No Such Thing as a Free Lunch: Principles of Economics (Part 52)

"Economics has as its purpose firstly to acquire knowledge for its own sake, and secondly to throw light on practical issues. But though we are bound, before entering on any study, to consider carefully what are its uses, we should not plan out our work with direct reference to them."

Alfred Marshall

Input Demand: The Capital Market and the Investment Decision

(Part B)

by

Charles Lamson

The Capital Market

Where does Capital come from? How and why is it produced? How much and what kinds of capital are produced? Who pays for it? These questions are answered in the complex set of institutions in which households supply their savings to firms that demand funds to buy capital goods. Collectively, these institutions are called the capital market.

Although governments and households make some capital investment decisions, most decisions to produce new capital goods---that is, to invest---are made by firms. However, a firm cannot invest unless it has the funds to do so. Although firms can invest in many ways, it is always the case that the funds that firms use to buy capital goods come, directly or indirectly, from households. When a household decides not to consume a portion of its income, it saves. Investment by firms is the demand for capital. Saving by households is the supply of capital. Various financial institutions facilitate the transfer of households' savings to firms that use them for capital investment.

Let us use a simple example to see how the system works. Suppose that some firm wants to purchase a machine that costs $1,000 and that some household decides at the same time to save $1,000 from its income. Figure 1 shows one way that the household's decision to save might connect with the firm's decision to invest.

Either directly or through a financial intermediary (such as a bank), the household agrees to loan its savings to the firm. In exchange, the firm contracts to pay the household interest at some agreed-to rate each period. If the household lends directly to the firm, the firm gives the household a bond, which is nothing more than a contract promising to repay the loan at some specific time in the future. The bond also specifies the flow of interest to be paid in the meantime.

The new saving adds to the household's stock of wealth. The household's net worth has increased by the $1,000, which it holds in the form of a bond. the bond represents the firm's promise to repay the $1,000 at some future date with interest. The firm uses the $1,000 to buy a new $1,000 machine, which it adds to its capital stock. In essence, the household has supplied the capital demanded by the firm. It is almost as if the household bought the machine and rented it to the firm for an annual fee. Presumably, this investment will generate added revenues that will facilitate the payment of interest to the household.

In general, projects are undertaken as long as the revenues likely to be realized from the investment are sufficient to cover the interest payments to the house.

Sometimes the transfer of household savings through the capital market into investment occurs without a financial intermediary. An entrepreneur is one who organizes, manages, and assumes the risk of a new firm. When entrepreneurs start a new business by buying capital with their own savings, they are both demanding capital and supplying the resources (i.e., their savings) needed to purchase that capital. No third party is involved in the transaction. Most investment, however, is accomplished with the help of financial intermediaries (third parties such as banks, insurance companies, and pension funds) that stand between the supplier (saver) and the demander (investing firm). The part of the capital market in which savers and investors interact through intermediaries is often called the financial capital market.

Capital Income: Interest and Profits

It should now be clear to you how capital markets fit into the circular flow: They facilitate the movement of household savings into the most productive investment projects. When households allow their savings to be used to purchase capital, they receive payments, and these payments (along with wages and salaries) are part of household incomes. Income that is earned on savings that have been put to use through financial capital markets is called capital income. Capital income is received by households in many forms, the two most important of which are interest and profits.

Interest The most common form of capital income received by households is interest. In simplest terms, interest is the payment made for the use of money. Banks pay interest to depositors whose deposits are loaned out to businesses or individuals who want to make investments. Banks also charge interest to those who borrow money. Corporations pay interest to households that buy their bonds. The government borrows money by issuing bonds, and the buyers of those bonds receive interest payments.

The interest rate is almost always expressed as an annual rate. It is the annual interest payment expressed as a percentage of the loan or deposit. For example, a $1,000 bond (representing a $1,000 loan from a household to a firm) that carries a fixed 10 percent interest rate will pay the household $100 per year ($1,000 * .10) in interest. A savings account that carries a 5 percent annual interest rate will pay $50 annually on a balance of $1,000.

The interest rate is usually agreed to at the time a loan or deposit is made. Sometimes borrowers and lenders agree to periodically adjust the level of interest payments depending on market conditions. These types of loans are called adjustable or floating rate loans. (Fixed rate loans are loans in which the interest rate never varies.)

A loan's interest rate depends on a number of factors. A loan that involves more risk will generally pay a higher interest rate than a loan with less risk. Similarly, firms that are considered bad credit risks will pay higher interest rates than firms with good credit ratings. You have probably heard radio or TV advertisements by finance companies offering to loan money to borrowers "regardless of credit history." This means that they will loan to people or businesses that pose a relatively high risk of defaulting, or not paying off the loan. What they do not tell you is that the interest rate will be quite high.

It is generally agreed that the safest borrower is the United States government. With the "full faith and credit" of the U.S. government pledged to buyers of U.S. Treasury bonds and bills, most people believe that there is little risk that the government will not repay its loans. For this reason, the U.S. government can borrow money at a lower interest rate than any other borrower. 

