Capital Consumption

Capital consumption is the depreciation of the capital stock, the reduction in the value of fixed assets due to wear and tear, obsolescence, and accidental damage. It is a central concept in national accounting, where it is used to convert gross measures of output and income into net measures.

Definition

Capital consumption is the amount of capital that is used up in production during a period. It represents the investment required to replace the capital that has been consumed, so that the capital stock is maintained at its existing level. In the national accounts, capital consumption is known as consumption of fixed capital.

The concept applies to fixed assets, including machinery, buildings, and infrastructure, and to other assets that are used repeatedly in production. It does not apply to inventories, which are treated separately, or to natural resources, whose depletion is recorded as a separate item.

Gross and Net Measures

Capital consumption is the difference between gross and net measures of output and income. Gross domestic product measures output without deducting capital consumption, while net domestic product deducts it. Similarly, gross national income differs from net national income by the amount of capital consumption.

The distinction matters for the interpretation of economic performance. Gross measures overstate the sustainable level of consumption, because they do not account for the capital that must be replaced. Net measures provide a better indication of the income that can be consumed without reducing the capital stock.

Measurement

Measuring capital consumption requires estimates of the capital stock and of its rate of depreciation. The perpetual inventory method is commonly used, in which the capital stock is estimated by accumulating past investment and applying depreciation rates to each vintage of investment.

Depreciation rates are typically estimated from asset-specific studies and applied to the capital stock. The estimates involve assumptions about asset lives and depreciation patterns, and they are subject to uncertainty. The resulting measures of capital consumption are therefore approximate, and comparisons across countries require consistent methods.

Significance

Capital consumption is significant for the analysis of growth and of sustainability. A country that invests less than its capital consumption is consuming its capital stock, a process that cannot continue indefinitely. A country that invests more than its capital consumption is adding to its capital stock, supporting future output.

The concept also informs the analysis of productivity, since measures of output and capital must be consistent in their treatment of capital consumption. It informs the assessment of fiscal policy, through the treatment of depreciation in the measurement of the deficit, and of corporate finance, through the treatment of depreciation in the measurement of profit.

Depreciation Methods

The measurement of capital consumption depends on the assumed pattern of depreciation. Under straight-line depreciation, the value of the asset declines by an equal amount each period. Under declining-balance depreciation, the value declines by a constant proportion, so that the decline is faster in the early periods.

Other patterns include sum-of-the-years-digits and asset-specific profiles derived from empirical studies. The choice of pattern affects the estimated capital consumption and the resulting measures of net output and income. Different patterns are appropriate for different types of assets.

Perpetual Inventory Method

The perpetual inventory method estimates the capital stock by accumulating past investment and applying depreciation to each vintage. The method requires long time series of investment and estimates of asset lives and depreciation patterns.

The resulting estimates of the capital stock and of capital consumption are used in the analysis of productivity and growth. The method is widely used by statistical agencies, though the estimates are sensitive to the assumptions about asset lives and depreciation.

Capital Consumption and Growth

Capital consumption affects the interpretation of growth. A country with high gross investment but equally high capital consumption may be adding little to its capital stock, while a country with lower gross investment but lower capital consumption may be adding more.

The analysis of growth must therefore consider net investment, the difference between gross investment and capital consumption. The measure of net investment provides a better indication of the addition to the capital stock and of the sustainability of growth.

Sustainability

Capital consumption is central to the analysis of sustainability, since a country that consumes more than it produces is depleting its assets, whether physical or natural. The concept of genuine saving extends the analysis to include the depletion of natural resources and the accumulation of human capital.

The measure of genuine saving, or adjusted net saving, provides an indication of whether a country is on a sustainable path. The analysis informs the assessment of development strategies and of the design of policies to promote sustainability.

See also

• Gross Capital Formation
• National Accounts
• Net Domestic Product