Wealth and Capital
It was pointed out in the earlier discussion that the actual utility of goods at a specific time and place depends on the nature of the wants that can then and there be satisfied, as well as upon the inherent characteristics of the goods themselves. Food, for instance, has a high utility if it is available when and where it is needed. It does not follow, however, that an infinite amount of food at that time and place would have infinite utility. If Crusoe picks and eats a banana, the fruit contributes toward relieving his hunger, a very important want, and it also satisfies his desire for a tasty food, another want distinct from mere nutrition. A second banana is not quite the equal of the first, as the sharp edge has been taken off the hunger sensation, and the taste satisfaction probably lacks something of being the equal of that gained from the original unit. By the time he reaches the fifth or sixth banana, the ability of another one to satisfy either hunger or taste at this time has sunk to a low level, and if he keeps up the process he soon arrives at a point where bananas have no further utility to him at the moment.
This situation, we find, is not a peculiarity of bananas, but is characteristic of utilities in general. After the point of maximum utility (often the first unit) is passed, the utility of each successive additional unit becomes less and less until it finally reaches the vicinity of zero. This is called the principle of diminishing utility, and it is one manifestation of the general principle of diminishing returns, a mathematically based relation of very wide applicability.
For many economic processes the utility of the last unit of a kind, the marginal unit, has a particular significance. Of course, any one of the group could be the marginal unit. In the case of the bananas, no specific one can be singled out, prior to being selected for eating, as having more utility than another, but this is simply because we cannot tell in advance which will be selected first. We can, however, say definitely that the first banana picked will have the maximum utility, and the last one will have the least utility. As soon as the selection is made, the utility is determined. The utility of the last, or marginal, unit is the marginal utility of the total supply of bananas.
Like the supply and demand relations, the concept of diminishing returns and the marginal concept have been quite fully developed by the economists, and for present purposes the results of their work can be accepted substantially as given in the economics textbooks. These concepts will, however, play an important part in the discussion of the nature of interest and other aspects of the cost of the services of capital later in this chapter, and they will therefore be reviewed in somewhat more detail than would ordinarily be necessary for standard textbook material.
Value, like utility, is subject to the principle of diminishing returns. As the utility of successive units decreases, value likewise tends to decrease. However, the two quantities do not move in parallel courses. The actual value is generally well below the potential value because of the modifying effect of the availability of substitutes, etc., and since it is the potential value that is reduced by the diminishing utility, rather than the cost of substitutes and the other determinants of actual value. The value is maintained in the face of diminishing utility until the utility reaches a low enough point to have a direct effect. But when the value starts to drop, it decreases faster than utility because total utility is limited by wants, which are practically infinite, whereas value is limited by productive capacity (ability to buy), which is decidedly finite.
To illustrate how value controls productive activities, let us assume that wild pigs are plentiful on Crusoe’s island, so that an average of only four hours per animal is required for hunting, transportation, and preparation of the meat. Let us further assume that deer are to be found less frequently and farther away, so that it requires 12 hours on the average to obtain an equivalent quantity of venison. Obviously the bulk of the meat requirements will be met by hunting pigs, since the same values can be obtained at less cost. But as the diet of pork continues monotonously week after week, the marginal value of pork drops to some extent, whereas the desire for a change in diet causes an upward revaluation of venison. If Crusoe is living close to the limit of survival he may still be unable to raise the valuation of venison very much, perhaps not above 6 hours, and since it is not obtainable at that cost he will have to forego deer hunting. But if he has enough margin over the bare necessities, he may be able to place a value of 12 hours each on a limited number, say two or three animals per year, and an occasional expedition into the deer country then becomes feasible. Still more frequent hunting would not be possible under these circumstances, as venison would then cease to be a special treat, and its marginal value (now determined primarily by the cost of pork) would drop below the cost of production.
As long as we are dealing with goods such as the bananas and meat of the preceding discussion, rapid deterioration prevents any appreciable amount of storage under the conditions prevailing in the Crusoe economy. There are other goods, however, which can be stored for substantial periods of time, and this feasibility of storage introduces another important factor into the economic picture. We will apply the term “wealth” to any accumulation of goods, and we will define the term accordingly.
Wealth is an accumulation of goods.
