What’s it? Capital deepening is an investment in increasing the capital-to-labor ratio. It is one way to encourage economic growth and increase potential output in the long run.
Assuming the supply of labor (as measured by the labor force) does not change, deepening increases economic growth. As the number of capital goods, such as machines, increases, people can use them to increase production. Also, technological advances in capital goods allow us to produce more efficiently and produce more output from the same amount of input.
Why capital deepening matters
Capital deepening refers to an increase in the capital-per-worker ratio. Capital goods in the economy include machinery, equipment, vehicles, buildings, and other essentials in the production process.
The capital-per-worker ratio is closely related to labor productivity. With more machines available, for example, we can produce more goods and services.
Consider a motor vehicle manufacturer. If the company buys multiple machines and robotics technology, it can produce more vehicles in the same amount of time. In the aggregate, capital deepening leads to an increase in the economy’s productive capacity.
Determinants of capital deepening
The capital-per-worker ratio is a function of capital and labor. If we wrote it in a simple mathematical equation, it would equal:
- Capital-per-worker ratio = Capital stock/Total labor supply
The capital-per-worker ratio is a key metric that economists use to understand how much capital each worker has access to. It’s essentially a division of two crucial factors in economic growth: capital stock and labor supply. Let’s break down each of these and see how they influence capital deepening:
Capital stock
Imagine a factory. The more machines, tools, and equipment it has (capital stock), the more a single worker can produce. This capital stock accumulates over time and depends on two things:
- Gross investment is the total amount spent on new capital goods like machinery, buildings, and vehicles. It is the money pumped into expanding the factory’s capabilities.
- Depreciation: However, capital goods don’t last forever. Machines wear out, and buildings deteriorate (depreciation). So, we need to constantly invest to replace these depreciating assets and maintain the capital stock.
The key driver of capital deepening is net investment, which is simply the difference between gross investment and depreciation. If net investment is positive, the capital stock grows, leading to a higher capital-per-worker ratio.
Labor supply: quantity + quality
On the other hand, the total labor supply represents the available workforce in an economy. This number is influenced by several factors:
- Population growth: As the population grows, the potential labor supply generally increases. More people entering the workforce can contribute their skills and effort.
- Labor force participation rates: Not everyone in the population actively participates in the workforce. Factors like age, education, and social norms can influence these rates. An increase in participation rates can boost the labor supply.
- Net immigration: The net number of people migrating into or out of a country also affects labor supply. A positive net immigration adds to the available workforce.
It’s important to remember that capital deepening isn’t just about having more machines per worker. The quality of both capital and labor plays a critical role in boosting output:
- Technology: Modern technology allows us to get more out of the same amount of capital. Consider computers compared to typewriters. A single worker with a computer can write and edit articles much faster and more efficiently than with a typewriter.
- Worker skills and education: A skilled and educated workforce can utilize capital goods more effectively. Imagine a factory with complex machinery. Workers with the proper training and knowledge can operate these machines efficiently, maximizing their output.
In conclusion, the capital-per-worker ratio, determined by capital stock and labor supply, is a significant driver of capital deepening. However, don’t forget the importance of technological advancements and a skilled workforce – these factors, alongside the quantity of capital and labor, ultimately determine how efficiently an economy can produce goods and services.
The role of savings on capital deepening
The national savings rate has an effect on capital deepening. A higher savings rate increases the supply of loanable funds in the economy. We can use it to invest in capital goods, increasing the capital stock.
Say, households set aside more of their income for savings. They then invest it in the capital market, for example, by buying corporate debt securities. The company then uses the proceeds from corporate debt securities’ issuance to buy capital goods and build new factories. Thus, in general, the higher the saving rate, the higher the funds available for productive use (investment).
Capital deepening vs. Capital widening
Imagine a factory assembly line. Capital deepening and capital widening are two ways to improve its efficiency, but they involve different approaches:
Capital widening
Capital widening occurs when the capital stock (machinery, equipment, etc.) increases at the same rate as the labor force. Think of it as adding new workers to the assembly line and providing each one with the same level of equipment they had before. In this scenario, the capital-per-worker ratio remains constant.
Here’s an example:
- The labor force grows by 5%.
