Input Demand: The Capital Market and the Investment Decision
(Part A)
by
Charles Lamson
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We saw in parts 45 to 50 of this analysis that perfectly competitive firms hire factors of production (inputs) up to the point at which each factor's marginal revenue product is equal to that factor's price. The three main factors of production are land, labor, and capital. We also saw that factor prices are determined by the interaction of supply and demand in the factor markets. The wage rate is determined in the labor market, the price of land is determined in the land market, and the price of capital is determined in the capital market. In parts 45 to 50, we explored the labor and land markets in some detail. In the next several posts we consider the capital market more fully. Transactions between households and firms in the labor and land markets are direct. In the labor market, households offer their labor directly to firms in exchange for wages. In the land market, landowners rent or sell their land directly to firms in exchange for rent or an agreed-to price. In the capital market, though, households often indirectly supply the financial resources necessary for firms to purchase capital. When households save and add funds to their bank accounts, for example, firms can borrow these funds from the bank to finance their capital purchases. Earlier, in parts 39 to 44 of this analysis, we discussed the incentives new firms have to enter industries in which profit opportunities exist and the incentives that existing firms have to leave industries in which they are suffering losses. We also described the conditions under which existing firms have an incentive either to expand or to reduce their scales of operation. Parts 39-44 described, in a preliminary way, the process of capital allocation. When new firms enter an industry or an existing firm expands, someone pays to put capital (plant, equipment, and inventory) in place. Because the future is uncertain, capital investment decisions always involve risk. In market capitalist systems, the decision to put capital to use in a particular enterprise is made by private citizens putting their savings at risk in search of private gain. The next few posts describe the set of institutions through which such transactions take place.  Capital, Investment, and Depreciation Before we proceed with our analysis of the capital market, we need to review some basic economic principles and introduce some related concepts. Capital One of the most important concepts in all of economics is the concept of capital. Capital goods are those goods produced by the economic system that are used as input to produce other goods and services in the future. Capital goods thus yield valuable productive services over time. Tangible Capital When we think of capital, we generally think of the physical, material capital employed by business firms. The major categories of physical, or tangible, capital are (1) nonresidential structures (e.g., office buildings, power plants, factories, shopping centers, warehouses, and docks); (2) durable equipment (machines, trucks, sandwich grills, automobiles, etc.); (3) nonresidential structures; and (4) inventories of inputs and outputs that firms have in stock. Most firms need tangible capital, along with labor and land, to produce their products. A restaurant's capital requirements include kitchen, ovens and grills, tables and chairs, silverware, dishes, and light fixtures. These items must be purchased up front and maintained if the restaurant is to function properly. A manufacturing firm must have plant, specialized machinery, trucks, and inventories of parts. A winery needs casks, vats, piping, temperature control equipment, and cooking and bottling machinery.  The capital stock of a retail drug store is made up mostly of inventories. Drug stores do not produce the aspirin, vitamins, and toothbrushes that they sell. Instead, they buy those things from manufacturers and put them on display. The product actually produced and sold by a drugstore is convenience. Like any other product, convenience is produced with labor and capital in the form of a store with lots of products, or inventory, displayed on the sales floor and kept in storerooms. The inventories of inputs and outputs that manufacturing firms maintain are also capital. To function smoothly and meet the demands of buyers, for example, the Ford Motor Company maintains inventories of both auto parts (tires, windshields, etc.) and completed cars. An apartment building is also capital. Produced by the economic system, it yields valuable services over time, and is used as an input to produce housing services, which are rented. Social Capital: Infrastructure Some physical or tangible capital is owned by the public instead of private firms. Social capital, sometimes called infrastructure, is capital that provides services to the public. Most social capital takes the form of public works like highways, roads, bridges, mass transit systems, and sewer and water systems. Police stations, fire stations, city halls, courthouses, and police cars are all forms of social capital that are used as inputs to produce the services that government provides. All firms use some forms of social capital in producing their outputs. Recent economic research has shown that a country's infrastructure plays a very important role in helping private firms produce their products efficiently. When public capital is not properly cared for---for example, when roads deteriorate or when airports are not modernized to accommodate increasing traffic---private firms that depend on efficient transportation networks suffer. Intangible Capital Not all capital is physical. Some things that are intangible (non-material) satisfy every part of our definition of capital. When a business firm invests in advertising to establish a brand name, it is producing a form of intangible capital called goodwill. This goodwill yields valuable services to the firm over time.  When a firm establishes a training program for employees, it is investing in its workers' skills. One can think of such an investment as the production of an intangible form of capital called human capital. It is produced with labor (instructors) and capital (classrooms, computers, projectors, and books). Human capital in the form of new or augmented skills is an input---it will yield valuable productive services for the firm in the future. When research produces valuable results, such as a new production process that reduces costs or a new formula that creates a new product, the new technology itself can be considered capital. Furthermore, even ideas can be patented and the rights to them can be sold. E-commerce companies generally start with limited capital, and most of that capital is in the skills and knowledge of its employees' human capital.
The Time Dimension The most important dimension of capital is the fact that it exists through time. Labor services are used at the time they are provided. Households consume services and nondurable goods almost immediately after purchase. However, capital exists now and into the future. Therefore, the value of capital is only as great as the value of the services it will render over time. Measuring Capital Labor is measured in hours, and land is measured in square feet or acres. Because capital comes in so many forms, it is virtually impossible to measure it directly in physical terms. The indirect measure generally used is current market value. The measure of a firm's capital stock is the current market value of its plant, equipment, inventories, and intangible assets. By using value as a measuring stick, business managers, accountants, and economists can, in a sense, add buildings, barges, and bulldozers into a measure of total capital.  Although it is measured in terms of money, or value, it is very important to think of the actual capital stock itself. When we speak of capital, we refer not to money or to financial assets such as bonds or stocks, but instead to the firm's physical plant, equipment, inventory, and intangible assets. Investment and Depreciation Recall the difference between stock and flow measures discussed in earlier posts. Stock measures are valued at a particular point in time, while flow measures are valued over a period of time. The easiest way to think of the difference between a stock and a flow is to think about a tub of water. The volume of water in the tub is measured at a point in time and is a stock. The amount of water that flows into the tub per hour and the amount of water that evaporates out of the tub per day are flow measures. Flow measures have meaning only when the time dimension is added. Water flowing into the tub at a rate of 5 gallons per hour is very different from a rate of 5 gallons per year. Capital stocks are affected over time by two flows: investment and depreciation. When a firm produces or puts in place capital---a new piece of equipment, for example---it has invested. Investment is a flow that increases the stock of capital. Because it has a time dimension, we speak of investment per period (by the month, quarter, or year).  As you proceed, be careful to keep in mind that the term investing is not used in economics to describe the act of buying a share of stock or a bond. Although people commonly use the term this way ("I invested in some Union Carbide stock" or "he invested in Treasury bonds"), the term investment when used correctly refers only to an increase in capital. Depreciation is the decline in an asset's (resource's) economic value over time. A capital asset can depreciate because it wears out physically or because it becomes obsolete. Take for example a computer control system in a factory. If a knew, technologically superior system does the same job for half the price, the old system will be replaced even if it still functions well.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 215-218* end |
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