User Cost
User cost is the cost to a firm of using a unit of capital for a period, comprising the interest cost of the funds tied up in the capital, the depreciation of the asset, and any change in its value. It is the relevant cost in the firm's decision about how much capital to employ.
Components
User cost includes the interest cost, the opportunity cost of the funds invested in the capital. If the firm borrows to finance the capital, the interest cost is the explicit interest paid. If it uses internal funds, the interest cost is the return forgone on alternative uses.
Depreciation is the loss of value of the asset through use and obsolescence, and it is a component of user cost. Any expected change in the price of the asset is also included, since an appreciation reduces the cost of holding the asset and a depreciation increases it. Tax treatment, including depreciation allowances and investment credits, affects the after-tax user cost.
Investment Decision
The firm invests up to the point at which the marginal product of capital equals the user cost. This condition determines the desired capital stock, and investment is the adjustment of the actual stock toward the desired level. The user cost therefore links the cost of capital to the demand for capital and to investment.
Changes in user cost affect investment. Higher interest rates, higher depreciation, or lower tax allowances raise user cost and reduce the desired capital stock, lowering investment. The analysis of user cost informs the evaluation of policies that affect investment, including monetary policy and business taxation.
Empirical Estimation
Estimating user cost requires data on interest rates, depreciation rates, asset prices, and tax parameters. The estimates are used in empirical analyses of investment and in the evaluation of tax reforms. The results depend on the specification of the tax system and on assumptions about expectations of future prices.
The measurement of user cost is complicated by the heterogeneity of capital assets, which differ in depreciation rates and in tax treatment, and by the difficulty of measuring expectations of future prices. These complications affect the precision of estimates and the interpretation of results.
Applications
User cost is central to the analysis of investment, of capital taxation, and of the cost of capital. It informs the design of tax systems, since the tax treatment of capital affects user cost and thus investment. It also informs the analysis of monetary policy, since interest rate changes affect user cost and investment.
The concept is applied in the analysis of housing, where user cost includes mortgage interest, depreciation, property taxes, and expected capital gains, and in the analysis of business investment, where it informs the assessment of the effects of tax reform and of changes in interest rates.
User Cost and the Rental Price of Capital
User cost is closely related to the rental price of capital, the price at which capital services are rented in a competitive market. In equilibrium, the rental price equals the user cost, since owners of capital must earn a return that covers the cost of holding and using it.
The relationship clarifies the conditions under which markets for capital services clear and the factors that determine the return to capital. It also informs the analysis of investment, since the firm's decision depends on the comparison of the marginal product of capital with its user cost.
Taxation and User Cost
The tax system affects user cost through depreciation allowances, investment tax credits, and the taxation of corporate income. Generous depreciation allowances and credits reduce user cost and encourage investment, while high corporate tax rates raise it and discourage investment.
The analysis of the effects of tax reform on investment relies on the calculation of user cost under different tax regimes. The estimates inform the evaluation of proposals to change the taxation of capital and the assessment of their likely effects on investment and growth.
Uncertainty and Irreversibility
Uncertainty and irreversibility affect the investment decision beyond the standard user cost calculation. Where investment is irreversible and uncertainty is high, firms may delay investment, because waiting preserves the option to avoid a poor outcome. The effective cost of investing includes the value of the option forgone.
The analysis of investment under uncertainty extends the user cost framework to incorporate the option value of waiting. It explains why investment may be depressed during periods of high uncertainty, even when user cost is low, and it informs the design of policies to support investment.
Applications in Housing
User cost is applied in the analysis of housing, where the cost of owning a home includes mortgage interest, property taxes, depreciation and maintenance, and the expected change in the value of the property. The comparison of user cost with the cost of renting informs the decision to own or rent.
The analysis of housing user cost informs the assessment of policies that affect housing markets, including tax treatment, mortgage regulation, and rent control. It also contributes to the understanding of housing booms and busts and of the role of expectations in property markets.