Physical Capital

Author:

Reviewed By:

Last Updated:November 25, 2023

In This Article

What Is Physical Capital?

Physical capital consists of all tangible and man-made assets or inputs to produce final goods and services. Therefore, they are crucial to the economy as they support the production of goods and services.

It is one of the three main factors of production according to classical and neoclassical theories of economics. Physical capital includes machinery, buildings, vehicles, and other equipment involved in the production process.

The level of physical capital in an economy is directly proportional to the output generated. This is because, with an increase in assets supporting manufacturing activities, firms' productivity increases, and aggregate output in the economy rises.

These durable non-financial assets are critical in converting raw materials into final goods. Thus, they are an essential contributor to a nation's real Gross Domestic Product (real GDP) growth.

In simpler words, it can be understood as follows:

Physical - This refers to the attribute of being tangible. This distinguishes physical capital from human and financial capital.
Capital - This refers to man-made assets that support economic activities. The significance of capital for economic progress and prosperity in a nation was given by Adam Smith in his book "The Wealth of Nations."

Thus, the term refers to all real assets used in manufacturing goods. They are also known as real capital, capital stock, or capital assets.

Since these assets cannot be divided into smaller parts and sold for monetary value, they are considered illiquid. These assets are also susceptible to natural depreciation. This means that their value diminishes over time with constant usage.

Because of their illiquid and subtractable nature, assessing and measuring their value becomes difficult. So instead, they derive their value from the organization's valuation as a whole.

This implies that any organizational changes, like a merger or a demerger, affect the value of the capital stock. Furthermore, in some cases, economists disagree on classifying assets as land or capital.

For example, some analysts classify a company's building as a physical asset, while some argue that it is part of the land. This makes the valuation of assets subjective to the analyst.

Some assets are customized to serve a specific purpose. For example, a beverage company uses a particular machine for a specific bottle design that cannot be used for other purposes. This reduces the machine's resale value and makes it an inaccurate depiction of its real value.

Capital assets also require heavy investment from entrepreneurs in the early phases of production. That is, the producer must first purchase a plant and invest in all necessary equipment before they can start producing the first unit.

Industries that require heavy investment in physical assets may have entry barriers. For example, a new firm cannot enter the industry without investing extensively in such assets.

This poses a challenge for start-ups involved in manufacturing-intensive industries.

Examples include the telecom industry, which requires a heavy and widespread stock of physical assets.

Types of physical capital

Physical assets can be classified into two different categories based on their liquidity:

1. Working Capital

Refers to a company’s liquid assets that can be readily converted into cash. Working capital includes all assets with high liquidity, like the inventory of raw materials and cash in hand or any other asset that can be easily converted into currency.

It is used to meet the short-term requirements of a company. Also known as Net Working Capital (NWC), it is the difference between a company’s current assets and current liabilities.

Other common examples include unpaid pills by debtors/accounts receivables and cash equivalents.

2. Fixed Capital

This refers to all physical investments that can be used multiple times. They are used to fulfill long-term requirements. Since they are fixed, they cannot be readily converted to cash.

Examples include buildings, heavy machinery, and equipment. Although they are long-term assets, their value decreases with time due to depreciation. On the other hand, such assets are durable as they last for a more extended period.

These assets are usually sold or replaced only after many years as they require a considerable investment.

For example, fixed capital assets for a firm in the automobile industry could include the following:

The factory premises.
The tools and equipment required for the assembly of automobile parts.
Robots or computerized equipment performing precision tasks.
Machinery and conveyor belts are used to move equipment around.
All technology controls the operations of machinery.

As you can see, the inclusions of physical capital differ according to the industry.

Factors of production

Factors of production refer to all inputs needed for creating a good or service to earn an economic profit. This includes any resource involved in the production of a good or service.

There are four factors of production:

Land
Labor
Capital
Entrepreneurship

However, classical economist Adam Smith proposed three factors of production: land/natural resources, labor/human capital, and physical capital. Human capital here also includes the expertise and talent of the entrepreneur and labor involved.

The aggregate production function is the technical relationship between the number of inputs and the quantity of output of a particular good. Economists use the aggregate production function to study economic growth in a nation.

The production function of goods in an economy is given as,

Y = F ( K, L, N )

Where,

Y = aggregate production function
F = production function
K = capital stock
L = labor/human resources
N = land/natural resources

Thus, it tells us the effect of physical assets and worker input on output in an economy.

Through this production equation and the theories of Adam Smith, economists conclude that total production in a nation increases with an increase in capital stock.

No good can be produced without the interaction of these factors.

Let us take a look at the other factors of production.

Other factors of production

Some of the other factors of production are:

1. Land/Natural resources

Land/natural resources include all commercial and agricultural real estate and all the resources available from them. It includes the land on which stores, plants, shipping facilities, and factories are built.

Some other examples include natural resources like oil and gold that can be extracted from the land and sold.

The land is an essential factor in production. However, its importance can vary depending on the industry. For example, a firm in the software industry invests less in the land than a manufacturing firm.

Both physical assets and natural resources are tangible. They differ only because human capital assets are built, whereas natural resources are found to exist in nature.

Some factors, like buildings, can be categorized as both natural or capital assets, as they share characteristics of both. For example, the building is man-made, whereas the land it stands on is a natural resource. This creates conflict in its classification.

2. Labor/Human capital

Labor/human capital refers to the efforts and expertise of all individuals involved in producing a good or service.

For example, a construction worker working on a building, the employees in the building, and the managers overseeing operations in the building are all part of human capital.

Unlike physical assets, they are intangible as they include human knowledge, experiences, expertise, and capabilities.

Some other ways in which it differs from physical assets are below.

Human vs. physical capital

Differences Between Human And Physical Capital
Human Capital	Physical Capital
Responsible for adding value to goods and services.	Develops and produces finished goods and services.
Relies on knowledge, ideas, skillsets, and experience.	It relies on raw materials.
Refers to labor, working hours, new initiatives, etc.	Refers to equipment, machinery, tools, etc.
It goes beyond the manufacturing process and involves planning and decision-making.	Mostly involved in production.
Intangible and complex to measure.	Tangible and relatively simpler to measure.
Measured against the quality of the final product.	Measured against the market price of the final product.
The skills cannot be separated from their owner.	The equipment can be separated from its owner through resale.
It can be used for multiple purposes and not just for production. Conventionally, a skilled worker adds more value to society than an unskilled worker.	Only useful for the firm that employs it.
Its value increases with time as people gain more experience and knowledge.	Its value decreases with time as it depreciates with use.
These assets do not appear on the balance sheet of the company.	They are visible as assets on the balance sheet of a company.
They cannot be sold at any cost as they cannot be separated from their owner. They can, however, be shared as managers pass on their knowledge to employees.	They can be resold for cash or sold for their scrap value.
International mobility of such assets is complex as it involves immigration laws.	Such assets are often exported to other countries using international transportation without any complications with trade barriers.