Economics for Everyone: Capital

Capital is distinct from land (or non-renewable resources) in that capital can be increased by human labor. At any given moment in time, total physical capital may be referred to as the capital stock (which is not to be confused with the capital stock of a business entity).

Jan 07, 2019 04:01 IST Universal Business School Prof. M. Guruprasad |

“The most valuable of all capital is that invested in human beings” ... Alfred Marshall
 
The term capital is used very frequently in economics. Over a period of time, the definition of this term has gained multiple meaning owing to the usage of this term in various contexts.
 
In traditional economic theory, capital consists of anything that can enhance a person's power to perform economically useful work. Capital goods, real capital, or capital assets are already-produced, durable goods or any non-financial asset that is used in production of goods or services. According to Adam Smith defines capital is "That part of a man's stock which he expects to afford him revenue". The term "stock" is derived from the Old English word for stump or tree trunk. It has been used to refer to all the moveable property of a farm since at least. In a fundamental sense, capital consists of anything that can enhance a person's power to perform economically useful work—a stone or an arrow is capital for a caveman who can use it as a hunting instrument, and roads are capital for inhabitants of a city. Capital is an input in the production function.
 
Capital is distinct from land (or non-renewable resources) in that capital can be increased by human labor. At any given moment in time, total physical capital may be referred to as the capital stock (which is not to be confused with the capital stock of a business entity). Classical and neoclassical economics regard capital as one of the factors of production (alongside the other factors: land and labour). All other inputs to production are called intangibles in classical economics. This includes organization, entrepreneurship, knowledge, goodwill, or management (which some characterize as talent, social capital or instructional capital). In Marxian political economy, capital is money used to buy something only in order to sell it again to realize a financial profit. For Marx capital only exists within the process of economic exchange—it is wealth that grows out of the process of circulation itself, and for Marx it formed the basis of the economic system of capitalism. In more contemporary schools of economics, this form of capital is generally referred to as "financial capital" and is distinguished from "capital goods".
 
Thus, it has many meanings, including the financial capital raised to operate and expand a business. In much of economics, however, "capital" (without any qualification) means goods that can help produce other goods in the future, the result of investment. It refers to machines, roads, factories, schools, infrastructure, and office buildings which humans have produced to create goods and services.

Capital asset

From the above discussions, we can infer that a capital asset is defined to include property of any kind held by an assesse, whether connected with their business or profession or not connected with their business or profession. It includes all kinds of property, movable or immovable, tangible or intangible, fixed or circulating. Thus, land and building, plant and machinery, motorcar, furniture, jewellery, route permits, goodwill, tenancy rights, patents, trademarks, shares, debentures, securities, units, mutual funds, zero-coupon bonds etc. are capital assets.
 
In most cases capital is replaced after a depreciation period as newer forms of capital make continued use of current capital non profitable.

Marxian economics distinguishes between different forms of capital:
  • Constant capital, which refers to capital goods
  • Variable capital, which refers to labor-inputs, where the cost is "variable" based on the amount of wages and salaries are paid throughout the duration of an employee's contract/employment,
  • Fictitious capital, which refers to intangible representations or abstractions of physical capital, such as stocks, bonds and securities (or "tradable paper claims to wealth")
Also, from the conventional accounting terms, Fixed capital — this includes machinery, factories, equipment, new technology, factories, buildings, computers, and other goods that are designed to increase the productive potential of the economy for future years. Nowadays, many consider computer software to be a form of fixed capital and it is counted as such in the National Income and Product Accounts of the United States and other countries. This type of capital does not change due to the production of the good.
 
Working capital — this includes the stocks of finished and semi-finished goods that will be economically consumed in the near future or will be made into a finished consumer good in the near future. These are often called inventory. The phrase "working capital" has also been used to refer to liquid assets (money) needed for immediate expenses linked to the production process (to pay salaries, invoices, taxes, interests...) Either way, the amount or nature of this type of capital usually changes during the production process.
 
Financial capital — this is simply the amount of money the initiator of the business has invested in it. "Financial capital" often refers to his or her net worth tied up in the business (assets minus liabilities) but the phrase often includes money borrowed from others.

As observed, initial examples often described capital as physical items, such as tools, buildings, and vehicles that are used in the production process. Later the economists have increasingly focused on broader forms of capital. For example, investment in skills and education can be viewed as building up human capital or knowledge capital, and investments in intellectual property can be viewed as building up intellectual capital.