A very important point that should be emphasized here is that money is not necessarily wealth. As will be brought out in the chapter on money and credit, money was originally some kind of goods that enjoyed wide acceptance as a trading item. This kind of money is an accumulation of goods and therefore does constitute wealth, although its value as wealth is not necessarily as great as its value as money. But modern money is almost entirely a credit creation, and it has no value in itself. It is only a claim against wealth. It has value to an individual only to the extent that some other individual can be induced to accept it in exchange for goods. The existence of money or other credit instruments thus adds nothing at all to the assets of the community as a whole. This is quite obvious when we consider the question in isolation, but like so many other economic truths, it is often lost to sight in the confusion of detail that surrounds specific economic problems, and we will find in the course of our inquiry that a great deal of unsound economic thinking is founded on the fallacious belief that money and credit instruments, particularly the latter, do constitute wealth.
The advantages of laying up a provision for the future in the form of a store of goods are so obvious that it does not take human intelligence to recognize them. Animals and even some plants make it a regular practice. The familiar example of the squirrel and his store of nuts is only one of many instances of this kind that can be found throughout the world of living things.
Consumption of the class of goods typified by the acorns that the squirrel stores away in some hollow tree is characterized by immediate use of all of the utility of the goods. When anyone eats an apple, all utility of the apple is eliminated. If we store such goods we merely postpone the enjoyment of their utilities to some future time. No utility is derived from the goods in the interim, aside from such satisfaction as may accrue from the feeling of security against future failures of the food supply. In fact, there is usually a certain amount of cost involved in providing storage space, maintaining proper storage conditions, and guarding against loss. In order to make such storage practical, therefore, it is necessary that the present value of the utility to be derived from the use of the stored goods at some future date be sufficiently in excess of the value of the goods for immediate consumption to justify these storage costs.
There is another class of goods that are consumed gradually rather than all at once, and yield utilities to the consumers over a period of time. When a certain amount of labor is expended in building a house, consumption of the product does not take place in one act, in the manner of consumption of food. The utility, which the dwelling is capable of furnishing, is developed over the entire useful life of the structure. For purposes of our analysis it is necessary to distinguish between these two classes of goods, and we will identify them by the terms transient goods and durable goods respectively.
It is convenient for many purposes to restrict the “durable” classification to goods that have a substantial lifetime. Many accounting procedures, for instance, allow tools to be capitalized only if they have an estimated life of more than one year. A similar criterion is applied to consumer goods in general by the economists, and on this basis such products as clothing are excluded from the durable category. From our analytical standpoint, however, the crucial issue is whether the consumption of the goods takes place immediately. If not, the length of the useful period is merely a limitation on total utility and value.
Time enters into the determination of the utility of transient goods only because the life of such goods is limited. The total utility of these goods is the summation of the utilities of the individual units that can be used during the limiting period of time. Values are based on the utilities thus derived, with certain modifications due to other factors, and have no time dimension; that is, the goods have a value at a specific time and place, and the same or some different value at another time and place prior to their consumption, but they do not have a value over a period of time. An orange may be worth ten cents at one time and place, or twenty cents at another time and place, but it has no value per unit of time. We cannot say that it is worth a certain amount per day or month.
The value of durable goods, on the other hand, does have a time dimension. The immediate utility of such goods is negligible. When time approaches zero, utility also approaches zero. The utility of a hat for an infinitesimal period of time is infinitely small. But durable goods have a rate of utility. A hat has a finite utility per week or per month. The total utility of the hat is then the integral of the utility over the useful life, or we may say that it is the product of the average utility per unit of time and the length of time the hat is in service.
Corresponding to the rate of utility, durable goods have a rate of value, a value per unit of time. These goods also have an immediate value, even though they have no immediate utility, as future utility is one of the elements entering into the determination of present value. In the modern economic organization we commonly recognize both immediate value and rate of value in connection with durable goods. We can buy a house for $100,000, or rent it for about $1500 per month. During the month we get essentially the same utility from the house whether we buy or rent. Indeed, we may not even know at the time whether we are buying or renting, as it is a common practice to execute rental contracts with an option to purchase that calls for a portion of the rent to be applied to the purchase price.
