Tuesday, November 11, 2008

What is Capital?

I have thrown around the word capital quite often recently in my economic analysis. I have struggled to find a concise definition, so here’s my own. Capital is all accumulated resources not intended for consumption now or in the future.

The five bucks in your wallet that you plan to use at Burger King for lunch is not capital, but the five bucks you stuck in a jar last night to save up for that restaurant you want to open is capital. Capital is not necessarily money. Money is only a medium for exchange. Money only represents the goods that you plan to buy. Money for a hamburger is not capital, but money for the hamburger oven is. Any item you plan to use, but not consume is capital.

What is the Role of Capital?

Capital allows individuals to pursue increases in output and material comfort.

Imagine being on a deserted island. In the lagoon are fish and in the trees are coconuts, both you are able to harvest. However, there are also wild chickens on the islands. They are too fast to catch, but occasionally you run across their nests and take their eggs.

You realize one day that if you built a chicken coop. The chickens will stay close by because they would feel safe in the coop, and you can harvest the eggs more frequently. If there exists no spare time away from harvesting coconuts and fish, the coop can not be built. You must save food for the construction period. This savings is capital.

This capital allows you to pursue an increase in material comfort by tiding you over while you pursue this new idea. You can then build the chicken coop and your food intake will grow commensurately. This is how the economy grows. Less capital, less growth. More capital, more growth.

What is the Role of a Capital Market?

Capital markets link those with capital and those with ideas. It allows new ideas for increased production by those without sufficient savings to pursue those ends. It also allows those with capital to increase their wealth by finding a use for their capital.

Assume now, in the story above, that you have no savings and have no ability to save up fish and coconuts without starving. However, Susan is a much better fisherman that you and has some savings of dried fish. Susan is not very handy with building so she cannot build the coop for herself. If you present your plan to Susan and she believes that you can build the coop in the amount of time you estimate the two of you can make a deal. She gives you her capital, the dried fish, and both of you share the output of eggs. You are better off by expanding your diet with an easy bounty of eggs, and she is better off as well.

Why is Redistributing Wealth Bad?

To conceive of new ideas for production requires a focus in the pursuit of these ideas. Those without this focus are unlikely to conceive of new ideas. To develop a valuable skill set that allows for production above sustenance, like Susan, requires a focus on that task as well. The greater the focus, the greater the output, and the greater the accumulation of capital. By taking money away from those focused on increasing new skills and new ideas for production, and giving these resources to those focused on just consumption we reduce the amount of capital in the economy. With less capital, we achieve less growth and less material comfort.

Using our story, imagine a government requiring you and Susan to give the wood for your chicken coop over to John who uses it for firewood. John is able to enjoy a brief increase in material comfort, but all three are worse off in the end because there are now no eggs to eat.

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