As discussed above, the types and hence the  definition of capital took various meaning over a period of time from traditional economics theory to the modern times. Some of them are-Natural capital, which is inherent in ecologies and which increases the supply of human wealth

Social capital, which in private enterprise is partly captured as goodwill or brand value, but is a more general concept of inter-relationships between human beings having money-like value that motivates actions in a similar fashion to paid compensation.

Instructional capital, defined originally in academia as that aspect of teaching and knowledge transfer that is not inherent in individuals or social relationships but transferrable. Various theories use names like knowledge or intellectual capital to describe similar concepts but these are not strictly defined as in the academic definition and have no widely agreed accounting treatment.

Human capital, a broad term that generally includes social, instructional and individual human talent in combination. It is used in technical economics to define balanced growth which is the goal of improving human capital as much as economic capital.

Economist Henry George argued that financial instruments like stocks, bonds, mortgages, promissory notes, or other certificates for transferring wealth is not really capital. Because "Their economic value merely represents the power of one class to appropriate the earnings of another." and "their increase or decrease does not affect the sum of wealth in the community”. Some thinkers, such as Werner Sombart and Max Weber, locate the concept of capital as originating in double-entry bookkeeping, which is thus a foundational innovation in capitalism, Sombart writing in "Medieval and Modern Commercial Enterprise" that: The very concept of capital is derived from this way of looking at things; one can say that capital, as a category, did not exist before double-entry bookkeeping. Capital can be defined as that amount of wealth which is used in making profits and which enters into the accounts."

Within classical economics, Adam Smith (Wealth of Nations) distinguished fixed capital from circulating capital. The former designated physical assets not consumed in the production of a product (e.g. machines and storage facilities), while the latter referred to physical assets consumed in the process of production (e.g. raw materials and intermediate products). For an enterprise, both were types of capital.

Human development theory describes human capital as being composed of distinct social, imitative and creative elements:

Social capital is the value of network trusting relationships between individuals in an economy.
 
Individual capital, which is inherent in persons, protected by societies, and trades labour for trust or money. Close parallel concepts are "talent", "ingenuity", "leadership", "trained bodies", or "innate skills" that cannot reliably be reproduced by using any combination of any of the others above. In traditional economic analysis individual capital is more usually called labour.
 
Instructional capital in the academic sense is clearly separate from either individual persons or social bonds between them.
 
This theory is the basis of triple bottom line accounting and is further developed in ecological economics, welfare economics and the various theories of green economics. All of which use a particularly abstract notion of capital in which the requirement of capital being produced like durable goods is effectively removed.
 
The Cambridge capital controversy was a dispute between economists at Cambridge, Massachusetts based MIT and University of Cambridge in the UK about the measurement of capital. The Cambridge, UK economists, including Joan Robinson and Piero Sraffa claimed that there is no basis for aggregating the heterogeneous objects that constitute 'capital goods.'
 
Capital deepening

Capital deepening is a situation where the capital per worker is increasing in the economy. This is also referred to as increase in the capital intensity. Capital deepening is often measured by the rate of change in capital stock per labour hour. Overall, the economy will expand, and productivity per worker will increase. However, according to some economic models, such as the Solow model, economic expansion will not continue indefinitely through capital deepening alone. This is partly due to diminishing returns and wear & tear (depreciation). Investment is also required to increase the amount of capital available to each worker in the system and thus increase the ratio of capital to labour. In some models in endogenous growth theory, capital deepening can lead to sustained economic growth even without technological progress.
 
Capital intensity

Capital intensity is the amount of fixed or real capital present in relation to other factors of production, especially labor. At the level of either a production process or the aggregate economy, it may be estimated by the capital to labor ratio, such as from the points along a capital/labor isoquant. The use of tools and machinery makes labor more effective, so rising capital intensity (or "capital deepening") pushes up the productivity of labor. Capital intensive societies tend to have a higher standard of living over the long run.
 
Capital-intensive industry

Capital-intensive industries use a large portion of capital to buy expensive machines, compared to their labor costs. The term came about in the mid- to late-nineteenth century as factories such as steel or iron sprung up around the newly industrialized world. With the added expense of machinery, there was greater financial risk. This makes new capital-intensive factories with high tech machinery a small share of the marketplace, even though they raise productivity and output.  Some businesses commonly thought to be capital-intensive are railways, airlines, oil production and refining, telecommunications, mining, chemical plants, electric power plants, etc.
 