Immediate value is the present equivalent of all of the values, which are estimated to be realized over the useful life of durable goods. When the rate of value is the same for two articles, the immediate value of the one having the longer life is the greater. However, if we start with short-lived goods, and examine the immediate value of goods that have the same rate of value but successively longer life periods, we find that beyond the first few increments the immediate value increases more and more slowly, and finally approaches a limit. Thus an item with an extremely long life does not have an extremely high value. There is a limit to what an individual is willing and able to pay for it.
Let us assume, by way of example, that the climate of Crusoe’s island is such that he has a continuing need for a hat, and that the type of hat which he wears has a useful life of one month. Then, for convenience, let us establish our system of units on such a basis that the utility of a hat is one unit of utility per month, and the value realized from one month’s use of the hat is one unit of value, so that utility and value are commensurable. Now if an improved hat, similar in all respects except that it has a useful life of two months, is produced, the rates of utility and value remain the same, but the immediate value of this new hat is two units, since it is the equivalent of two of the less durable hats.
If the improvement process continues, and hats with a still longer life become available, the total utility realized from a hat increases in proportion to the extension of the useful life. The immediate value, however, soon begins to lag behind the utility because of the finite limit to Crusoe’s productive capacity. He is not able to devote more than a certain amount of time to the manufacture of hats, and he is not willing to spend even this much, as other wants take precedence. Hence he might not credit a hat with a useful life of ten months with more than perhaps eight units of value, he might give one with a useful life of a hundred months a value in the neighborhood of 50 units, and ultimately the valuation would reach a limit beyond which he would not increase it further even if the useful life became practically infinite. The magnitude of this limiting value depends on factors such as Crusoe’s productivity, the natural advantages of his environment, etc., but we know that the limit is finite, and we can deduce that it is not very high, since neither Crusoe nor anyone else in his right mind is going to set aside any very substantial portion of his income to provide himself with headgear for the far distant future. For purposes of this present illustration, we will estimate the limiting value at 200 units.
Now let us look at this same situation from a slightly different angle. The immediate value of the second hat is two units, and since the utility and value per month are each one unit, Crusoe is using up half of the total utility and realizing half of the immediate value during each of the two months. The consumption of the utility thus accounts for the entire realization of value, just as it does in the case of transient goods. When we come to the 10-month hat, however, we find that the one unit of utility chargeable to the first month represents 10 percent of the total utility, whereas the one unit of value realized in this first month is 12.5 percent of the total immediate value. In this case, then, the consumption of the utility no longer accounts for all of the values realized from the use of the hat; there is an additional increment of value over and above the value corresponding to the amount of utility consumed.
As the hat life increases, this value increment approaches a fixed limit, since one month’s consumption of utility in the use of a permanent article is zero, and all of the value realized by the use of such an article is due to the excess value factor. In the illustration given, this limiting increment is 0.5 percent of the immediate value. The following tabulation shows the entire situation:
Table 1: Value Realized by Article
|Monthly value realized||1||1||1||1||1|
|Percent of total value||100||50||12.5||2||0|
|Monthly use of utility||1||1||1||1||1|
|Percent of total utility||100||50||10||1||0|
|Monthly excess value||0||0||2.5||1.0||0.5|
We thus find that the rate of value of durable economic goods includes not only the value of the utilities that will be consumed during their useful life, but also an additional amount. This increment is a direct mathematical consequence of the fact that man’s productive capacity is limited, and it represents the value of the use of the unconsumed portion of the goods. In essence, the mathematical relation involved here is another manifestation of the principle of diminishing returns. Since the immediate value is always finite (that is, it is not possible to devote an infinite amount of labor to the production of any item) the extension of useful life results in continually decreasing increments of value until a point is reached at which the value increment due to consumption of the utility is zero. The rate of value under this limiting condition is the value of the services of wealth, a quantity that can most conveniently be expressed as a percentage of the immediate value. In the example cited, it is one half of one percent per month, or six percent per year.
The fact that the services of wealth do have a value is obvious. Anyone who questions this statement needs only to reflect how different life would be if it was not necessary to take into account the first cost of durable goods; if we could enjoy their utilities merely by meeting maintenance and depreciation costs (that is, replacing the utilities as they are consumed). Even the boldest utopia promises nothing like this. But the reason why this value exists is not so obvious, and there has been considerable difference of opinion on this score. The objective of the foregoing discussion has been to answer this question; to show why the value exists and how its magnitude is determined.