Profits Corporate profits after tax are divided into two categories: dividends (after-tax profits distributed to shareholders) and retained earnings (after-tax profits retained by the corporation). These profits are accounting profits, and this concept of profit is not the same as the one we have been using thus far in this analysis. Recall that our definition of profit is total revenue minus total cost, where total cost includes the normal rate of return on capital. We defined profit in this way because true economic cost includes the opportunity cost of capital.

Suppose, for example, that I decide to open a candy store that requires an initial investment of $100,000. If I borrow the $100,000 from a bank, I am not making a profit until I cover the interest payments on my loan. If I use my own savings or raise the funds I need by selling shares in my business, I am not making a profit until I cover the opportunity cost of using those funds to start my business. Because I always have the option of lending my funds at the current market interest rate, I earn a profit only when my total revenue is large enough to cover my total cost, including the foregone interest revenue I could make from lending my funds at the current market interest rate.

As another example, suppose that the Kauai Lamp Company was started in 2017, and that 100 percent of the $1 million needed to start up the company (to buy the plant and equipment) was raised by selling shares of stock. Now suppose that the company earns $200,000 per year, all of which is paid out to shareholders. Because $200,000 is 20 percent of the company's total capital stock, the shareholders are earning a rate of return of 20 percent, but only part of the $200,000 is profit. If the market interest rate is 11 percent, then 11 percent of $1 million ($110,000) is part of the cost of capital. The shareholders are only earning a profit of $90,000 given our definition of profit.

Functions of Interest and Profit Capital income serves several functions. First, interest may function as an incentive to postpone gratification. When you save, you pass up the chance to buy things that you want right now. One view of interest holds that it is the reward for postponing consumption.

Second, profit serves as a reward for innovation and risk taking. Many argue that rewards for innovation and risk taking are the essence of the U.S. free enterprise system. Innovation is at the core of economic growth and progress. More efficient production techniques mean that the resources saved can be used to produce new things. There is another side to this story, however. Critics of the free enterprise system claim that such large rewards are not justified and that accumulations of great wealth and power are not in society's best interests. 

Financial Markets in Action

When a firm issues a fixed interest rate bond, it borrows funds and pays interest at an agreed-to rate to the person or institution that buys the bond. Many other mechanisms, four of which are illustrated in Figure 2, also channel household savings into investment projects.

Case A: Business Loans As I look around my hometown, I see several ice cream stores doing very well, but I think that I can make better ice cream than they do. To go into the business, I need capital: ice cream-making equipment, tables, chairs, freezers, signs, and store. Because I put up my house as collateral, I am not a big risk, and the bank grants me a loan at a fairly reasonable interest rate. Banks have these funds to lend only because households deposit their savings there.

Case B: Venture Capital A scientist at a leading university develops an inexpensive method of producing a very important family of virus-fighting drugs, using microorganisms created through gene splicing. The business could very well fail within 10 months, but if it succeeds, the potential for profit is huge. 

The result is exactly the same as if the firm had gone to households via some financial intermediary and borrowed the funds. If GM uses its profits to buy new capital, it does so only with the shareholders' implicit consent. When a firm takes its own profit and uses it to buy capital assets instead of paying it out to its shareholders, the total value of the firm goes up, as does the value of the shares held by stockholders. As in our other examples, GM capital stock increases, and so does the net worth of households.

When a household owns a share of stock that appreciates, or increases in value, the appreciation is part of the household income. Unless the household sells the stock and it consumes the gain, that gain is part of saving. In essence, when a firm retains earnings for investment purposes, it is usually saving on behalf of its shareholders.

Case D: The Stock Market A former high-ranking government official decides to start a new peanut processing business in Atlanta, and he also decides to raise the funds needed by issuing shares of stock. Households buy the shares with income that they decide not to spend. In exchange, they are entitled to a share of the peanut firm's profits.

The shares of stock become part of a household's net worth. The proceeds from stock sales are used to buy plant equipment and inventory. Savings flow into investment, and the firm's capital stock goes up by the same amount as household net worth.

Capital Accumulation and Allocation

You can see from the preceding examples that various, and sometimes complex, connections between households and firms facilitate the movement of saving into a productive investment. The methods may differ, but the results are the same.

Think again about Colleen and Bill, whom we discussed in part 5 of this analysis. They found themselves alone on a desert island. They had to make choices about how to allocate available resources, including their time. By spending long hours working on a house or a boat, Colleen and Bill are saving and investing. First, they are using resources that could be used to produce more immediate rewards---they could gather more food or simply lie in the sun and relax. Second, they are applying those resources to the production of capital and capital accumulation.

Industrialized or agrarian, small or large, simple or complex, all societies exist through time and must allocate resources over time. In civil societies, investment and saving decisions are made by the same people. However, in modern industrial societies, investment decisions (capital production decisions) are made primarily by firms. Households decide how much to save, and in the long run saving limits or constrains the amount of investment that firms can undertake. The capital market exists to direct savings into profitable investment projects. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 218-223*

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