Capital widening is the situation where the stock of capital is increasing at the same rate as the labour force and the depreciation rate, thus the capital per worker ratio remains constant. The economy will expand in terms of aggregate output, but productivity per worker will remain constant.

Organic composition of capital
The organic composition of capital (OCC) is a concept created by Karl Marx in his critique of political economy and used in Marxian economics as a theoretical alternative to neo-classical concepts of factors of production, production functions, capital productivity and capital-output ratios. It is normally defined as the ratio of constant capital (capital invested in plant, equipment and materials) to variable capital (capital invested in the labour-costs involved in hiring employees). The concept does not apply to all capital assets, only to capital invested in production (i.e. production capital). The neoclassical concept synonymous to increasing organic composition of capital is capital deepening.
 
Marx demonstrates that the organic composition of capital decisively influences industrial profitability. According to Marx, the OCC expresses the specific form which the capitalist mode of production gives to the relationship between means of production and labor power, determining the productivity of labor and the creation of a surplus product. This relationship has both technical and social aspects, reflecting the fact that simultaneously consumable use values and commercial exchange-values are being produced. Marx calls this capital composition "organic", because it refers to the relationship between "living" and "dead" (or inert) elements in a capital investment. The "living element" is employed labour actively at work. The "dead" parts are the tools, materials and equipment worked with, which are the results of past labour.

Marx argues that a rising organic composition of capital is a necessary effect of capital accumulation and competition in the sphere of production, at least in the long term. This means that the share of constant capital in the total capital outlay increases, and that labor input per product unit declines. Thus by the above assumptions, the plant- and machinery-intensive oil industry would have a high organic composition of capital, while labor-intensive businesses such as catering would tend to have a low OCC. The OCC varies according to differences in production technology, between sectors of an economy, or according to changes in production technology over time.
 
Capitalism

Capitalism is an economic system and an ideology based on private ownership of the means of production and their operation for profit. Characteristics central to capitalism include private property, capital accumulation, wage labor, voluntary exchange, a price system, and competitive markets. In a capitalist market economy, decision-making and investment are determined by the owners of the factors of production in financial and capital markets, and prices and the distribution of goods are mainly determined by competition in the market.
 
The term capitalist, meaning an owner of capital, appears earlier than the term capitalism. It dates back to the mid-17th century. Capitalist is derived from capital, which evolved from capitale, a Latin word based on caput, meaning "head" – also the origin of chattel and cattle in the sense of movable property (only much later to refer only to livestock). Capital emerged in the 12th to 13th centuries in the sense of referring to funds, stock of merchandise, sum of money, or money carrying interest. By 1283 it was used in the sense of the capital assets of a trading firm. It was frequently interchanged with a number of other words – wealth, money, funds, goods, assets, property, and so on.

Economists, political economists, and historians have adopted different perspectives in their analyses of capitalism and have recognized various forms of it in practice. These include laissez-faire or free market capitalism, welfare capitalism, and state capitalism. Different forms of capitalism feature varying degrees of free markets, public ownership, obstacles to free competition, and state-sanctioned social policies. The degree of competition in markets, the role of intervention and regulation, and the scope of state ownership vary across different models of capitalism; the extents to which different markets are free, as well as the rules defining private property, are matters of politics and policy. Most existing capitalist economies are mixed economies, which combine elements of free markets with state intervention, and in some cases economic planning.
 
The development of capitalist societies, however, marked by a universalization of money-based social relations, a consistently large and system-wide class of workers who must work for wages, and a capitalist class which dominates control of wealth and political power, developed in Western Europe in a process that led to the Industrial Revolution. Capitalist systems with varying degrees of direct government intervention have since become dominant in the Western world and continue to spread.
 
Capitalism has been criticized for establishing power in the hands of a minority capitalist class that exists through the exploitation of a working class majority; for prioritizing profit over social good, natural resources, and the environment; and for being an engine of inequality and economic instabilities. Supporters believe that it provides better products through competition, creates strong economic growth, yields productivity and prosperity that greatly benefits society, as well as being the most efficient system known for allocation of resources.

Capital accumulation

The accumulation of capital refers to the process of "making money", or growing an initial sum of money through investment in production. Capitalism is based around the accumulation of capital, whereby financial capital is invested in order to make a profit and then reinvested into further production in a continuous process of accumulation. In Marxian economic theory, this dynamic is called the law of value. Capital accumulation forms the basis of capitalism, where economic activity is structured around the accumulation of capital, defined as investment in order to realize a financial profit. In this context, "capital" is defined as money or a financial asset invested for the purpose of making more money (whether in the form of profit, rent, interest, royalties, capital gain or some other kind of return).

