What’s it: Capital deepening is an investment to increase the capital-to-labor ratio. It is one of our ways 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 is capital deepening important
Capital deepening points to an increase in the capital-per-worker ratio. Examples of capital goods in the economy include machinery, equipment, vehicles, buildings, etc. They are essential 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 productive capacity in the economy.
What causes 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
From the above formula, you can see, the capital-per-worker ratio will be higher when the capital stock increases or the total labor supply decreases.
The capital stock represents the accumulation of capital over time. It depends on the economy’s investment (also called gross investment) and the depreciation of capital assets. Economists call the difference between gross investment and depreciation net investment. Thus, we can say the capital stock increases as long as the net investment is positive.
In aggregate, the labor force represents the supply of labor in the economy. That changes due to population growth, labor force participation rates, and net immigration (the net number of people leaving and entering a country).
Suppose you relate the capital-per-worker ratio and output. In that case, it is not only the quantity of capital and labor that affects the quantity of production but the quality of both. Quality depends on factors such as technology and the level of education and skills of workers.
More advanced technology allows us to produce more output using the same input. We can also produce goods and services faster. For example, computers allow you to create more articles than typewriters. You can also write an article more quickly using a computer than a typewriter.
Furthermore, the education and skills of workers also affect their productivity in using capital goods. Even though the number of machines increases, it will not produce output optimally if workers do not have sufficient skills to operate them.
The impact of the savings rate 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).
The difference between capital deepening and capital widening
Capital widening is when the capital stock increases at an equal rate as the increase of the labor force. As a result, the capital-per-worker ratio remains constant. For example, if the labor force increases by 5%, the capital stock increases by 5%.
The increase in the capital stock is equivalent to net investment, which is the difference between gross investment and capital depreciation. If the depreciation is around 2%, then to increase the capital stock by 5%, the economy increases gross investment by 7%. Gross investment is the money we have to spend on investing in capital assets without considering depreciation.
Meanwhile, as I previously explained, capital deepening involves increasing capital per worker. Therefore, in that case, capital deepening occurs when the capital stock increases by more than 5%. Since depreciation is around 2%, the economy needs a gross investment of more than 7%. In this way, investment contributes to increased aggregate output through increased productivity (output per worker).
The impact of capital deepening on the economy in the long run
To explain it, I took the Solow growth model. The model shows you two determinants of economic growth. They are:
The equation is as follows:
Y = A Kα Lβ
- 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, and it shows you, 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.
Capital per worker is high in developed countries and low in developing countries. Therefore, for each additional investment of capital, it will result in a more significant increase in output in developing countries than in developed countries.
Thus, there should be a convergence between the income per capita of developed and developing countries. The income per capita of developing countries should grow higher than in developed countries. At one point, it will match the developed world.
However, this is not the case. Developing countries have not been able to match developed countries. The model above shows a residual factor, namely the total factor productivity (A), which is mostly contributed by the technological advancement factor. It allows developed countries to maintain their dominance and be one step ahead of developing countries.