In economics, capital includes all material objects that improve one’s ability to do productive work efficiently. For instance, an arrowhead is valuable capital to a hunter-gatherer who can use it to kill prey; similarly, streets are always capital for humans living in a complex society because they link to one another easily. Thus, the value of real estate is defined by its potential value as capital. In the realm of finance, capital refers to funds that represent future financial gain.
What is Capital? The definition of capital is crucial for determining the efficiency of an economy. The standard definition is, ‘The value of a definite amount of goods and services produced from the output of labor and capital which has been offered to customers as payment for the total value of the labor and capital.’ Although the standard definition of capital has long since been adopted by most scholars and politicians, there are many varied definitions of capital which depend on different assumptions about how money and credit are created and how these relate to the operation of the economy. This paper will deal only with the assumption that money and credit are created equal.
Money is a medium of exchange which enables individuals and enterprises to purchase goods produced by other producers. Money, in the classical theory of capital, is a product of the operation of the economy through the operation of circulation. Money, therefore, does not appear as a source of capital goods. On the assumption that money is a product of production, money is a medium of exchange in the classical model of the economy.
Credit, unlike money, is a tangible asset. It is a particular amount of money (as opposed to a commodity) that, as an asset, lends itself to capital investment. Thus, it is the ability of an enterprise to make further production which determines its potential worth as capital. This definition of credit differs slightly from that of the definition of capital itself.
The amount of potential capital available to an individual or family depends on how much production that individual or family can make. If more goods can be produced than can be sold, then capital increases as income increases. However, in an economy where the goods produced are a function of what people want rather than their need, then the amount of potential capital available increases because more wants are met than are available. In this definition capital itself is not a commodity, but the means of production of commodities. Thus, in this example, the production of commodities is not the key determination of capital.
On the assumption that production must be continually increased in order to keep pace with desires, the definition of capital itself becomes blurred. What is capital to an accountant may be nothing more than raw material used to make the goods to be sold. To another investor, capital may be money, land, plant, or equipment that has been utilized over a period of time to increase production. Again, in either case, the value of capital is determined by its ability to increase the supply of goods relative to demand.
In order to determine the exact value of capital, several other considerations become necessary. These include the rate at which new goods are produced relative to the rate at which existing goods are produced, whether cash payments are made when production occurs and how long it takes for payments to be delivered, whether profits are realized during production and how they are retained or reinvested, and how market interest rates affect capital investment. All of these considerations become important as the world grows, because technological advances are sometimes not possible quickly enough to offset the costs of production.
Another question often asked is what is the capital good for and what about depreciation? For most businesses, savings, if not capital formation, are the largest part of their income. Saving represents the reduction of income from income produced minus the amount expended on capital goods. Depreciation is a reduction in value with respect to an item that occurs as a result of time. A company can depreciate its property, buildings, and equipment, but it cannot depreciate the value of its savings. It is important, however, to remember that savings represent income and capital formation is the process by which income and savings are created and retained.