No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Sixteen: Valuing the Future - Concepts in Capital & Finance 394 Every production process takes place in time —they don’t just take time . Yes the amount of time passage is important (as you’ll see in this chapter), but being a process in time means that each moment will be coincident with new knowledge gained. This is knowledge of consumer preferences which are continuously being formed, adjusted and shaped, knowledge of business suppliers’ complementary capabilities, knowledge of new technological possibilities that could affect production processes, etc. Being in time means that expectations are in play in decisions made at every step of the production process. All of these aspects of change which occur in time will potentially affect our valuation of capital assets. The higher order goods identified in chapter 7 are part of what we identify as capital goods : goods used in production of consumer goods. But physical items that we often call “capital” (such as a hammer, robot, or a store building) aren’t truly capital outside the plan of an entrepreneur. Capital assets only truly become capital when they are embedded in an entrepreneur’s plan for production; in a plan that is necessarily limited in the information that an entrepreneur may have in an uncertain future; in a plan that will be frequently revised as the entrepreneur gains more knowledge. The uncertainty that confronts every entrepreneur is highlighted in Proverbs 16:9: “The mind of man plans his way, but the Lord directs his steps.” Or as the common phrase says, ‘man proposes, but God disposes.’ We do our best to plan for the future, but circumstances will change, new knowledge will be gained, and the entrepreneurial function of appraisal will be critically necessary. As time passes, should capital be redeployed? To answer this question, we can compare valuation of capital assets embedded in entrepreneurial plans. Part of the reason that the plans will be adjusted is that many entrepreneurial plans are necessarily in conflict: two (or more) entrepreneurs may be trying to capture a potential market. Every day there are entrepreneurs trying to meet consumer needs ahead of their competitors; often only one (at most) will succeed in his or her plan. It works in the other direction Capital assets only truly become capital when they are embedded in an entrepreneur’s plan for production. Capital goods: goods used for the production of end- use (or 1st Order goods) consumer goods. HETEROGENEITY OF CAPITAL Heterogeneity. Wow, I bet you won’t pull that word out for your date this weekend! But it is a very important word in economics. Even the earliest economists understood that capital assets were very dissimilar, in that their usefulness outside their primary purposes was limited, sometimes only useful for scrap material. Nevertheless, they abstracted away (ignored) from this heterogeneity and assumed capital was homogenous (or substitutable). This made for tractable models and was not necessarily a bad assumption in the very long run, when redeployment of capital from one industry to another is more easily done. But in the real-world decisions that entrepreneurs actually make, homogenous capital is a fantasy. The assumption of homogeneity allows the value of capital assets to be added up, such that all investment in capital is good, since the total of capital in the economy will be higher. Further, homogeneity of capital leads to thinking that capital released in one area can be costlessly transferred to another use. If capital is all the same, that would be true—homogeneous capital is substitutable capital (i.e., one unit of capital is just as good for any purpose as another). But heterogeneous capital is complementary capital (i.e., one capital asset will be paired with other different capital assets as part of an overall entrepreneur’s plan). Investment in new capital may reduce the value of other capital assets.