M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
Economists like to call the products and services we buy and consume goods. There are two kinds of goods in this world. One that you know very well is called consumer goods, the kind you purchase every day at a store or online. That pizza you bought last night is a consumer good. The other kind of good is a capital good, they are the things used to produce consumer goods and services. If the pizza is a consumer good, then the oven that baked the pizza is a capital good. No consumer is going to buy that pizza oven, but the pizzas that it cooks will get bought as fast as they come out.
All capital goods have what accountants call a useful life, or how long that capital good will be able to do its job and keep baking pizzas! The average pizza oven has a useful life of ten years. The owner of the pizza place will depreciate that oven over its useful life of baking pizzas. Every year that oven gets a lot of wear and tear, so it is worth less than the year before. Accounting depreciation marks down the value of that oven on the owners books every year until it has a value of $0 at the end of its useful life.
The Big Picture
Bob works for the Bureau of Economic Analysis in Washington D.C. The value of the pizza ovens in a pizza place is easy to see from the owners accounting books. What Bob is interested in is the value of all of the pizza ovens in a whole country. These ovens are part of a nation's capital stock which is all of the capital goods in the country. The capital stock includes not only pizza ovens but a lot of heavy equipment used to make things like cars that consumers buy. It also includes smaller things. Jill is an author who writes novels, the computer she uses to type out her next bestseller is also a capital good. What concerns Bob and the economists he works with is the fact that the capital stock in the country loses value every year, and that has consequences. Capital goods lose value for several reasons:
- Normal wear and tear which is measured by the depreciation of the capital stock.
- Capital goods break down before they are supposed to and become unusable. They can be damaged or destroyed by fire or natural disasters like flooding.
- Capital goods can become technologically obsolete. When the sewing machine was invented 150 years ago, all of the old spinning jennys used to make clothing became obsolete! Technology will continue to make many capital goods used today obsolete as well.
The capital stock in a country is losing value every day. If all of the pizza places in the country stopped buying new ovens for 10 years, the ones they are using now would wear out and no more pizzas would be cooked. Bob is eating a few slices for lunch and finds that worrisome, no more pizza would mean that the standard of living in the country declines. Businesses must keep buying some level of new capital goods or we might have a no pizza disaster!
The Capital Consumption Allowance
The capital consumption allowance (CCA) measures just how much the value of the capital stock in the country has declined in a year. It measures economic depreciation which includes not only accounting depreciation but the other reasons like destruction or obsolescence mentioned before. It is important for Bob and the economists to get a good handle on this number because it can be compared to business spending or investment to see if we are adding enough each year to our capital stock to make up for what we are losing. Let's say the pizza owners in the country spent $500,000 on new ovens last year, while the value of the stock of ovens declined by only $400,000. That would mean that we added to our capacity to cook pizzas!
Likewise the capital consumption allowance for the capital stock of the whole country can be compared to business investment to see if we added to the nation's ability to make products and services for its citizens.
Let's put some of this together into a few formulas. Bob is going to calculate net investment spending it is:
Gross Investment Spending - Capital Consumption allowance = Net investment spending
The CCA is also used to calculate the net national product like this:
Gross Domestic Product - Capital Consumption Allowance = Net Domestic Product
Gross domestic product is the total goods and services produced in a country. Since the CCA is negative production, Bob deducts that from gross national product to get net national product which is how much we really produced overall.
Capital goods are goods used to make the consumer goods and services that we consumers buy. Capital goods are reduced in value to account for wear and tear by accounting depreciation. The capital stock of a country is all of the capital goods in the country. This capital stock loses value each year from wear and tear and other reasons. This loss in value is called the capital consumption allowance (CCA), it is a measure of economic depreciation. It is important that business investment is at least enough to cover the capital consumption allowance or the country's capacity to make consumer goods falls and its standard of living declines. Net investment spending is the addition to a country's capital stock. Its formula is:
Gross investment spending - Capital consumption allowance = Net investment spending
The net domestic product reduces the gross domestic product by the capital consumption allowance to get the net amount of goods and services produced in the economy.
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