DEFINITION of ‘Physical Capital’
Physical capital is one of the three main factors of production in economic theory. It consists of man made goods that assist in the production process, like machinery, office supplies, transportation and computers.
BREAKING DOWN ‘Physical Capital’
In economic theory, factors of production are the inputs needed to engage in the production of goods or services in pursuit of profit. Economists have sometimes disagreed about the exact contours of each category, but there are generally said to be three main factors of production:
- Land or natural resources: This is both the land on which factories, shipping facilities or stores are built and the natural resources of a production process, like the corn needed to make tortilla chips or the iron ore which is used to make steel.
- Human capital: This includes labor as well as other resources that humans can provide – education, experience or unique skills – which contribute to the production process.
- Physical capital: Manmade goods which enable the production process, like machinery, buildings, computers and other goods needed for the production process to run smoothly.
New or startup companies have to invest in physical capital early in their lifecycle, often before they have produced a single good or landed a single client. This can have many different applications. For example, a company that manufactures microwave ovens will have to make a series of investments before it can expect to sell a single microwave; it must build a factory, purchase the machinery it needs to manufacture the product and it must manufacture some sample microwaves before convincing any stores to carry their product.
The accumulation of physical capital with established firms can make the investment required to catch up a major barrier to entry for new companies, especially in manufacturing-intensive industries. The diversification of physical capital is a good way to judge how diversified a particular industry is. From the perspective of physical capital, starting a new law firm is much easier than opening a new manufacturing plant – theoretically, an attorney would only need an office, a phone and a computer. Consequently, law firms outnumber steel manufacturers by a significant margin.
It has long been agreed that physical capital is an important consideration in a company’s valuation, but it is also one of the most difficult assets to evaluate. It is considered fixed capital, which is appropriate in that something like manufacturing machinery has long-term value and is relatively illiquid, since it is usually only designed to fulfill a particular purpose. On the other hand, the value of physical capital can change over the years, or can increase in value with upgrades to the asset itself or with changes to the firm that affect its value.