The value of the services of wealth is, of course, the basis for the existence of interest, and a consideration of the mathematical derivation of this value in the preceding paragraphs should be sufficient to dispose of most of the misconceptions as to the nature and origin of interest that are now prevalent. It is quite generally believed that interest is something that developed after the economic organization had reached a rather high degree of complexity, and it is true that the practice of charging interest on loans is of fairly recent origin—some of the churches considered this practice immoral up to a few centuries ago. But even Crusoe, who knew nothing of interest, or of borrowing money (or of money itself, for that matter), was faced with exactly the same situation. Because of the finite limits to his productive capacity, the use of existing wealth had a value to him over and above the value attributable to the utilities consumed, and he could not afford to put his available labor into the production of durable goods from which such values are not obtained.
Present-day theories of interest generally attribute it either to time preference, or to the productive capacity of wealth, or to something on the order of Keynes’ concept that it is “the reward for parting with liquidity for a specified period of time, ”45 but it should be evident from the foregoing analysis that none of these factors is basic. Any preference for present consumption over future consumption, or vice versa, or any preference for liquidity, will modify the rate of interest, but as long as human productive capacity is finite the services of wealth have a value, and hence an interest rate exists independently of any time or liquidity preference. Similarly, the productivity of wealth in certain forms may have an effect on determining the current rate of interest, but the services of wealth have a value even if that wealth is in such a form that it can neither be used in production nor converted to a productive form. The existence of interest is a purely mathematical consequence of a finite productive capacity.
Under the limiting condition of extremely long life, the value of the utilities consumed during a relatively short period—a year, for instance—is zero, and the entire value rate is attributable to the services. The limiting condition in the other direction is represented by transient goods which approach zero useful life, and therefore have no service value. Durable goods occupy the entire range between these two limits, varying from items which have a very short life and therefore have a value comparable to that of transient goods, to items which last almost indefinitely, and thus have a value approximating the value of the services alone.
In setting up a definition of the term “goods” in Chapter 5 it was necessary to take into account a class of items which do not have the ability to satisfy human wants directly, but which contribute in an indirect manner to such satisfactions by taking part in the production of goods suitable for direct consumption. Heretofore the discussion has been confined to direct consumption goods, but we have now reached the point where we are ready to begin considering this second major goods classification. To distinguish between the two we will use the terms consumer goods and producer goods.
Consumer goods were further subdivided into transient goods and durable goods. Corresponding to transient consumer goods is a class of transient producer goods consisting of materials and supplies and production services. Some of these transient goods fall into the category of producer goods by virtue of necessity, being inherently incapable of satisfying human wants. Limestone, for instance, ministers to no want directly, but it is an important factor in the production of many goods, which do satisfy wants. Other materials could be used either as producer goods or as consumer goods, and their classification must be based on the purpose for which they are actually used, or for which they presumably will be used.
In the primitive economies where each individual is a combination producer and consumer there is some uncertainty as to the classification until the time of use, but as the evolution of economic organizations has progressed, producers and consumers have been separated in most cases, and this makes the matter of classification much simpler. All goods in the possession or ownership of consumers, other than those to which they have title because of their ownership of the producing enterprises, can be classified as consumer goods. Goods held by producers for sale, directly or indirectly, to consumers are also consumer goods, but all other goods in the possession of producers are presumably intended for use in the production processes and hence are producer goods.
Transient producer goods differ from transient consumer goods in that their utilities are used but not consumed. In the process of consumption the utilities possessed by consumer goods are destroyed, but in the utilization of producer goods the utilities are passed on to other goods. Sugar consumed has lost all utility, but the utility of sugar used in making candy still exists as definitely as ever until the candy itself is consumed. The utility of the lubricating oil that overcomes friction in the bearings of the locomotive is transformed into place utility added to the products transported with the aid of the locomotive.
Producer goods can have no utility, as that term is defined in this work, other than the extent that they can be employed for the purposes of producing or increasing the utility of consumer goods. The measure of their utility is therefore the contribution, which they are able to make toward creating other utilities. This means that the actual utility of producer goods is dependent to a large degree on a factor, which does not enter into the utility of consumer goods: the efficiency of the productive process. The relation between potential and actual utility is therefore much less simple than in the case of consumer goods.