In economics, accounting, capital accumulation is often equated with investment of profit income or savings, especially in real capital goods. The concentration and centralisation of capital are two of the results of such accumulation. In modern macroeconomics and econometrics the phrase capital formation is often sometimes used in preference to "accumulation".

Capital formation
Capital formation is a concept used in macroeconomics, national accounts and financial economics. Occasionally it is also used in corporate accounts. It can be defined in three ways:
  • It is a specific statistical concept used in national accounts statistics, econometrics and macroeconomics. In that sense, it refers to a measure of the net additions to the (physical) capital stock of a country (or an economic sector) in an accounting interval, or, a measure of the amount by which the total physical capital stock increased during an accounting period. To arrive at this measure, standard valuation principles are used.
  • It is used also in economic theory, as a modern general term for capital accumulation, referring to the total "stock of capital" that has been formed, or to the growth of this total capital stock.
  • In a much broader or vaguer sense, the term "capital formation" has in more recent times been used in financial economics to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, and development of secondary markets. In this usage, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways. This broadened meaning is originated in credit-based economic growth during the 1990s and 2000s, which was accompanied by the rapid growth of the financial sector, and consequently the increased use of finance terminology in economic discussions.
 
GCF Decadal Averages, % of GDP- India

Different interpretations
  • The use of the term "capital formation" and "investment" can be somewhat confusing, partly because the concept of capital itself can be understood in different ways.
  • Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital actually used for investment purposes and not held as savings or consumed. But in fact, in national accounts, the concept of gross capital formation refers only to the accounting value of the "additions of non-financial produced assets to the capital stock less the disposals of these assets". "Investment" is a broader concept that includes investment in all kinds of capital assets, whether physical property or financial assets. In its statistical meaning, capital formation does not include financial assets such as stocks and securities.
  • Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not normally an accounting concept in modern accounts (although it is sometimes used by the IMF and the United Nations Conference on Trade and Development), and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people become wealthier, although society as a whole becomes poorer, and the net capital formation decreases. In other words, the gain could be a net total gain, or a gain at the expense of loss by others that cancels out (or more than cancels out) the gain in aggregate.
  • Thirdly, gross capital formation is often used synonymously with gross fixed capital formation but strictly speaking this is an error because gross capital formation refers to more net asset gains than just fixed capital (it also includes net gains in inventory stock levels and the balance of funds lent abroad).
Capital formation measures were originally designed to provide a picture of investment and growth of the "real economy" in which goods and services are produced using tangible capital assets. The measures were intended to identify changes in the growth of physical wealth across time. However, the international growth of the financial sector has created many structural changes in the way that business investments occur, and in the way capital finance is really organized. This not only affects the definition of the measures, but also how economists interpret capital formation. The most recent alterations in national accounts standards mean that capital measures and many other measures are no longer fully comparable with the data of the past, except where the old data series have been revised to align them with the new concepts and definitions. The main reason is that national accounts were at first primarily designed to capture changes in tangible physical wealth, not financial wealth (in the form of financial claims).

Capital flight
Capital flight, in economics, occurs when assets or money rapidly flow out of a country, due to an event of economic consequence. Such events could be an increase in taxes on capital or capital holders or the government of the country defaulting on its debt that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength.
 
This leads to a disappearance of wealth, and is usually accompanied by a sharp drop in the exchange rate of the affected country—depreciation in a variable exchange rate regime, or a forced devaluation in a fixed exchange rate regime.
 
This fall is particularly damaging when the capital belongs to the people of the affected country, because not only are the citizens now burdened by the loss in the economy and devaluation of their currency, but probably also, their assets have lost much of their nominal value. This leads to dramatic decreases in the purchasing power of the country's assets and makes it increasingly expensive to import goods and acquire any form of foreign facilities, e.g. medical facilities.
 
Source: IMF
Marginal Efficiency of Capital MEC

The marginal efficiency of capital displays the expected rate of return on investment, at a particular given time. The marginal efficiency of capital is compared to the rate of interest.

Keynes described the marginal efficiency of capital as:
  • “The marginal efficiency of capital is equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price.” – J.M.Keynes, General Theory, Chapter 11.
 
This theory suggests investment will be influenced by:
  • The marginal efficiency of capital
  • The interest rates
  • Generally, a lower interest rate makes investment relatively more attractive.
 
