, capital is that money that allows businesses to both start and expand businesses.

Circular Flow Chart
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In a healthy business, we hope that basic operating costs are met through sales of a product. However, in many fields, the money to expand a business simply cannot be raised through a company saving part of its income. Instead, firms solicit households for investments to raise capital. In exchange for providing funds to become business capital, the household gets something in return. We'll discuss what form that something is in a few minutes.

First, let's talk about what capital is specifically used for. Capital is generally used to expand a company's operations, whether through technological innovation, new employees, training new employees, or purchasing the ability to do more business through land or manufacturing potential. Again, this is assuming that the company in question is healthy. In fact, a good piece of investment advice is, as a household, don't buy capital in a firm that uses that money to pay operating costs! Also, before we move on, I want to make sure you caught something important. In a resource market, households tend to be the producers, and a capital market is no exception. Households are the producers, while firms consume capital.

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