All of the general discussion of utility and value in the preceding pages applies to transient producer goods in the same manner as to transient consumer goods. The only observation that needs to be made in this connection is that the mental calculations leading to appraisal of the value of producer goods are somewhat more roundabout than the corresponding calculations for consumer goods. On the other hand, the subjective element is much less prominent, and the variations between appraisals made by different individuals is correspondingly minimized. In the final analysis, however, value is still a matter of individual judgment.
Corresponding to durable consumer goods are durable producer goods with similar characteristics. The term capital goods will be used to cover both durable producer goods and production materials; that is, all tangible producer goods.
In setting up this, the first of a series of definitions in the field of capital, we are entering another of the major areas of economic controversy. As Fraser expresses it, “Capital… is the most difficult term in the whole range of elementary analysis.”46 But here again, the controversy is wholly unnecessary, at least from the standpoint of a factual economic science. The debate is addressed to the issue as to how capital and associated terms should be defined. Once more, as in the case of value, the economists are putting the cart before the horse. They are first setting up a name, “capital,” and then trying to attach a definition to it. The logical procedure, the standard procedure of science, is to reverse this sequence, first formulating and defining the concepts that will be used in analyzing the phenomena in question, and then attaching appropriate names to them. The definition of capital goods set forth in the preceding paragraph is not being presented as the way in which this term ought to be defined, but as the description of a concept which will be used in the ensuing discussion, and to which the designation “capital goods” can appropriately be applied.
Since capital goods have been defined as tangible producer goods, and producer goods are those items which contribute in an indirect manner to the satisfaction of wants by taking part in the production of other goods, it follows that all of the items that the economist includes under the category of “land” are capital goods on the basis of this definition. At first glance this may seem to be completely heretical, since it is in direct conflict with the time-honored classification of the factors of production as land, labor, and capital. In reality, however, the economists themselves are growing weary of trying to maintain this distinction without a difference, and here and there in the economic literature we are beginning to find admissions of disillusionment such as this from Fraser: “For the moment we are left with the conclusion that it might have saved much time and trouble if the word “land” had never come to be used as the name of a factor of production in economic theory.”47
The trouble here stems from the fact that the original distinction between land and capital was not drawn on the basis of any economic analysis of the relation of these factors to economic processes, but rather on the basis of the particular social and technological situation existing in England and the neighboring European countries at the time when economic theory was in the formative stage. It is a social distinction, not an economic distinction. The British economy at that time was predominantly agricultural, and ownership of the agricultural land was primarily in the hands of a landowning class of society quite distinct from the tenants in one direction, and from the industrialists and factory workers in another. This combination of an economy based principally on a production process in which land plays a very important part, together with the existence of a social class deriving its income almost exclusively from the ownership of land naturally made a very strong impression on the early economists, and recognition of land as a separate factor of production followed somewhat as a matter of course.
As the development and clarification of economic ideas continued, however, it became more and more difficult to justify setting land off by itself as something distinct from any other economic item. To Ricardo and other early economists it seemed clear that land, as a product of nature, was inherently of a different character than goods produced by man, but it soon became evident that whatever could be claimed for land in this respect was equally true of the facilities utilized by the extractive industries—mines, quarries, etc.—and the economists’ definition of “land” was therefore enlarged to include all “free gifts of nature.”
Still further study revealed that this step taken to eliminate one difficulty simply plunged the theory into another. When “land” was redefined as a gift of nature to distinguish it from the products of human effort, the status of land itself as “land” in the economic sense became questionable. Productive land is not ordinarily a gift of nature. The raw material is supplied by nature, to be sure, but in order to fit it for a specific productive use an amount of effort is required which is not at all disproportionate to the amount of effort required to fashion mineral “land” into a productive machine. In the words of Fraser, “field and machine are alike in being the results of applying technical processes to a given material. From which it follows that fields are not “land” in the strict economic sense at all.”48 Now we have traveled the full circle. Land was originally designated as a separate factor of production because its special characteristics seemed to set it apart from ordinary capital goods. But when we analyze these characteristics and attempt to set up a definition that recognizes this presumably unique status, we find ourselves with a definition, which excludes land itself. Actually, land is a form of capital goods, and therefore cannot be distinguished from capital goods on any logical basis.
