Precise meaning and implication of capital
An accountant's definition of Capital tends to be abstract. The value assigned to Capital is a derivative of capital goods that the business unit holds. In our earlier post Saving, Production and Economic Calculations in an Economy, we briefly touched upon how money-economy - as against barter economy - allows for the denomination of transactions in monetary terms. This causes heterogeneous capital goods to be expressed in a single measure of value viz., Capital.
Capital is an abstract definition and possibly leads to misconceptions. Capital exists only in the form of distinct capital goods. When consumers exhibit a low time-preference (that is, they are willing to postpone a part of their consumption to the near future), it allows for production activities to simultaneously take place. We also discussed this in the aforementioned post that production length and waiting time of consumers must synchronize. The longer the waiting time (and by corollary, production length), the more complex and technologically advanced the production process becomes. A complex technology-oriented production process results in higher productivity: greater quantity at lower unit costs.
Entrepreneurs plan production activity according to their estimates of future consumer desires. The validity of such plans assumes great importance depending on the size of the outlay. The assessment that consumers are currently postponing consumption in favour of greater consumption tomorrow is an important input for the plan. The nature of consumer goods, taste, technology and other ephemeral consumer desires go in determining the manner of executing those plans. Plans drive the design of the production processes and consequently the different types of capital goods that the entrepreneur must acquire.
In another post The Genesis of Capital Accumulation in Societies, we described capital goods as intermediary goods. That is, capital goods are like intermediary stations towards reaching a definite goal. These goals are significant in the market process. Goals serve as a guide towards causing market action; such as arranging production processes which culminate in consumer want-satisfaction. However, it must be stated that goals are not cast in stone.
When goals change - especially during the production - the future use of those capital goods are at stake. The entrepreneur is faced with the following possibilities;
- abandon the production process altogether
- subject the existing capital goods to some process by which it transforms to usable capital goods
- acquire new capital goods that would meet the new goals as assessed at the time of acquisition
All the above three are difficult choices. By the process of economic calculation (cost accounting), the entrepreneur must examine the merits/demerits of each choice. The change in goals are also called market-data changes While production is underway, the entrepreneur is constantly making judgement about consumer time-preference, goals and market-data. He constantly runs the risk of market-data changes. Even when he is holding cash before investing in specific lines of capital goods he is worried about;
- changes in purchasing power of money: A fall in purchasing power means certain factors of production can't be acquired in sufficient quantity
- after buying capital goods: From the moment he owns the capital goods, he is worried about changes in market-data that would upend plans
The purpose of achieving greater clarity about the meaning of capital goods is also to demystify some accounting terminologies. 'Free capital', 'fixed capital' or 'floating capital' are not distortion-free unless we reference plans, goals and market-data in our discussion. A misleading notion of quick convertibility of capital goods is portrayed when one refers the aforementioned accounting terms. The convertibility argument needs further analysis.
Capital-convertibility and asset write-off
Maximum losses occur as a result of changes in market-data when intermediary goods are closer to the ultimate goal. Because the specificity of capital goods increases as one employs capital goods that are nearer to the end of the long length of the production process. Specificity means those capital goods function to meet only certain specific goals. When those goals change, capital goods likely become redundant. Copper is less specific than copper wires or iron is less specific than gears. The closer the capital good is in its journey to morph into consumer goods the less likely it is to convert it into another type of capital good fit for achieving a new goal.
Easier convertibility of capital goods is a desirable trait. Those capital goods that have a long physical life and an extensive service period are preferably converted so that it can be employed in pursuing new goals. In comparison, it is less painful to abandon perishable capital goods. Or, one that has reached its useful life. It's another matter that consumers too face convertibility issues. After purchase, when desires change, consumers too grapple with alternative uses for the goods purchased. However, the gravity of the issue is much more for capitalists and entrepreneurs than it is for consumers.
Capital accounting, through the valuation of capital goods expressed as 'Capital', provides a convenient aggregate measure of resources that are dedicated to definite goals. The specific descriptors such as fixed, floating or free capital should not detract from the truth that capital refers to definite capital goods. And, those capital goods are intermediary goods which are 'stationed' for meeting ultimate ends. Where necessary appropriate valuation adjustments must be provided considering factors such as market-data change, the proximity of components of production to final consumer good creation, degree of convertibility considering technical factors etc.
The description of Capital and the challenges thrown by market-data provide a glimpse of the risks borne by entrepreneurs. Entrepreneurs are constantly engaged by the following;
- In holding cash, they are worried about the fall in purchasing power of money
- In holding cash, they wait for opportunities to acquire factors of production at cheaper prices to start the production process
- By purchasing capital goods, they run the risk of being too early or too late in executing plans
- Once invested, they worry about changes in market-data
- If market-data doesn't change, they are engaged in the process of production ensuring production length matches consumer waiting time, incomes exceed expenses, capital remains intact or growing
- Once market-data changes, they are worried about convertibility issue, that is, redeploying production lines to meet new consumer goals
The size of entrepreneur’s profits must be commensurate to bear the above-mentioned challenges and risks.
By clarifying the meaning of capital goods, it becomes clear that the whole enterprise of production is fraught with risks. Accounting measures alone may not succeed in conveying clarity without thinking about plans, goals and market-data changes. In our next post, we address one specific variety of market-data, namely technology.