PRINCIPLE OF ECONOMIC
6 EDITION
KARL CASE, RAY FAIR
PRENTICE HALL BUSINESS PUBLISHING
COPY RIGHT 2002
Capital
•
One of the most important concepts in
all of economics is the concept of capital.
•
Capital goods
are those goods produced by the economic system that are used as inputs to
produce other goods and services in the future.
Physical Capital
•
Physical,
or tangible, capital refers to the material things
used as inputs in the production of future goods and services.
•
Major categories of physical capital:
•
Nonresidential structures
•
Durable equipment
•
Residential structures
•
Inventories
Social Capital
•
Social capital
is capital that provides services to the public.
•
Major categories of social capital:
•
Public works (roads and bridges)
•
Public services (police and fire
protection)
Intangible Capital
•
Nonmaterial things that contribute to
the output of future goods and services are known as intangible capital.
•
For example, an advertising campaign to
establish a brand name produces intangible capital called goodwill.
Human Capital
•
Human capital
is a form of intangible capital that includes the skills and other knowledge
that workers have or acquire through education and training.
•
Human capital yields valuable services
to a firm over time.
Measuring Capital
•
The measure of a firm’s capital
stock is the current market value of its plant, equipment, inventories,
and intangible assets.
•
When we speak of capital, we refer not
to money or financial assets such as bonds or stocks, but to the firm’s
physical plant, equipment, inventory, and intangible assets.
Investment
•
Investment
refers to new capital additions to a firm’s capital stock.
•
Although capital is measured at a given
point in time (a stock), investment is measured over a period of time (a flow).
•
The flow of investment increases the
capital stock.
The Capital Market
•
The capital market is a
market in which households supply their savings to firms that demand funds to
buy capital goods.
Bond Lending
•
A bond is a contract
between a borrower and a lender, in which the borrower agrees to pay the loan
at some time in the future, along with interest payments along the way.
•
In essence, households supply the
capital demanded by a business firm.
Presumably, the investment will generate added revenues that will
facilitate the payment of interest to the household.
The Financial Capital Market
•
The financial capital market
is the part of the capital market in which savers and investors interact
through intermediaries.
•
Capital income
is income earned on savings that have been put to use through financial capital
markets.
Capital Income:
Interest and Profit
•
Interest
is the payment made for the use of money.
Interest is a reward for postponing consumption.
•
Profit
is the excess of revenues over cost in a given period. Profit is a reward for
innovation and risk taking.
Financial Capital Markets in Action
•
Four mechanisms for channeling household
savings into investment projects include:
•
Business loans
•
Venture capital
•
Retained earnings
•
The stock market
Capital Accumulation and Allocation
•
In modern industrial societies,
investment decisions (capital production decisions) are made primarily by
firms.
•
Households decide how much to save, and
in the long-run saving limits or constrains the amount of investment that firms
can undertake.
•
The capital market exists to direct
savings into profitable investment projects.
Forming Expectations
•
Decision makers must have expectations
about what is going to happen in the future.
•
The investment process requires that the
potential investor evaluate the expected flow of future productive services
that an investment project will yield.
The Demand for New Capital and the Investment
Decision
•
The ability to lend at the market rate
of interest means that there is an opportunity cost associated
with every investment project.
•
The evaluation process thus involves not
only estimating future benefits, but also comparing the possible alternative
uses of the funds required to undertake the project.
•
At a minimum, those funds earn interest
in financial markets.
Comparing Costs and Expected Return
•
The expected rate of return
is the annual rate of return that a firm expects to obtain through a capital
investment.
Determinants of the Expected Rate of Return
•
The expected rate of return on an
investment project depends on:
•
the price of the investment,
•
the expected length of time the project
provides additional cost savings or revenue, and
•
the expected amount of revenue
attributable each year to the project.
A Menu of Investment Choices and Expected Rates of
Return
•
When the interest rate is low, firms are
more likely to invest in new plant and equipment than when the interest rate is
high.
•
The interest rate determines the
opportunity cost (alternative investment) of each project.
Investment Demand
•
The market demand curve for new capital
is the sum of all the individual demand curves for new capital in the economy.
•
In a sense, the investment demand schedule
is a ranking of all the investment opportunities in the economy in order of
expected yield.
The Profit-Maximizing Investment Decision
•
A perfectly competitive
profit-maximizing firm will keep investing in new capital up to the point at
which the expected rate of return is equal to the interest rate.
•
This is analogous to saying that the
firm will continue investing up to the point at which the marginal revenue
product of capital is equal to the price of capital.
Present Value
•
The present value (PV), or
present discounted value, of R dollars t years from now is:
•
Lower interest rates result in higher
present values. The firm has to pay
more now to purchase the same number of future dollars.
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