Physical capital comprises real assets yielding services to producing firms or consuming
households. The main categories of physical capital are plant and machinery, residential
structures, other buildings, consumer durables and inventories. Tangible wealth is physical
capital plus land.
Present values convert future receipts or payments into current values. Because lenders can
earn – and borrowers must pay – interest over time, a pound tomorrow is worth less than a
pound today. How much less depends on the interest rate. The higher the interest rate, the
lower the present value of any future payment.
Since lending or borrowing cumulates at compound interest, for any given annual interest
rate the present value of a given sum is smaller the further into the future that sum is earned
or paid.
The present value of a perpetuity is the constant annual payment divided by the rate of
interest (expressed as a decimal fraction).
Nominal interest rates measure the monetary interest payments on a loan. The inflationadjusted
real interest rate measures the extra goods a lender can buy by lending for a year
and delaying purchases of goods. The real rate of interest is the nominal interest rate minus
the inflation rate over the same period.
In the long run, the real interest adjusts to make investment equal to saving, and is
determined by the return on firms’ investment and the degree of impatience of households.
The demand for capital services is a derived demand. The firm’s demand for capital services
is its marginal value product of capital curve. Higher levels of the other factors of production
and higher output prices shift the derived demand curve up. The industry demand for
capital services is less elastic than the horizontal sum of each firm’s curve because it also
allows for the effect of an industry expansion in bidding down the output price.
In the short run the supply of capital services is fixed. In the long run it can be adjusted by
producing new capital goods or allowing the existing capital stock to depreciate.
The required rental is the rental that allows a supplier of capital services to break even on
the decision to purchase the capital asset. The required rental is higher the higher the
interest rate, the depreciation rate or the purchase price of the capital good.
A rise in the industry wage has two effects on the derived demand curve for capital services.
By reducing labour input it reduces the marginal physical product of capital. By reducing the
industry output it increases the output price. When output demand is very inelastic the latter
effect will dominate. When output demand is very elastic the former effect dominates.
The asset price is the price at which a capital good is bought and sold outright. In long-run
equilibrium it is both the price at which suppliers of capital goods are willing to produce and
the price at which buyers are willing to purchase. The latter is merely the present value of
anticipated future rentals earned from the capital services that the good provides in the
future.
Land is the special capital good whose supply is fixed even in the long run. However, land
and capital can move between industries in the long run until rentals on land or on capital
are equalized in different industries.
Technology and the ease of factor substitution dictate the very different capital intensity of
different industries. Most industries are becoming more capital-intensive over time but at
different rates. This reflects the ease with which industries can substitute capital for labour,
the rise wage rates rise relative to capital rentals, and technical advances in different
industries.
The functional distribution of income shows how national income is divided between the
factors of production. The share of each factor has remained fairly constant over time. This
conceals a rise in the quantity of capital relative to labour and a corresponding fall in the
ratio of capital rentals to labour wages.
The personal distribution of income shows how national income is divided between different
individuals regardless of the factor services from which income is earned. A major cause of
income inequality in the UK is a very unequal distribution of income-earning wealth.
