A recap of the meaning of capital goods

Land and labour combine to produce capital goods. The latter helps produce consumer goods necessary to satisfy consumer wants. Capital goods are intermediary goods which - through production function - transforms itself into consumer goods. A producer producing using the aid of capital goods will be able to produce consumer goods faster than one who doesn't use capital goods.

Therefore, the essential feature of capital goods is being not just a combination of land and labour, but also a store of time-element. Thus, in acquiring capital goods, the producers buy time which helps him get consumer goods faster to the hands of the consumer. In the absence of such capital goods, a first-time producer will need to first produce the capital goods by bringing land and labour together. Then he must proceed in the course of production to eventually reach the ultimate end

[optional further reading: The Meaning of Capital and its Implications for Entrepreneurial Risks]

The risks to capital goods

All capital goods eventually depreciate over time. A normal form of depreciation is through wear and tear: that is in performing their part in the course of the production. Perishable capital goods have a definite shelf life attached to time. Bigger risk of depreciation arises on account of changes in market data. The latter term refers to the risks facing production facilities due to sudden changes in consumer preference.

While consumers signal a preference for more goods through their act of saving, the exact nature of purchase is subject to change every moment. In our previous article [The Issue of Technology and Adaptability of Production Choices] we described mitigating factors to market data risk. In short, we described that consumers too are locked-in in the current systems of production - that is, existing modes of production influence consumer choices. Despite these mitigating risks, the market data risk still exists as consumers eventually assert its supremacy in the market place.

Capital goods are therefore subject to extinction. Irrespective of the stage of development of an economy, the current stock of capital goods is perpetually at risk of fading out. There is no unceasingly fixed quality about the stock of capital goods in an economy.

The role of accounting

The concept of capital in accounting is an outcome of economic-calculation. In an economy aided by money as a medium of exchange, measurement of prices, expenses, income is possible through the numeraire attribute of money. Capital is necessary to ensure that measured production exceeds consumption or incomes exceed expenses. Only this ensures capital grows without internal consumption. Capital adequacy ensure production plans can be rolled out to match consumer waiting-time. An earlier post [Saving, Production and Economic Calculations in an Economy] delves deeper into this aspect of production-length matching consumer waiting-time. The intellectual framework of accounting only ensures overall triumph of entrepreneurial plans.

A well-executed entrepreneurial plan may give the appearance of a constant level of capital (even after depreciation and profit take-out). But, a constant level of capital doesn't mean constant capital goods. Capital doesn't make a direct correspondence to definite capital goods. Such a physical one-to-one between accounting capital and economic capital goods will not be found.

One of the functions of capital (referring to the accounting concept) is the signalling for providing for sufficient internal funds for the replenishment of capital goods in general with no specificity attached. By an approximation provided by the aid of economic-calculation, a provision is made to account for the finite nature of capital goods. Capital accounting understands that production plans, in order to be sustainable, has to counter depreciation as well as mitigate market data risks. For these reasons, capital accounting is a necessary element in a modern industrial economy.

Such sophistication is superfluous in primitive, simple operations such as small agriculture, hunting where tools can be simply replaced quickly or its deterioration perceived fairly easily.

The usefulness of accounting has been misconceived to mean capital replenishes itself automatically. It gives a mirage that capital is constant and the holders of it enjoy its fruits indefinitely to the disadvantage of others. This is a prime accusation of Marxian who view capital as manna and the controllers of it as in an invincible position in society. The accusers don't realize that capital itself is a fine conception - a concept that has been further used to guide future actions.

The origins of capital accumulation process

The realization that goods could be saved up today and deployed as intermediary goods in a production process so that greater amount of consumer goods can be had, must have been an accidental discovery at first, but the continued persistence in such acts denote his use of reasoning. The earlier post [The Genesis of Capital Accumulation in Societies] addresses this point. In summary, some people engaged in such processes earlier than others - the cumulative effect of it is seen today in the form of vast differences in material prosperity levels.

The formation of capital and its continued accumulation is a deliberate action aided by computation using capital accounting. It doesn't, however, imply that errors and misjudgments don't occur in this process. While the entrepreneur strives to ensure that the products bring in revenue at least equal to the cost of the factors of production, a shortfall in his estimate can happen. A point of departure between accounting mechanics and economic logic is the implications of profits.

Every instance of a churning of profit doesn't imply capital accumulation. Principally, savings drive capital accumulation. While production in excess of consumption, de-facto, implies accumulation, it is not always the case. The additional entrepreneur action of re-investment of profits is required to ensure capital grows. Despite a scenario where product inflows fall short of costs of production, the entrepreneur could desist from consumption and create savings. In the opposite scenario, despite profits, an entrepreneur's consumption behavior could breach capital, meaning, he ends up consuming some amount of capital. Such vitiation in capital occur due to misjudgments and errors.

