What’s it: Physical capital refers to man-made means to aid production. Economists classify it as a factor of production. Examples of physical capital are buildings, vehicles, machinery, and equipment. You can find the components in the fixed assets or property, plant, and equipment (PP&E) account in a financial statement.
Why is physical capital important
Physical capital is important because it increases productivity, affects economic growth and potential output. In economics, capital is one of the production factors besides land, labor, and entrepreneurship.
Economists specifically refer to capital as physical capital because it is directly useful for the production process. For example, carmakers make use of machines and robots to install car frames. They use vehicles to transport raw materials and final output.
Economists exclude financial capital from production factors because firms cannot use it directly to produce goods and services. Instead, we must convert it into physical capital, for example, by buying a production machine.
The availability of physical capital is one of the determinants of a company’s production capacity and the economy. Long story short, the supply determines the potential output produced. For example, when they have more machines, the firm and the economy can produce more output – see the Solow growth model.
Apart from the quantity of capital (capital stock), the production capacity and potential output also depend on their quality. In this case, the technological factor plays an important role. With more technologically advanced machines, we can produce more output using the same number of inputs. Or, we can produce the same output but faster.
Difference between physical capital, financial capital, and human capital
Physical capital differs from financial and human capital in terms of their physical substance and contribution to production.
Physical capital is a tangible asset and is useful for helping the production process. We use it directly to help generate output. Unlike raw materials or semi-finished goods, it does not form part of the final output.
Financial capital is an economic resource, measured in terms of money, to buy everything needed to produce a product. Through it, companies can buy machines and vehicles. They can also use it to buy raw materials and hire labor.
Examples of financial capital include cash on hand, deposits in banks, and investments in securities. They contribute indirectly to the production process. I mean, companies can’t use them to make products like machines or production equipment.
Furthermore, human capital refers to the knowledge, talents, skills, and abilities accumulated in a person. It has no physical substance but is essential to labor productivity. Investing in education and skills is one way to improve the quality of human capital. Experience is also another contributor.
Effect of physical capital stock on economic growth
Investing in physical capital is an important driver of economic growth, not only in the short term but also in the long term. Such expenditure is a component of gross domestic product (GDP), in addition to household consumption and government spending. So, if investment increases, it will boost GDP growth.
Investment in capital goods increases production capacity. It also contributes to boosting production efficiency and labor productivity. New equipment usually adopts newer and more sophisticated technology. With more and higher quality equipment, workers can produce more output than with older equipment.
Capital investment during the business cycle
During an economic expansion, businesses see strong demand and better profit prospects. They then use their physical capital more intensively. Suppose they expect demand to continue to grow. In that case, they will buy new capital assets because their existing assets are fully utilized. With new equipment, they can produce more goods and make more money.
When the economic cycle reaches its peak, the growth rate for business investment slows down. Increasing production is unprofitable because the prospect of demand is weakening. Some companies are starting to stop ordering new equipment.
Furthermore, during an economic contraction, capital expenditures usually decrease. Businesses see the prospect of demand for their products deteriorating. The situation depressed their sales and profits. They are starting to streamline operations. The utilization of production facilities has become less intensive. They also cancel existing orders because they do not need to expand production capacity.
Finally, after exiting the trough phase and at the beginning of the economic recovery, businesses do not necessarily increase investment. They tend to be careful in making investment decisions. The economic recovery may lead to expansion. However, it may also move in the direction of contraction.
Thus, early in the economic recovery, businesses preferred to order light equipment to increase productivity. They also recruit temporary workers to meet increasing demand instead of permanent workers. Alternatively, they can increase overtime. When demand leads to more robust and more sustainable growth, businesses then start investing in capital goods.
Effect of saving on physical capital investment
The savings rate gives you an idea of how much the supply of loanable funds is in the economy. Savings flows into several financial instruments such as stocks, bonds, and bank deposits. This eventually flows to several macroeconomic sectors, including the business sector.
On the demand side, companies need funds to purchase capital goods to increase production capacity. They borrow from banks, issue stocks or bonds to raise money.
The supply and demand for money occur in financial markets. Long story short, a higher savings rate increases the supply of loanable funds in the economy. That drives interest rates down due to abundant liquidity.
Lower interest rates make funding costs cheaper and attract businesses to raise money. They can use it to finance capital investments such as building factories or buying new machines. As interest rates fall, investment costs become cheaper, increasing their viability.
Paradox of thrift
This paradox tells you that a higher saving rate does not necessarily encourage capital investment. This situation usually occurs during the depression, where aggregate demand falls.
Interest rates are not the only reason businesses invest. Demand is another major factor influencing investment decisions. Interest rates affect investment costs. Meanwhile, demand affects revenue. Costs and revenue ultimately have an impact on profits.
The ultimate goal of companies investing in capital goods is to meet increasing demand. They add machines or build new production facilities to increase output. That way, they can generate more sales and revenue.
But, if demand falls, businesses have no reason to increase output and invest in capital goods. An increase in output will only result in excess supply in the market, push down prices, and worsen profits.