- To maintain the same level of equipment per worker, the capital stock also needs to grow by 5%.
How is this achieved?
Net investment (gross investment minus depreciation) needs to be sufficient to cover the growth in the labor force and replace depreciating capital.
Suppose depreciation is around 2%. To achieve a 5% increase in the capital stock, the economy would need a gross investment of 7%. This ensures each new worker has the same equipment as existing workers.
Capital deepening
Capital deepening, on the other hand, focuses on increasing the capital-per-worker ratio. This is like adding more advanced machinery or tools to the assembly line, allowing each worker to be more productive. Here, the capital stock increases at a faster rate than the labor force.
Continuing the example:
- The labor force still grows by 5%.
- But for capital deepening, the capital stock needs to increase by more than 5%.
How much more?
The exact amount depends on depreciation. With a 2% depreciation, gross investment would need to be significantly higher than 7%. This additional investment allows for not only replacing depreciated equipment but also acquiring new and more advanced capital goods, ultimately boosting productivity per worker.
In a Nutshell:
- Capital widening: Maintains the capital-per-worker ratio by keeping pace with labor force growth.
- Capital deepening: Increases the capital-per-worker ratio by investing in more and better capital goods than needed to keep pace simply.
Both approaches contribute to economic growth, but capital deepening has the potential for greater output gains due to increased worker productivity. However, it requires a higher level of investment.
Long-term impact on economic growth (Solow growth model)
To explain it, we took the Solow growth model. The model shows us two determinants of economic growth. They are:
- Labor
- Capital
The equation is as follows:
- Y = A Kα Lβ
Where
- Y = Aggregate output
- L = Number of labor
- K = Capital stock
- A = total factor productivity, representing technological progress
- α = Output elasticity of capital (α <1)
- β = Output elasticity of labor (β <1), where α + β = 1
If we rewrite the above equation to be output per worker, we get the following equation:
- Y/L = A (K/L)α
Where K/L represents capital per worker, and Y/L represents output per worker.
The value of α is less than 1, which shows that the marginal productivity of capital is decreasing. When capital per worker has been high, any capital deepening will only result in a lower additional aggregate output than if the capital-per-worker ratio was low. In other words, the higher the capital per worker, the lower the contribution of capital deepening to the increase in aggregate output.
The convergence myth: why developing economies struggle to catch up
The Solow growth model suggests a phenomenon called convergence. This idea proposes that developing economies with a lower capital-per-worker ratio should experience faster economic growth as they invest in capital deepening. Here’s the logic:
- Lower capital stock, higher returns: Since developing countries have a lower starting point (less capital per worker), their initial investments in machinery, equipment, and infrastructure yield a higher return in terms of increased output. Think of it as adding the first few machines to a factory – each one has a significant impact on production.
- Convergence in income levels: This faster growth in developing economies, driven by capital deepening, should theoretically lead to a convergence in income per capita between developed and developing nations. In simpler terms, the gap in living standards between these two groups should shrink over time.
Reality check: The TFP factor
However, the real world doesn’t always follow the textbook model. Here’s why convergence hasn’t been as smooth as predicted:
The Solow model doesn’t fully account for a crucial factor – Total Factor Productivity (TFP). This is a kind of “catch-all” term that represents the efficiency with which a country uses its resources (capital and labor) to produce output. TFP is heavily influenced by technological advancements, innovation, and the skills of the workforce.
Developed nations often have a higher TFP due to factors like:
- Innovation and research: They invest heavily in research and development, leading to cutting-edge technologies that boost productivity.
- Skilled workforce: They have a more educated and skilled workforce that can effectively utilize advanced capital goods.
- Efficient management practices: They have well-developed management systems that optimize production processes and resource allocation.
This TFP advantage allows developed economies to not only maintain their lead but also potentially outpace the simple output gains achievable by developing countries through capital deepening alone. In essence, even as developing countries invest in more capital, they might struggle to keep up with the ever-evolving efficiency gains of developed economies.
The takeaway? Capital deepening remains a significant strategy for economic growth, especially for developing economies. However, achieving true convergence requires addressing the TFP gap by investing in research, education, and innovative practices.
