Part II. Capital, Interest, and Profits

In Part II I consider some of the more traditional areas of capital theory. Chapter 4 discusses the nature of capital. It is a curious fact about the concept of capital in economics that economists still disagree about what it is. A brief historical overview suggests that this probably has something to do with the evolution of the concept in the context of economic evolution more broadly. The transition from a predominantly agricultural economy to a predominantly industrial one, and then to an increasingly “information-based” one, has occasioned changes in the way in which economists and others have thought about production, and therefore about capital. Sometimes concepts appropriate for one context have been transplanted to another with unfortunate consequences. We begin with a look at Adam Smith’s corn economy, and note its influence on Ricardo and those who followed him. We contrast the Ricardian approach with that of Carl Menger and the Austrian School. The most space is devoted to Böhm-Bawerk, arguably the most influential capital theorist of all. In Chapter 5 I look briefly at modern capital theory in the production function literature and the work of the Cambridge neo-Ricardians. We will find, surprisingly, that both are in the Ricardian spirit.

In Chapter 6 I examine the recent work on capital theory of John Hicks. Hicks struggled his whole professional life to reconcile various approaches to capital theory. In his last extended attempt he provides a very interesting and useful framework for thinking about capital values in and out of equilibrium.

In Chapter 7 I turn to a discussion of the nature of interest as a phenomenon. The nature of capital is bound up with the fact that production occurs over time. So the question of the relative valuations of useful outputs at different points of time arises. Does time itself exert an influence in determining the relative value of things? Indeed, we find that the fact that people are not indifferent to the date at which they obtain useful things is the essential explanation for the existence of the discounting of the future which is the basis of all capital valuations. This allows us to distinguish interest, which is an expression of this time discount (time preference), from profit.

Profit is seen to be the result of uncertainty. It is the reward for being right in an uncertain world, for discovering an “opportunity” that others had overlooked. Traditionally it has been approached by examining a world in which it would not exist, a world devoid of uncertainty. In such a world all incomes are certain and can be the basis of known contractual relationships. Such incomes are composed in the aggregate only of the payments for the services of the original factors of production, land and labor, which are wages and rent, and of “pure” interest. When we move from such an economy to the real world we can then understand that profit is what is left over after these “contractual” payments have been made. Profit is thus clearly distinguished from interest and rent (on physical capital).

I conclude with some observations connecting the capital processes (the processes of production) to planning processes more generally and as explored in the previous chapter. This lays an important basis for our discussion of disequilibrium theories of capital in Part III.