3.0 Capital and Wealth

© 1999-2020, Douglas A.Ruby (06-09-2020)

Imagine a country where the primary goal of its economic policy is to accumulate a single commodity -- gold for example. Does the accumulation of wealth in this manner generate benefits to the members of this economy? Yes, but only if another country exists that devotes its energy and resources to the production of food, clothing, and other essentials and that this second country is willing to trade these goods for the gold of our first country.

3.0.1 Wealth

Individuals cannot directly consume commodity wealth. Gold, oil, iron ore , and the like provide no nutrition or protection from the elements. These commodities have little value in direct consumption. However if trade is possible with another nation -- a nation that realizes that the true measure of wealth is in production of necessary goods and services, then these commodities do have value.

Adam Smith was early to realize that the Wealth of a Nation (An Inquiry into the Nature and Causes of the Wealth of Nations)was not in the accumulation of commodities nor in the resource reserves that a nation may happen to possess. But rather wealth exists in the productive knowledge of its people. The ability to efficiently transform resources (factor inputs) into desired goods and services represents the true source of a nation's wealth.

Physical and human capital represents the true embodiment of wealth. This wealth is used to generate factor income as a payment for the production of desired goods and services Xi [i = 1,2,...,n-goods] and this income will be used to purchase these same goods and services. Thus wealth 'W' may be measured in terms of the future stream of income 'Yt', discounted at some rate 'r', generated by the use of physical and human capital:

Xi = f(Li,Ki,Mi) for all i = 1, 2, ...n-goods
Yt = Σ[i=1,n]Pi,0Xi,t {expenditure}

= Σ[i = 1, n] w x Li + r x Ki + n x Mi {factor income}
such that:
W = Σ[t = 1, T(i)] {[Σ[i=1,n]Pi,0 f(Li,t,Ki,t,Mi,t)] /(1+ ρ)-t}

This rate of discount 'ρ' is a measure of how economic agents discount future economic activity (and use of resources) relative to the present. Via use of this rate we then are able to convert the stream of present and future income/output -- a flow variable into a measure of wealth -- a stock variable.

The numeric value of wealth is really less important than what it represents. The members of a given society are interested in living standards such that growth in output (economic growth) will at a minimum, equal or exceed the rate of population growth. Thus they are interested in a stock of human and physical capital sufficient to produce desired growth in income and output.

Note: over time labor input will grow at some rate 'n' proportional or perhaps equal to the rate of population growth:

Lt = L0(1+n)t

Growth in capital is dependent on savings rates in a given economy to support gross investment (changes in the capital stock overtime) at some rate 'g' less the rate in depreciation 'δ'. This rate of depreciation is a reflection of the fact that, over time, capital does where out. Thus 'g - δ' represents the net growth in the capital stock over time.

Kt = K0(1 + g - δ)t

Increases in living standards require more capital per unit of labor thus making each unit of labor more productive or:

(g - δ) > n

such that:

Kt/Lt is increasing over time.

Small changes in growth rates can have a big impact on long-term living standards.

You can practice with the Accelerator model below:

No support for the HTML5 object!
Country-A Growth Rate: 0.25% 10%
Country-B Growth Rate: 0.25% 10%

3.0.2 Examples...

A sole proprietor operating a small restaurant uses raw materials in the form of food ingredients, capital in the form of a stove or oven, and labor input in the form of his own time. The proprietor is motivated by the fact that he is able to create a meal that is valued by his customers over-and-above the value of the individual inputs. This added value is created by his talents and know-how as a cook or chief combined with the physical capital of the restaurant. Wealth in this case is not only in the materials or factors of production but also in the proprietor's knowledge of preparing a meal. Over time this human capital will generate a stream of income for the proprietor for as long as he operates the restaurant and as long a there is a demand for his product.

An airline makes decisions to purchase an airplane based on anticipated demand for transportation services. The value of these services are based on the benefits customers receive by flying relative to other forms of traveling from one place to another. Like the restaurant the value of the airplane (a unit of physical capital) is in the provision of passenger services. Building this airplane represents an addition to wealth in that it will generate a stream of revenue (income) for the corporation generated over its physical life provided demand for passenger services remain.

Finally, the construction of an apartment building represents an addition to wealth based on the demand for apartments by those seeking housing services. The building will generate a stream of rental income over its life based on occupancy levels and rental rates. If however, the building is largely vacant--demand is lacking, its contribution to (national) wealth is close to zero. It becomes an asset with limited realized value even though its construction represents a combination of valuable materials, labor services, and land area.

3.0.3 Summary

The creation of wealth is based on knowledge -- the ability to take raw inputs and convert them into output with value greater than the sum of the individual parts. Additionally, this value is determined by correctly assessing the demand for the output -- how it will satisfy needs and wants.

Creation of a restaurant, airplane, or apartment building (physical capital) all represent a contribution to a nation's wealth in that they all generate a future stream of income based on the willingness of the members of that nation to purchase food services, transportation services, or housing services to satisfy specific wants. Creation of a school teacher or engineer (human capital) also represent additions to a nation's wealth in that they also generate services desired by others in a given economy and thus produce a stream of income for the individual based on demand for those services.

Concepts for Review:

Top of page related: Macroeconomic Policy next: Capital and Living Standards Macroeconomic Theory
© 1999-2020, Douglas A.Ruby (05-20-2020)