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Physical Capital

Physical Capital

BIBLIOGRAPHY

Capital is a contested concept and thus its components are contested. Physical capital generally refers to plant and equipment, while financial capital refers to money. The first is a matter of physics and biology. The latter is an understanding among people allocating opportunities an institution. Financial capital is part of the social system controlling the physics of production and the distribution of income. Physical capital is a produced good used in further productionnot used up when a consumer good is made. But, the relevant time period needs definition. Stocks of raw materials and inventory of finished goods are usually referred to as circulating capital. Capital has a beneficent connotation in modern societies and thus many adjectives are added to capital, such as social capital, cultural capital, and human capital.

Some aggregative measure of physical capital is necessary if one is to relate its quantity to cross-country or time series differences in physical output (economic growth). But there is no way to measure a collection of physical things that differ in quality. How is one to add up a computer and a blast furnace and the change in their capacity over time? This presents an index number problem. At first glance, it appears that capital might be aggregated in terms of money invested. But a unit of money invested in the past may buy a quite different machine today. There are no convenient or unambiguous units of technology. Counting the number of scientists or patents or putting an increasing weight on investment over time only hints at changing technology. If physical capital is measured by its value today, the aggregate is influenced by the rate of profit and interest, making the measure circular. The quantity of capital would be sensitive to the business cycle and capacity utilization. In short, the money value of plant and equipment cannot be used as a proxy for the amount of physical things used in production. If capital cannot be measured unambiguously, it is impossible to determine its marginal value product and use it to justify factor shares.

Alternative capital theories and definitions are part of the history of legitimating distribution. The payment of interest was justified to motivate waiting by owners of financial assets. If the rate of interest reflected the marginal value product of capital, it could justify the income of capitalists. But the argument becomes circular if the value of capital stock is influenced by income distribution. The value of capital cannot be ascertained independently of the rate of interest.

Harrod-Domar models of growth held the ratio of financial capital to labor constant, in spite of empirical contradiction. It would be useful if investments could be ranked according to the marginal product of capital. The so-called Cambridge capital theory controversy arose over another long-held notion that a falling rate of profit would lead to more capital intensive techniques. However, it was noted that a technique profitable at one rate of interest might not be at another and may then become profitable again at still higher rates. This reswitching phenomena upset the conception of a unique equilibrium. The conceptual problem turns on the fact that capital is not homogeneous. It is questionable to claim that the rate of profit equals the marginal value product of financial capital.

Harrod-Domar models led to policy recommendations emphasizing saving as the means to economic growth. Poor countries were encouraged to save more. When it was clear that it was hard for the poor to save, development aid took the form of loans and capital grants. Growth then depended on exogenous inputs. The results were uneven and many countries had little growth, but huge debts. Modern growth theory has shifted attention to endogenous factors such as research and developmentchanging the quality of physical capital and preventing diminishing returns. New growth theory suggests that less-than-perfect competition and the promise of extraordinary profits may be necessary to entice innovation. The empirical record is mixed. The Asian Tigers had high savings rates, but little research and development of their own. The United States has high growth, but saves little. In rich countries such as the United States, the asserted relationship between the rate of profit and physical capital formation is used to justify tax breaks for the wealthy, even though the higher profit may be used to acquire other financial assets rather than build new plant and equipment.

Increasing the volume of financial capital transferred to poor countries may not increase growth if it is used for consumption (or fraudulently stolen by the elite) rather than investment. And, even if it is invested, it may not be invested in the most advantageous physical projects and sectors, or it may be poorly managed. Modern technology may be in place, but inputs may not be available in a timely fashion. The picture is complicated by the fact that some sources of growth, such as computers, are not capital intensive, while such things as petrochemicals and power-generation plants are. Both physical labor and physical capital have problems of aggregation because of different qualities. An hour of work from illiterate laborers is not the same as an hour from skilled workers. This led to the conceptualization of human capital. But, again, readily available measures of years of education beg many qualitative problems, as was the case for technology over time. Even land (natural resources) is difficult to aggregate because of differences in quality and kind. The ecological system can degrade without a production or financial impact in the short run.

The coordination of physical inputs to production and its distribution is a matter of institutions affecting learning and incentives. In short, the distribution of income is not some natural result of supply and demand, but of the distribution of power. It would be convenient for growth accounting and legitimation of income distribution if it were easy to clearly relate increments of physical and financial capital to increments of growth, but alas this problem has not been solved. Confusion arises when financial and physical capital inputs are mixed together in empirical studies.

SEE ALSO Cambridge Capital Controversy; Capital; Cultural Capital; Human Capital; Natural Resources, Nonrenewable; Social Capital

BIBLIOGRAPHY

Cohen, Avi J., and G. C. Harcourt. 2003. Whatever Happened to the Cambridge Capital Theory Controversies? Journal of Economic Perspectives 17 (1): 199214.

Easterly, William. 2001. The Elusive Quest for Growth: Economists Adventures and Misadventures in the Tropics. Cambridge, MA: MIT Press.

Keen, Steve. 2001. The Holy War over Capital. In Debunking Economics: The Naked Emperor of the Social Sciences, 129147. New York: St. Martins Press.

Romer, Paul. 1994. The Origins of Endogenous Growth. Journal of Economic Perspectives 8 (1): 322.

A. Allan Schmid

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Physical Capital

PHYSICAL CAPITAL


Physical capital consists of man-made tangible assets, such as factories, buildings, machinery and equipment, that are used to actually convert raw materials into usable products for consumer purchase. Physical capital is considered to be secondary to primary resources such as money, raw materials, and land. Since it is used to produce goods or services over time, the wear and tear on physical capital makes it subject to depreciation, or loss of value, and requires replacement periodically. The more physical capital a nation or company possesses, the greater its capacity to produce goods or services. Physical capital may also be referred to as capital goods.

See also: Capital Goods

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