Saturday, November 20, 2010

The Importance of Capital

Yesterday, I began a series of posts that will briefly explain the economic sources of prosperity. I discussed the nature and beneficial consequences of the market division of labor and how voluntary exchange is necessary for the division of labor to thrive. (By the way, an outstanding article on the topic is Murray Rothbard's masterful, "Freedom, Inequality, Primitivism, and the Division of Labor.")

A highly developed division of labor would be impossible, however, without capital goods. Another engine of economic development, therefore, is capital. Capital goods are produced means of production: tools, machines, buildings, and intermediary goods.Capital is the sum of the monetary value of all a firm’s assets that are dedicated to that firm’s productive operations minus the sum of the monetary value of all of a firm’s liabilities . These assets may consist of land, physical plant, tools, machinery, goods-in-process, receivables, cash, etc.

The use of capital goods increases the productivity of the user, by allowing people to produce a greater quantity of output in the future. They also enable people to produce some goods that could not be had at all without capital goods, such as watches, automobiles, or iPads.

However, capital goods do not spontaneously spring fully developed from nature. Before capital goods can be used, they must be produced. Producing them takes time. In order to obtain capital goods it is necessary to save and invest these saved resources toward the formation of capital.

Additionally, because capital goods are perishable, they must be replaced with further investment. At any moment in time, therefore, each producer has the option of accumulating capital, maintaining capital, or consuming capital. Accumulating and maintaining capital requires a certain amount of saving. Consuming capital requires only that the producer use up his capital stock. As implied above, the choice regarding whether a producer is going to accumulate, maintain, or consume his capital depends upon how much that producer values present goods over future goods. It depends on his time preference.

The higher people’s time preferences are, the more present-oriented they are. They tend to consume more and save and invest less. With high enough time preferences they will consume capital, resulting in less productive labor. Output and real incomes will fall and society endures a lower standard of living.

The lower people’s time preferences are, the more they save and invest. Over time, people will have more capital goods and labor will be more productive. Output will increase and the general standard of living rises. Consequently, a chief determinant of whether an economy expands or contracts is the size of the stock of capital.

If we want a society that enjoys increased prosperity, therefore, we need to foster social institutions that encourage capital accumulation. Such an institution is private property. Unless an investor is secure in his property, he will remain uncertain whether he will be able to keep both his accumulated capital and any positive return on his investment. He will have little incentive to save and invest in further capital maintenance not to mention accumulation. Private property, the institutional setting of capitalism, is therefore a key that opens the door to prosperity. As Mises says in Human Action (p. 562):
The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living.

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