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15.2 Productivity of Capital

(A) Physical and Value Productivity: Capital is a productive agent; so it must result into an enhanced productive efficiency in the act of production. The result of employment of machines should lead to a sizable increase in the total output produced. If a handloom factory produces 300 yards of cloth daily then, with the introduction of the powerloom, there must be net improvement in the cloth output produced such as of about 400 to 500 yards. This is termed physical productivity of capital. According to Bohm Bawerk, there must also be value productivity (in terms of future utilities) of capital. This is necessary because in the act of capital formation there is considerable time lapse. Human valuation of present goods or their present consumption opportunity is relatively larger than similar but uncertainopportunities in the future. Therefore future enhanced size of goods must also compensate for such value differences. This compensation is called agio or discounting process.

(B) Stock and Flow: The concept of capital is essentially a stock concept. Such a stock of goods produces income for future consumption opportunities. A house purchased with an investment of $15,000 today will bring in rent for the future 20 years or so. Investment in the house is the stock and future rent is an income flow. Sir Irving Fisher has spoken in terms of a cherry tree which is the stock and cherries that are collected every day as the flow of income. Flow comes only when stock is present. Therefore in order to enrich future income one has to build the stock and improve it from time to time.

(C) Net Investment and Depreciation: Capital formation is not a once for all activity. It needs to be continuously sustained and improved. This can be possible only when the stock of capital grows in size in the long run. Fresh addition made to the stock annually or from time to time is called net investment. However, total annual investment activity may not be fully realized in the form of increase in the stock of capital. This is because part of the present capital is likely to depreciate. Hence, additional investment expenditure over and above depreciation charges makes for the net investment and capital formation activity. As an illustration, let a company that produces goods possess a total stock of capital goods worth $10,000. These capital goods such as machinery, tools etc. may have an average life span of 5 years. Therefore after 5 years the entire capital stock will be exhausted and no further productive activity will be possible. In order to replace the present stock after 5 years some amount of current income has to be set aside. Such an allowance is called depreciation charge or alternatively capital consumption or replacement charge. In the above example, the firm has to set aside 1/5 or 20 percent of the value of the stock every year. Hence the firmís depreciation charges will be $2000 per year (10,000 ł 5 = 2000). If the annual investment activity of the firm is $3000 then it can add to the stock as well. In this case $3000 is the gross investment. Out of this amount $2000 are required for depreciation purposes; the remainder $1000 is the firmís net investment. We can conclude that the firmís net investment or capital formation activity will be positive and its stock of capital will increase when its gross investment exceeds depreciation requirement. If gross investment falls short of the depreciation allowance then net investment will be negative.

GI - D = NE 3000 - 2000 = 1000 Positive

GI - D = NE 2000 - 2000 = 0 Nil

GI - D = NE 1500 - 2000 = - 500 Negative

(D) Interest and Discount: Capital goods are productive and they increase the future stock of goods. Therefore capital is said to be an asset which brings net return or additional income in the future course of time. Such net return on capital is called its rate of interest. Rate of interest may be both real as well as monetary in form. If we lend 500 quintals of wheat to a farmer during the planting season to be used as seeds, he may promise to return 550 quintals after the harvest season. The additional 50 quintals he returns is the real interest on the capital lent. The rate of interest in this case is 10 percent. Since almost all economic transactions today are performed in currency units the rate of interest is charged and paid in monetary units. The farmer in the above example may approach a banker for a loan of $1000 with a promise to return $1100 after a year. In this case the farmer pays an interest of $100 which is 10 percent of the loan but in monetary units. It is easier and more convenient to compute and charge interest in the form of money. This is because loan transactions are carried out over a long number of years in which case, the compound interest to be charged also increases in value.

As in the example above, if a bank lends an amount of $1000 at 10% rate of interest after one year the total amount repayable will be $1100 of which the capital or principal amount is $1000 and the interest amounts to $100. Further if we suppose the loan is extended over the second year the amount to be repaid will be more than $1200 because at the end of the first year $1100 were repayable and hence have been renewed as loan for the second year. 10% of 1100 will be equal to $110. Therefore at the end of the second year, the borrower would have to repay $1210.

1000 (principal) + 100 (first yearís interest) + 110 (second yearís interest) = 1210

This process is called compounding of interest charges. As the number of years of the borrowing period increase the compounded interest goes on increasing. In general, for n number of years, the mathematical formula used for compounding purposes is as follows:

V = K(l + r)n [V = K(l + r)1, K(l + r)2Ö, K(l + r)n]

íVí is the final value of the loan plus interest, íKí is the capital or principal amount borrowed, írí is the rate of interest and íní is the number of years of borrowing.

In our example, V = 1210, K = 1000, r = 10% or 0.10 and n = 2

Discounting is an opposite process. The interest rate enhances the present value of the principal in the future course of time. On the other hand, the discounting method reduces future incomes or values at a certain rate to determine their worth under present valuation. Since the future is uncertain, price levels and other conditions may alter and therefore the lender considers the future value to be lower under present valuation. The rate of discount is calculated as the extent of difference in valuation. Normally the rate of interest also acts as a rate of discount. In the above example the amount of $1100 an year ahead is equivalent to $1000 today. This way, the present value of the future income has been discounted by 10 percent.

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15.1 - Basic Concepts
15.2 - Productivity of Capital
15.3 - Market Rate of Interest
15.4 - Investment Decisions

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