Physical Capital

Article byPeter Johnson
Reviewed byDheeraj Vaidya, CFA, FRM

Physical Capital Definition

Physical capital refers to tangible assets used to develop or build final goods and services. It is an essential element for most manufacturing processes. Unlike human capital, its value can diminish over time because of the continuous use of physical items, such as machines, equipment, vehicles, computers, buildings, etc., in production.

Physical assets constitute one of the three fundamental factors of production alongside land or natural resources and labor or human resources. The term can describe human-made items that a company purchases or invests in to create finished products or services. It can be – fixed with long-term value, or the working, depending on its nature.

What is physical capital

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Key Takeaways

  • Physical capital meaning refers to tangible assets made by humans that a corporation buys or invests in and then uses to produce finished goods or services.
  • It is one of the three factors of production together with land or natural resources and labor or human resources, involving physical assets, such as machines, cars, computers, buildings, etc.
  • It is distinct from human capital in the former refers to tangible assets like equipment and real estate, while the latter refers to intangible assets like people’s expertise and talents.
  • Economists believe that access to physical assets is directly proportional to the output generated and use aggregate production function to explain this.

Explanation Of Physical Capital

Physical capital in economics is one of the three factors of production. It comprises lasting, man-made, non-financial assets utilized in manufacturing goods and services from raw materials. It is critical for the economic activities of a business and a nation’s real GDP growth. Physical assets necessitate a significant amount of capital from entrepreneurs during the earliest stages of production and hence may pose challenges for start-ups.

Importance of physical capital

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Physical capital is crucial for determining a company’s valuation, but it is also illiquid, customizable, and purpose-oriented. As a result, it may become difficult for a business to assess and measure it. Furthermore, tangible assets can lose their value over time due to natural depreciation. For example, a machine in a manufacturing plant will inevitably start to malfunction over some time. Moreover, the merger and demerger of a company can also affect the value of its physical capital.

The best way to understand what physical assets is to break them down into two parts:

  • Physical: It signifies any material or object that is touchable or tangible.
  • Capital: In economics, capital refers to any human-made goods used in production. The capital was a prominent theme in Scottish economist Adam Smith’s book “The Wealth of Nations,” focusing on how capital is necessary for economic progress and prosperity.

Therefore, Physical + Capital = Real assets used in the manufacturing of goods or services.

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Types Of Physical Capital

Physical capital is often broken down into two different types, including:

Types of physical capital

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  1. Working Capital: Working capital refers to a company’s liquid assets, such as cash and inventory in hand, or anything that can be swiftly changed into currency.
  2. Fixed Capital: Fixed capital can be thought of as physical investments in producing a good that can be used on several occasions or at least multiple accounting periods. Since it is fixed and reusable (e.g., buildings and machinery), it cannot readily be converted to cash. Although it is not consumed during the manufacturing process, it has a long-term value that can fluctuate and, in most cases, deteriorate with time.

Physical Capital As A Factor Of Production

Adam Smith proposed three factors of production in his classical economics theory, such as:

Factors of Production

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  1. Land and Natural Resources: It includes the land and any natural resources found on it, for example, oil, minerals, and water. While the real property involves constructing manufacturing, shipping, and storage facilities, raw materials like potatoes go into finished goods like chips.
  2. Human Capital or Labor: Labor is the work done by individuals during the production process that leads to final goods. For example, someone involved in the manufacturing of steel from the iron ore. Also known as human capital, labor utilizes skill, experience, and knowledge to accomplish a task.
  3. Physical Capital: Physical assets include material assets used during the production of products or services.

‘Entrepreneurs,’ according to some economists, are the fourth factor of production as they put other variables together to create the final product.

Aggregate Production function

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Today, economists use the aggregate production function to explain economic growth, i.e., the real GDP of a nation. It also tells how physical assets and worker input affect total output. The formula is as follows:

Y = F (K, L, N)

Where:

Y = Aggregate production function

F = Production function

K = Physical capital

L = Human resources/Labor

N = Land/Natural resources

According to this equation and Smith’s theories, total production increases when workers have greater access to physical capital.

Examples

Let us look at the following physical capital examples based on its two types to understand the concept better:

Example #1: Car Production (Fixed Capital)

Let us take a closer look at the production process for the automotive company Toyota. According to information from Toyota’s website, its production process comprises four stages:

  1. Stamping
  2. Welding
  3. Painting
  4. Assembly

The stamping process uses complex machinery to stamp or prints the body parts of the vehicle. After the stamping is complete, robotic arms will start welding the various printed parts together. Next up is the painting portion of the production. First, the body is dipped in paint, and then the vehicle is put through a series of automatic robot painting procedures. Once that is complete, workers will assemble the rest of the car using various tools and equipment. In this case, the fixed physical capital for Toyota will be the following:

  • Factory housing the production process
  • Tools and equipment assembling automobile parts
  • Robots completing various tasks
  • Machinery used to move vehicles along
  • Technology controlling the machinery

Example #2: Landscaping Services (Working Capital)

Let us consider the case of a company that provides lawn mowing services for landscapes. Here, the working capital for the business can be:

  • Equipment used (i.e., lawnmower, weed wacker, trimmers, etc.)
  • Truck to get to and from jobs
  • The building that houses the equipment

The type of landscaping services the company provides will determine the amount of additional working capital required. For example, if it cuts down trees, tools such as a chainsaw would be considered physical capital that can be sold for cash.

Human Capital vs Physical Capital

Capital is crucial for the smooth functioning of any manufacturing business. It typically consists of physical capital and human capital and requires considerable investments. While the former includes tangible assets such as equipment and property, the latter involves intangible items such as human expertise and capabilities. The other subsets of the capital are financial, knowledge, and social. Let us look at the differences between the physical and human capital:

Physical capital vs Human capital

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Human CapitalPhysical Capital
Value addition done by human resourcesDevelops and builds finished products and services
Includes knowledge, skillset, experience, and ideasRelies on raw materials for production
Refers to labor, working hours, and other resourcesInvolves equipment, machinery, building, etc.
Not limited to manufacturing processesMostly seen in the production processes
Intangible and complex to measureTangible and simple to measure
Measured against the quality of the final product or serviceMeasured against the market value of the finished goods or service
Cannot be separated from its owners as it is a part of the individualCan be separated from its owner (individual)
Can be used for multiple purposes, not just businessOnly beneficial to the company (or individual) that deploys it
Value increases with timeValue can depreciate over time
Does not appear on the balance sheetVisible on the balance sheet
Cannot be sold at any costCan be sold for cash quickly
International mobility is complicated due to immigration lawsInternational transportation is easy, except for trade barriers

Frequently Asked Questions (FAQs)

Why is physical capital important?

Physical capital is one of the three main factors of production like land and natural resources and human resources or labor. It can help determine the total output and business economic activities and the growth of a nation’s real GDP.

What are the items that come under physical capital?

Equipment, machinery, computers, buildings, and other assets created by humans to produce goods or services from raw materials belong to the physical capital. A machine made to design and make bottles of a specific shape is a perfect example of it.

What is the advantage of increased physical capital?

Physical capital is a class of tangible assets used in the production of finished products or services. An increase or upgrade in these assets can result in better productivity and more profits.

This has been a guide to physical capital and its definition. Here we discuss its explanation, types, and role as factors of production, along with examples. You may also learn more about financing from the following articles –

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