The Basics of Capital Formation

Capital formation has to be understood in order to be put into the proper place in a new economic theory. Just as with other concepts in economics, such as debt, there are details which obscure the actual nature of capital formation. These details need to be cut through in order to develop a good new economic theory.

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Capital will be defined here as physical capital, including anything needed to increase productivity of labor. It includes a wide range of items, which are not usually lumped into one category. It includes tools for craft work, ranging from a hammer up to a robotic assembly line. It includes transportation items, including vehicles for transporting goods up to cargo aircraft. It includes communication, from post offices to communication satellites.

Many of these items are dual use, meaning they serve consumption uses as well as production uses. This is especially true with transportation and communication. There is not much difference between transporting a 75kg person on vacation and a 75kg person going to work and a 75kg box of commodities. Separating out these uses takes a little diligence, but that is a task for another day.

Besides physical capital, there is knowledge capital, which is the information needed to build the physical capital, to maintain it, and to operate it. It has to be generated and it has to be preserved before being put into use.

Both physical capital and knowledge capital have to be paid for, or “formed”. For a long, long time, the metric used to measure these has been labor. A field plowed in ancient times by humans pulling a plow might look the same as a field plowed by a plow pulled by an ox, but the custom is to say that there was more labor in the first field, and less but more productive labor in the second field. If there was some measure of the value of the plowed field, and the first one took six man-days to do it, old economic theory might say the value of the labor for a day was one-sixth of that of a plowed field, and if the second one took one man-day to do it, that the productivity of that batch of labor was five, induced by the capital of the ox and the associated ox-driven plow, together with the knowledge capital of how to maintain oxed and how to plow fields with them.

The simple example illustrates the ghastly mess that traditional economics finds itself in. There are no good metrics. Because so little can be comparatively measured, the task of measurement becomes a problem for society, and the introduction of money is treated as a solution for this. If there is a large enough community, and plowed fields become a category of exchange, there can be a translation of plowed fields into currency units. Then the value of the plowed field can be defined in economics as whatever someone pays for it. There are multiple obvious flaws with this system of valuation, and they undermine any theory of economics, and any discussion of capital formation. Some sort of market trading everything is a mandatory requirement for setting the value of things, and only certain types of markets will suffice.

The existence of a monopoly or cartel on any type of goods or services destroys the concept of value for necessities, as the holder of the monopoly or the cartel participants can choose a range of prices and have them paid, meaning the value of this good or service is not well defined. For goods and services that are not necessities, there might be said to be a tradeoff between alternate consumption items which fixes the transitional value of an item. If the monopoly controls a whole set of alternate consumption items, such as all foods, we are back to the lack of value situation.

Markets have only existed for certain items in history, typically long-distance trade goods. The distribution of consumption goods was handled in a different way, up to a few hundred years ago in some places, and up to a shorter time in others. Instead, there was a social hierarchy, and the responsibility of the higher levels was to ensure that the lower levels received a share of consumption goods. Let’s call this situation, a pre-market situation.

In a pre-market situation, capital goods had to be provided for out of the share of consumption by those making the divisions. Those making the divisions could simply order the distribution of labor to be such that capital goods were produced by some fraction of the population or by some fraction of the population’s labor time. Alternately, some fraction of produced goods could be saved and given over to a subset of the population for the purpose of supporting their efforts at capital formation.

In the market situation, capital goods were part of a market, and so some consumption goods could be used for the production of more capital goods, by the choice of those who participate in the market. In both the pre-market and market situations, capital formation was subtracted from current consumption. The decision making as to how much of what capital was formed depended on the vision of the decision-makers, who implemented their decisions either through a command hierarchy or through a market choice, or a combination of both. The combination occurs when a leader of a group, call it a company but it could be any group, participates in a market to obtain some precursor materials, brings them into the company, and then commands some of those in the group to produce capital goods out of them instead of producing consumption goods.

Markets are not necessarily better at deciding on value than command decision-makers. Those who participate in markets are limited by the information they possess, by their ability to consider the variability of future events, by their personal preferences, and certainly other factors, just as are command decision-makers. Markets in stable situations might tend to produce some values for items, perhaps optimal in some undefined sense, but in stable situations experienced command decision-makers also do much better. Monopoly effects ruin markets, and a large command hierarchy might avoid this peril, but it has its own perils.

There would seem to be a different source of values, and that would be the preferences of those who make command decisions or who participate in markets. Their vision as to the utility, in the longer-term, of capital formation has an important influence on the growth of capital within some area. A decision-maker who sees some utility in more capital formation can use a market or the command hierarchy to attempt to form this envisaged capital. Having such a vision distorts the market somewhat, and influences the remainder of the command hierarchy.

Thus, capital formation happens, not by some magic in a market, but from a vision of a high-level decision-maker, who does two things mentally. One is to envision the result of diverting current production from current consumption into capital formation and to see that the longer-term result is preferable. The other is to assess alternate uses of diverted current production, for example into inventory to average out production over some future period, and to compare this use with that of capital formation. The decisions are all about long-term benefits versus current consumption. The decision-maker must also assess the needs of the population he takes responsibility for and their desires as well, and make a decision as to how much current consumption can be reduced to pay for either capital formation for enhancing long-term productivity or other expedients for easing potential hardships such as the maintenance of an inventory.

Sometimes the vision of a particular decision-maker might be accurate, sufficiently, to produce some long-term benefit from the diversion of current consumption. Alternately, the result could be desultory and produce little for future consumption. This is often denoted as the risk involved in decision-making.

Decision-makers can make inaccurate decisions, however we might measure inaccuracy. If they have advisors who have more, and more diverse, experience, there could be an improvement in accuracy. One of the advantages of the last century stock market is that investors would seriously investigate a company before buying stock in it, and the stock price then represented information for the decision-makers in the company that they might use. The institution of the board of directions might have been founded for just such a purpose. Of course, stock markets can just become a means of gambling, satisfying whatever emotional needs gamblers have.

For a new economic theory, what has been discussed here is important. It means that the choice of decision-makers and advisors is critical to the success of a society following the new theory. These decision-makers make continual decisions as to the allocation of current production, into a variety of possible capital formation options, as well as many others. How the consumption fraction for this allocation is obtained is less relevant, as it might be from something labelled a tax or a mandatory investment or a mit’a, a mandatory labor allocation used by the Incas, or temporary conscription, or something else. The principal issue is the selection of the decision-maker, their education and experience, and the domain over which they make decisions, and the scope or depth of their decision-making in the hierarchy. Just as debt is only one means of allocating current production, mit’a and other mechanisms are just particular means of forming capital. What matters in an economic theory is not the details of the mechanism, but how the current production is allocated. A good economic theory is one in which the best decision-making for this allocation is ensured.

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