An entrepreneur who accumulates capital affords lengthy production processes i.e. roundabout processes that Eugen Bohm Bawerk referred to, which means a disproportionate increase in output for a given increase in input. This happens because the additional savings direct more combinations of land and labour and this in turn stores-up time. On the other hand, entrepreneurs who end up consuming capital must now contend with shorter production processes i.e. their output will not be disproportionately higher than the input. Intermediary goods that help bridge the gap between resources and consumption goods is beyond his reach.

At the level of the economy, the net effect of capital accumulation determines its overall productivity. Savings by few could be negated by dis-savings by others rendering overall capital at the same level.  

Transactions in capital

Sale and purchase of capital goods don't amount to capital accumulation. Definite types of capital goods are demanded by entrepreneurs who need them for the execution of their plans. The overall success of his project determines when capital has been added or consumed. There is no departure here between accounting convention and economics since the former recognizes purchases as merely a transformation from one form of asset (cash) to another. But, as we described above merely profiting from transactions is not sufficient, the overall consumption behaviour of the parties is determinant. To drive home this point, it could be possible that the seller of the capital goods could consume the proceeds of the sale leading to dis-saving at a personal level (and at the level of the economy).

It must be reiterated that the concept of capital is an important conception developed through human reasoning. That is, the need to provide for the future. The need to keep sufficient resources for laying out production plans that would meet consumer demands. Entrepreneurial success is said to happen when the product revenues suffice to replace worn-out capital goods. Regular provisioning out of capital for funding future capital goods replacement ensures dis-savings out of errors don't occur. Market data risk (changing preferences) is an idiosyncratic entrepreneurial risk that can seldom be avoided. However, with sufficient capital buffer, he can ensure that such risk is stopped at the level of definite lines of capital goods, rather than breaching capital.

The role of stock exchanges

The limited convertibility feature of capital goods was addressed in an earlier post [Meaning of Capital and its Implications for Entrepreneurial Risks]. With the presence of stock markets, entrepreneurs could take certain actions based on their speculation of project profitability. He is not fully locked-in with the definite capital goods that serve specific consumer wants. If he senses ahead of time that market data changes can occur he can sell his investment to those who think otherwise. In that sense, the stock market creates a class of investors whose fortune ride like entrepreneurs who are directly concerned about the viability of their project.

The investors now share similar concerns about the underlying matching of capital goods with consumer wants as the entrepreneur would do. Both - the investor and the entrepreneur - are engaged in the speculation that market data changes only favourably. The distinction between what constitutes an investment and what constitutes speculation is only in degree. In a moving economy, no one has absolute information about the trend of market data changes. To that extent, an element of speculation is present in both direct entrepreneurial investment and secondary stock market exchange transactions.

When market data changes unfavourably, the future viability of definite capital goods dedicated to that production (the previous goals that have now altered) is called into question. The stock market allows for a quick reflection of this in the prices of capital representing the underlying investment. A red flag is signalled which means more investors would now avoid this activity.

Sometimes anticipated changes in market data may not unfavourable as predicted. In this scenario, a shrewd entrepreneur will make out-sized profits as he is among the few ones standing with definite capital goods satisfying a goal that didn't alter as the majority investors and entrepreneurs had anticipated.

The stock exchanges allow quick expression of view of the future market data trends by allowing investments in new lines of production and/or abandoning ones (at a profit or loss) where he perceives a future loss is likely. This action is at the level of the stock market transaction and has no relevance with regards to the actual convertibility of capital goods. Convertibility, as we have seen in an earlier post, is a crucial element of the structure of capital goods in an economy. Convertibility cannot be easily modelled at a high level; suffice to say  that early-stage production industries have a lesser problem of conversion than late-stage industries wherein the capital goods assume a particular form specific to consumer goals.

Stock markets allow ownership changes, but don't remove the problem of convertibility.

Stock markets are a limited ground where investors exchange ownership in securities representing underlying production facilities. The profits or losses generated by the totality of transactions reflects the productivity of the definite lines of capital goods; an independent stream of profit or loss of the stock exchange (devoid of actual production activity) cannot simply exist.

The proverbial consumer is king...

It is important to reiterate that definite lines of capital goods generate profit only when it meets consumer-wants, and on the other hand, incur losses when it fails to meet those wants. Therefore, it is consumers who ultimately influence investment decision making, decide the fate of specific capital goods, influence the convertibility factor and decide which group of investors and entrepreneurs earn profits.