Saturday, January 26, 2013

Capital as sunk cost

Commenter Gregg wants me to explain why every advanced capital-intensive industrial economy (ACIIE) needs to socialize investment. The primary source of my belief on this issue is Michael Perelman's Railroading Economics. It's been a while since I've read the book, so I'm not sure what's his argument directly, and what's my interpretation.

First, let me define my terms. An advanced capital-intensive industrial economy (ACIIE)is an economy where capital investment in many sectors is large enough such that if the capital had to be paid for in full up front, the firm would be uneconomical in the short run. However, if we can amortize the capital costs over the long run, then the business becomes economical.

(click for larger image)

What the above graph shows is the supply and demand schedule for a firm. I'm assuming linear demand and marginal cost curves, and three average total cost curves: one with all the capital paid up front, one with no capital payments (just fixed and variable costs), and one with an amortized payment of capital. The return on investment (~3% p.a.), amortized yearly, is chosen intentionally to make the average total cost with capital payments equal to the marginal cost at the equilibrium.* The equilibrium price is 70 per unit at 41 units per year, the ATC without capital costs is 41 per unit, the operating profit is, on average, 29 per unit.

Long-run competition will ensure that the cost of capital for the sector will move the ATC to the marginal cost at the equilibrium quantity/price.

In a truly laissez faire economy, everything has to be cash on the barrel-head. There's no way to enforce a long-term contract. If I have to pay cash on the barrel-head for my capital, I don't turn a profit until the middle of the 8th year. And that's assuming a relatively steep supply curve. If the supply curve is flat (no diseconomies of scale), then my average total cost excluding capital costs is nearly equal to my marginal cost, and I never make a profit, because annual ATC then equals MC, and the average total cost over the lifetime of the capital is MC + CC/Q, which is greater than MC. (And even if I could make a profit over the ten year lifetime of the capital, long-term competition would ensure that someone would try to undercut me for a little less profit, and someone would try to undercut her, and so forth, until sector was making a penny total profit over ten years.)

It's important to note that minarchism is not a truly laissez faire economy: a truly laissez faire economy has no forcible government intervention at all, and forcible government intervention to enforce a long-term contract is, well, forcible government intervention.

Because capital is a sunk cost (indeed, all fixed costs are sunk costs), no one can make money by investing unless we have a political, i.e. non-economic, way of recovering capital costs. Capitalism is one such way of socializing capital costs; socialism and communism are also ways of socializing capital costs.

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