Inasmuch as we have defined cost and value in commensurable terms, we may simplify our value-cost comparisons by considering the values, which will be lost by diverting effort away from the production of consumer goods as the effective cost of producer goods. This effective cost can then be compared directly with the values produced. Such a procedure is particularly helpful when the time factor enters into the situation and we want to consider the rate of cost rather than the total cost. If we extend the previous consideration of the rate of value of durable consumer goods to capital goods as well, we arrive at a figure which represents both the rate of value of the services of productive wealth and the effective cost of using wealth for productive services, the cost of the services of capital, we may say.
The services of capital are the services of wealth used in production.
The cost of the services of capital to the supplier is the value of the services of the corresponding amount of wealth in the form of consumer goods.
It will be noted that we have defined the services of capital without previously defining capital itself. This may seem odd, but it is entirely logical. Whenever A is a function of B, it follows that B is likewise a function of A. We can therefore define B in terms of A just as logically as we can define A in terms of B. It is true that the simple term is usually defined before the compound term, but this is merely because the simple term is normally applied to the quantity that is most easily defined, regardless of its nature. In hydraulics, the integral quantity, the gallon, is defined before the differential quantity, the gallon per minute, but in electrical technology the opposite course is followed. Here the differential quantity, the watt, is first defined, and the integral quantity is expressed as a compound unit, the watt-hour. In the present instance we have found it simpler to follow the electrical example and define the services of capital first, and then proceed with the definition of capital.
Capital is the present equivalent of the future productive services of wealth.
An analogy with labor may be useful at this point. Labor is analogous to the services of capital, not to capital itself. Capital is analogous to the present equivalent of future labor, a concept to which no name has been attached. Here we note that labor, the continuing item, analogous to the differential quantity in physical relations, is the thing that has been defined, and to which a simple name has been applied. If we wish to speak of the present equivalent, analogous to the integral quantity in physical measurement, we then express this quantity in terms of labor. This is exactly the same thing that we have just done with capital.
The distinction between wealth and capital should be carefully noted. Wealth, as herein defined, yields satisfactions. Capital, as herein defined, yields goods. Capital meets the specifications of wealth indirectly, as goods yield satisfactions, but the converse is not true, as satisfactions do not yield goods. Wealth, which does not already exist in the form of capital goods, is capital only to the extent that it can be converted into capital goods. In the primitive types of economies such conversion is possible only in certain special cases, except to the extent that the consumption of stored goods may release labor for the production of capital goods. Wealth in the form of durable consumer goods must remain in this status until consumed. Later, when we consider more complex economic organizations we will find that means become available whereby the individual (but not the economic unit as a whole) can make the conversion from wealth to capital through transactions with other individuals. But even here we will find that it is not possible to make a complete conversion; that is, the value of goods as capital is normally less than the value of goods as wealth to be consumed.
It may not be immediately apparent why we have adopted a somewhat roundabout way of defining capital rather than merely saying, as the economists do (if they visualize capital in anything other than purely monetary terms), that it denotes goods devoted to production, or words to that effect. One reason is that there is a very important difference between wealth and capital that is ignored by such a definition. Since this difference will play a significant part in the subsequent analysis, it is necessary to take it into account from the start. Any tangible consumer goods that have a degree of permanence constitute wealth. In order to be classified as goods they must have utility, and that utility. However small it may be, has some value, and is preferable to no utility at all. Hence all such goods are assets to their owners and meet the definition of wealth. But not all capital goods constitute capital.
By definition, capital goods are goods used, or intended to be used, in the production of other goods. A tool, which Crusoe has made for use in his productive activities, meets this definition. But let us assume that after some experience with the use of the tool, Crusoe finds that the labor required to keep the tool sharp enough to serve its purpose exceeds the labor saved by the use of the tool. Immediately it ceases to be capital. The tool can still be used in production, and when it is so used it is the equivalent of a certain amount of labor, but it is not the equivalent of enough labor. We cannot say of capital goods, as we did of consumer goods, that a little utility is preferable to none at all. The zero point for the utility of capital is not at absolute zero, as in the case of consumer wealth, but a higher figure representing the cost of maintaining the capital. Any satisfactions that are derived from consumer wealth constitute a net gain, but unless the goods produced by the use of capital exceed a certain minimum, the net result is a loss.
