Lecture 12

Markets for other resources

Value of capital stocks

• People want to own capital stocks because they expect them to be productive over some time period into the future

• How do we find out whether to buy an asset makes sense or not?

• We need to look at the cost of the asset and the present value of future benefits and costs of this asset.

• How?

Present value of future funds

• You should make the investment into, for instance, a machinery, if the PV of returns in the future is greater than the cost of making the investment.

• Therefore, we need to know how to calculate the PV of future returns (and, if any, of costs)

Present value of future funds

Risk vs. uncertainty

• Risk: The exact outcome is unknown, but the chance of

each possible outcome occurring is known

• Uncertainty:The exact outcome is unknown, and the range of

outcomes and/or their probabilities of occurring are also unknown

Manufactured capital in the traditional neoclassical model

Should natural capital be treated differently?

• Natural capital stocks include both renewable and non-renewable resources

• How should these natural capital stocks be valued?– Economistic view: These resources are seen a valuable only

to the extent that they contribute to profitability (Ex: an animal species for which there is no use profitable to humans can be destroyed at zero cost)

– Ecological view: Natural resources are valued for the long-term survival of life on this planet (Ex: Extinction of a species is a problem even though it has no direct market value)

Should natural capital be treated differently?

• Economistic point of view is based on market conditions:

Larry Summer (chief economist in the World Bank at the time) stated in his 1991 Memo:

• Toxic wastes should be dumped in low-wage countries!!

• Why? Because the environmental costs (measured in terms of wages lost due to poor health and death) would be lowest there!!!

Markets for financial capital• Firms borrow money (bonds) or sell stocks in order to finance

business start-ups or expansions or they use their retained earnings (profits that a company keeps for its own uses)

• Bonds:When a large business sells bonds, the buyer of the bonds provides

money to the company and, in return,

he/she receives a promise that the company will pay him/her a fixed amount of money each year for a period of time and at the end of this time, will repay the principal amount.

• Stocks:When large companies sell stocks to raise money, the shares give the

buyers a claim to ownership in this company (but the repayment of the money to the buyer is not guaranteed)

Markets for financial capital

• Why does anyone buy a stock?

The hope is that the company will prosper and the stockholder will benefit from this prosperity.

• This benefit can take two forms:– Dividends: a portion of the company’s profits will be

distributed to stockholders in cash– If total value of the company rises, stock prices rise,

and value of stockholdings increases. The holder can sell the stocks and realize capital gains.

Markets for financial capital

• As long as other people believe that a company is going to be profitable, shareholders can find a buyer for their shares at a good, or even, rising price.

• Speculative bubble: People’s mutually reinforcing optimism causes stock values to rise far above any value that could be rationalized in terms of actual assets and profitability of the firm.

• One short note about financial capital:Financial markets can be viewed as markets in the means of

acquiring a factor of production. Financial capital is not a factor of production itself!