Stretching the Definition of Capital, 8/17

Because the neoclassical production function doesn't fit

Carol Corrado and others write,

But when this practitioner of economics encounters the real world, this basic production function approach exhibits some glaring holes. Table 1 sets out the world’s leading companies by market capitalization in March 2021. Market capitalization refers to the total value of the company, based on stock market valuations. (It should be noted that some companies, like Saudi Aramco, remain primarily owned by the government of Saudi Arabia.) A first lesson from Table 1 is that the value of these companies is clearly not based on the textbook physical or “tangible” capital, which covers “property, plant, and equipment.” The gap between tangible assets as reported in corporate annual reports and the market value of these companies is enormous, even though tangible assets do include, for example, Amazon’s property, plant, and equipment in cloud server farms.

Nicolas Crouzet and others write,

Intangible capital is generally defined by what it lacks—that is, as productive capital that lacks a physical presence. Familiar and important examples include patents, software and databases, trademarks, customer lists, franchise agreements, and organization capital and firm-specific human capital.

They point out that property rights are not as easily established with intangible assets.

Bart J. Bronnenberg and others write,

we believe the more recent economics literature has unduly neglected intangible marketing and brand capital and its many micro and macro implications in its studies of industry structure, productivity, and aggregate output.

David J. Deming writes,

First, human capital explains a substantial share of the variation in labor earnings within and across countries. Second, human capital investments have high economic returns throughout childhood and young adulthood. Third, the technology for producing foundational skills such as numeracy and literacy is well understood, and resources are the main constraint. Fourth, higher-order skills such as problem-solving and teamwork are increasingly economically valuable, and the technology for producing them is not well understood.

Points two and three contradict the Null Hypothesis. I do not think that Deming is justified when he calls these “four facts.” It is more like “Four things I choose to believe, even though the literature regarding at least some of them is quite mixed.”

Katharine G. Abraham and Justine Mallatt write,

Three broad approaches have been taken to measuring investments in formal education and the resulting human capital stock: the indicator approach, the cost approach, and the income approach (Le, Gibson, and Oxley 2005; Jones and Fender 2011; UNECE 2016). The indicator approach attempts to capture a country’s investments in human capital using measures such as school enrollment, average years of schooling, or adult literacy. The cost approach values investments in education-related human capital based on education spending. The income approach values these investments by looking forward to the increment to expected future earnings attributable to current school enrollments and calculating the present value of those added earnings.

All of these papers are from the latest issue of the AEA Journal of Economic Perspectives. And these do not even begin to explore all of the phenomena that have been dubbed “capital:” social capital, network capital, cultural capital, and so on.

If you ask non-economists to explain capital, they will usually describe financial capital. “To start a business, I need to go to a bank to get capital.”

Classical economists (although not Adam Smith—see the Abraham paper) describe physical capital—plant and equipment used to produce goods. But modern economists want to use the term “capital” anywhere they observe differences in output or earnings across individuals, firms or countries.

Suppose that you read a study that reports “the difference in income between company X and company Y can be explained by brand capital.” And another study says that the difference can be explained by cultural capital. And so on. At some point, outcomes appear to be overdetermined.

I am relatively pessimistic about the prospects for rescuing the neoclassical production function using these various concepts of capital. In Specialization and Trade, I try to go back to doing economics without the production function.