Capital is one of the commonly misunderstood idea in the business and economic environment. We hear people refer capital to variety of things and it seems every time they refer it to a different thing. My goal is to explain what it is and remove any misconception wrapped around this important idea. What explained here is based on not the way I think about it but instead from the best people in this subject area.
Capital is important because it is one of the factors of production along with land, labour and enterprise. Without capital it is not possible to produce anything. If you have an idea of a product then you will need capital in order to produce it.
Investopedia defines capital as ‘financial assets or financial value of assets, such as funds held in deposit account, as well as tangible machinery and production equipment used in environments such as factory and other manufacturing facilities.’
What they mean is: All form of money in your bank account, monetary value of assets use for producing things and factories itself are seen as capital. I saw most people have difficulty of knowing capital, and I think it is important to know how to identify and differentiate what is capital and what is not capital.
Anyone who is not in business would say capital is money or money is capital. This is not completely wrong. But there is more to it.
‘What capital does for production, is to provide the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process.’ John Stuart Mill
Unlike investopedia, Mill talks about what capital does instead of what capital is. This is much more practical way of describing it. Let me show a real world working example of capital in production.
Choose any of the resort in Maldives you go there by a speed boat. From speed boat you step on the jetty and then walk to the reception where they already assigned a room for you. At the reception you pay for the room. After that they give you the key and then take you to the room.
Each of this process operates because of capital. Speed boat, reception, room, cash etc. are all capital. In an operating business everything that enables production is a capital. For a business that is just going to start has no capital other than cash. They have to exchange cash with machinery, labor and other things required to run the business.
Take a look at farming. A farmer who has a land applies capital in to different uses. He use labor, seeds, water, spades and hoes to produce fruits and vegetables. Here the idea of capital is used metaphorically. Farmer employ different form of capitals for different areas of production. Each industry uses capital that are suitable for the production of that particular industry. There are capitals such as labor and money required in every industry.
Therefore capital is not only cash in hand or bank. It also consists of anything that helps producing goods or services.
Principles of Political Economy and Taxation – John Stuart Mill
Principles of Economics 9th Edition – Alfred Marshall
Wealth of Nations – Adam Smith