If the marginal efficiency of capital was lower than the interest rate, the firm would be better off not investing, but saving the money. To finance investment, firms will either borrow or reduce savings. If interest rates are lower, it’s cheaper to borrow, or their savings give a lower return making investment relatively more attractive.
 
John Maynard Keynes advocates the rate of return approach to economic calculation. In the rate of return approach investors use the marginal efficiency of capital (MEC) to rank investment projects. Keynes defines the marginal efficiency of capital as the “rate of discount which would make the present value… equal to its supply price”. In the Keynesian rate of return framework investment decisions are made by comparing the marginal efficiency of capital to the interest rate. The MEC rule is to accept an investment project if the marginal efficiency of capital is greater than the interest rate. Put differently, the MEC rule is to accept an investment project if the rate of return is greater than the cost of capital. Expectations play an important role in Keynes’s theory and the marginal efficiency of capital is Keynes’s outlet for expectations. According to Keynes, a collapse of the marginal efficiency of capital is the cause of the economic crisis: “It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle”. The marginal efficiency of capital is completely determined by the investor’s expectations about the size and timing of future cash flows, so the marginal efficiency of capital collapses when there is a collapse in cash flow expectations. 

Capital Output Ratio

The concept of capital output ratio expresses the relationship between the value of capital invested and the value of output. It is a tool that explains the relationship between the level of investment made in the economy and the consequent increase in GDP is capital output ratio. Capital output ratio is the amount of capital needed to produce one unit of output. For example, suppose that investment in an economy, investment is 24% (of GDP), and the economic growth corresponding to this level of investment is 6%. Here, a Rs 24 investment produces an output of Rs 6. Capital output ratio is 24/6 or 4. In other words, to produce one unit of output, 4 unit of capital is needed. Capital output ratio has very good use in economic planning. Suppose the government targets an economic growth of 8% for next year. Planners know that the capital output ratio in India is 4. Here, to realize 8% growth, investment should be increased to 32% (8 x4).
 
Incremental Capital Output Ratio (ICOR)

Another variant of capital output ratio is Incremental Capital Output Ratio (ICOR). The ICOR indicate additional unit of capital or investment needed to produce an additional unit of output. The utility of ICOR is that with more and more investment, the capital output ratio itself may change and hence the usual capital output ratio will not be useful. A lower capital output ratio shows that only low level of investment is needed to produce a given growth rate in the economy. This is considered as a desirable situation. Lower capital output ratio shows that capital is very productive or efficient. It is possible mainly through technological progress. When there is superior technology, capital will be efficient to produce more output and capital output ratio will be lower.
 
Some critics of ICOR have suggested that its uses are restricted as there is a limit to how efficient countries can become as their processes become increasingly advanced. For example, a developing country can theoretically increase its GDP by a greater margin with a set amount of resources than its developed counterpart can. This is because the developed country is already operating with the highest level of technology and infrastructure. Any further improvements would have to come from more costly research and development, whereas the developing country can implement existing technology to improve its situation.
 
 A primary complaint of critics is its (ICOR) inability to adjust to the new economy — an economy increasingly driven more by intangible assets, which are difficult to measure or record. For instance, in the twenty-first century, businesses are impacted ever more by design, branding, R&D and software, all of which are more challenging to factor into investment levels and GDP than their predecessor tangible assets, like machinery, buildings and computers — a hallmark of industrial periods.
 
A recent analysis by CRISIL economists in India indicates the following
 
“After a significant decline between fiscals 2012 and 2014, productivity of investments, as measured by incremental capital output ratio (ICOR), has shown some improvement in the last four years. Between fiscals 2015 and 2018, ICOR averaged 4.3 compared with 5.5 between 2012 and 2014. Lower the ICOR, higher is the productivity of capital because ICOR measures the capital required to produce an additional unit of output. The recent ICOR, however, is still higher than the 3.4 achieved during the high-growth (over 9%) years of fiscals 2005 to 2008.”

The discussions on capital is endless, to quote
 
“To say that "the worker has an interest in the rapid growth of capital", means only this: that the more speedily the worker augments the wealth of the capitalist, the larger will be the crumbs which fall to him, the greater will be the number of workers than can be called into existence, the more can the mass of slaves dependent upon capital be increased.” 
― Karl Marx, Wage-Labour and Capital/Value, Price and Profit.
 
The author, Prof.M.Guruprasad is Director Research, UNIVERSAL BUSINESS SCHOOL

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