Capital, Interest, and Investment

Capital is a resource, or factor of production, used in combination with other resources to produce consumer goods and services or other cap ital goods. Capital may be either physical capital, such as factory buildings and machines, or human capital, such as education and training.

The use of capital in production is sometimes described as "roundabout production. " That term recognizes that producers often have a choice between using labor and natural resources directly to produce consumer goods and services or first using these noncapital resources to produce capital, which is in turn used to produce the consumer products. Long-term efficiency is often increased by following the roundabout production method.

The creation of capital is called investment. Whether to provide for the creation of new capital, and if so, how much, is called the investment decision. Because a business firm will invest in order to make a profit, it is expected to invest up to the point where the marginal revenue product of capital is equal to its marginal factor cost.

When making the investment decision, firms face problems related to the fact that the cost of capital is usually incurred well before the returns to capital are received. Capital is durable and generally provides returns in the form of an income stream over a considerable period of time. Not only do firms suffer an opportunity cost (the time problem), but they also must contend with the risks and uncertainties of obsolescence and the possible de crease in end-product prices (the derived-demand problem).

The concept of present value recognizes that the value of a certain sum of money to be received in the future is less than the value of that same sum of money if it were received now. At any particular interest rate, the further into the future that a sum of money will be received, the lower is its present value. The higher the interest rate used to discount the future payment, the lower is the present value of that future payment.

Discounting is the method used to determine the present value of returns that will be received in the future. Future returns from capital goods must be discounted to their present values to make the marginal revenue product of capital comparable to its marginal factor cost, most or all of which is incurred at the time the investment is made. Only the present value (PV) of the marginal revenue product should be used to compare with the marginal factor cost.

Interest is payment for the use of someone's money. Interest rates are determined in markets for loanable funds. The equilibrium rate of interest is the interest rate at which the quantity demanded of loanable funds is just equal to the quantity that lenders are willing to supply. If a firm finds that the internal rate of return for a particular investment is below the equilibrium market rate of interest, then it will not undertake this investment.

The demand for loanable funds comes from business firms, households, and governments. Business firms seek profits through investment. Because households want to buy consumer goods, they are often willing to pay the interest that will enable them to buy them now rather than later. Governments may also want to spend more than they can finance from their current tax receipts. The demand curve for loanable funds is expected to be negatively sloped, since high interest rates will discourage borrowing and low interest rates will encourage borrowing. 

The supply of loanable funds comes from savers. At times, business firms, households, and governments don't want to spend all of their income right away. The supply curve for loanable funds is expected to be positively sloped, since high interest rates will usually encourage saving and lending, and low interest rates will usually discourage saving and lending. 

Human capital is that part of the productive power of individuals that has been developed through earlier expenditures for education, job training, and health care. How good a "producer " a person is will depend partly on the amount that has been invested in him or her. Whether or not to allocate scarce resources to human capital, and if so, in what amount, comprises the human capital investment decision. 

Individuals invest in human capital for both monetary and psychic returns. They may also consider their expenditures for something like higher education to be partly consumption. Therefore, in analyzing an individual's "human capital investment decision, " all three returns-monetary, psychic, and consumption-must be weighed against his or her cost.

Firms invest in human capital in order to gain higher profit. They do not have a property right to people as they do to physical capital. Therefore, in countries like the United States, where labor is quite mobile, firms are more reluctant to invest in training their employees than in a country like Japan, where employees are more likely to remain with the same firm.

Governments invest in human capital in order to benefit society as a whole. Their aim may be to have better-informed citizens or to expand the frontiers of knowledge. But just as private investment in human capital yields some social returns, government investment in human capital results in some private returns.