The foregoing is not intended to imply that there is anything inherently incorrect in using the term “capital” synonymously with “capital goods”, or applying it to an accumulation of money, but such definitions preclude the use of this term in any accurate sense. Money, as such, serves no purpose in production, and consequently it is not capital, so far as the economy as whole is concerned. It is the equivalent of capital to the individual only because it enables him to secure capital from some other individual. Capital does exist in the form of capital goods, but the common usage of the term “capital” even in the textbooks that define it in another way, is clearly inconsistent with any other definition than that given herein. When we say that a person has lost his capital through unwise investments, we are not implying that the capital goods to which he acquired title have disappeared or changed in any way. We simply mean that these goods do not have the earning power that the owner anticipated. When we speak of capital gains and losses in our tax jargon, we are not talking about any change in physical goods. We are talking about revaluation of those assets based mainly on present views of their future earning power.
All capital, as herein defined, is subject to the cost of subsistence, regardless of the form in which it exists. This is easy to see in the case of tools, buildings, and other items, which visibly wear out or depreciate. It is no less true of capital in a presumably “indestructible” form. Even diamonds and bars of gold require protection and care, and the cost of that attention is a charge against capital. Land is often cited as an example of an indestructible form of capital, but to the rather limited extent to which land can legitimately be described as indestructible, it is as a capital good that the term is applicable, not as capital. Land is by no means free from maintenance costs. Furthermore, in order to constitute capital, land must be restricted as to ownership (nationally, if not individually), and ownership cannot be restricted without cost. Where the ownership is individual, the owner must either stand the cost of defending his title personally, as was the rule under primitive or feudal conditions, or he must rely upon organized society to defend it for him, in which case that society will tax him to defray the cost. Unless the land produces enough to support this cost, capital will erode away, even though the land itself remains intact.
Regardless of the stage of economic development or the nature of the existing economic institutions, a continuous replacement of capital is required in order to maintain the existing capital supply. Once the replacement ceases, or is diminished, the capital in service begins to decrease, for the process of capital deterioration never stops. Many a business fails because the owners are unable to appreciate the necessity of diverting part of the current income into a depreciation fund, which will enable replacing capital goods that wear out or become obsolete.
Much of the effort that is devoted to attempts to improve the economic status of workers at the expense of their employers likewise ends in futility because it conflicts with this same necessity of replacing capital. Because of factors which will be discussed in detail in the subsequent pages, the impact of most of these actions ultimately falls on the general public rather than on the employers at whom the actions are aimed, but if circumstances are such that an action of this kind does have the intended effect, this merely kills off the enterprise, as the owners of an unprofitable business are not inclined to increase their losses by making financial provision for depreciation, and without such provision the enterprise cannot long survive.
Now let us turn our attention to the question as to the value of capital. In order to be consistent with previous definitions it will be necessary to define the value of the services of capital is this manner:
The value of the services of capital is the amount that the producer is willing and able to pay (or, in the case of a self-employed individual, the amount of labor he is willing to expend) to obtain these services.
As in the case of consumer goods, the cost of substitutes is one of the determinants of the value of the services of capital. In many applications labor is a satisfactory substitute, and in general the cost of labor is the controlling factor in determining the extent to which capital is used. When the cost of labor is low, the value of the services of capital is likewise low, and since the cost of capital is relatively constant, the use of capital is minimized. Where the cost of labor is greater, the value of the services of capital rises accordingly, and the relation of this value to the cost of capital becomes more favorable, hence the use of capital increases.
Another of the determinants of the value of the services of capital is the contribution, which those services make toward production. If a workman using hand tools can make only two pairs of shoes per day, but by installation of power machinery can raise his daily production to twenty pairs, the difference of eighteen pairs, less the cost of operating and maintaining the equipment (including provision for depreciation) represents the gain made by the use of the machines. The value of the services of the capital invested in the equipment cannot exceed this amount, and it therefore constitutes a determinant. In accordance with the general principles governing multiple determinants, the factor that is controlling in any given situation depends on the particular conditions existing at the relevant time and place.