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The market for capital

22 December, 2015 - 11:13

The stock of physical capital includes assembly-line machinery, rail lines, dwellings, consumer durables, school buildings and so forth. It is the stock of produced goods used as inputs to the production of other goods and services.

\mid Physical capital is the stock of produced goods that are inputs to the production of other goods and services.

Physical capital is distinct from land in that the former is produced, whereas land is not. These in turn differ from financial wealth, which is not an input to production. We add to the capital stock by undertaking investment. But, because capital depreciates, investment in new capital goods is required merely to stand still. Depreciation accounts for the difference between gross and net investment.

\mid Gross investment is the production of new capital goods and the improvement of existing capital goods.

\mid Net investment is gross investment minus depreciation of the existing capital stock.

\mid Depreciation is the annual change in the value of a physical asset.

Since capital is a stock of productive assets we must distinguish between the value of services that flow from capital and the value of capital assets themselves.

\mid A stock is the quantity of an asset at a point in time.

\mid A flow is the stream of services an asset provides during a period of time.

When a car is rented it provides the driver with a service; the car is the asset, or stock of capital, and the driving, or ability to move from place to place, is the service that flows from the use of the asset. When a photocopier is leased it provides a stream of services to a printing company. The copier is the asset; it represents a stock of physical capital. The printed products result from the service the copier provides per unit of time.

The price of an asset is what a purchaser pays for the asset. The owner then obtains the future stream of capital services it provides. Buying a car for $30,000 entitles the owner to a stream of future transport services. We use the term rental rate to define the cost of the services from capital, to distinguish this cost from the cost of purchasing the asset – which is its price. The cost of using capital services is the rental rate for capital. The price of an asset is the financial amount for which the asset can be purchased.

\mid Capital services are the production inputs generated by capital assets.

\mid The rental rate is the cost of using capital services.

\mid The price of an asset is the financial sum for which the asset can be purchased.

But what determines the price of a productive asset? The price must reflect the value of future services that the capital provides. But we cannot simply add up these future values, because a dollar today is more valuable than a dollar several years from now. The key to valuing an asset lies in understanding how to compute the present value of a future income stream.