Academic journal article Economic Inquiry

Issues in the Measurement of Economic Depreciation: Introductory Remarks

Academic journal article Economic Inquiry

Issues in the Measurement of Economic Depreciation: Introductory Remarks

Article excerpt

I. INTRODUCTION

Most capital goods are used up in the process of producing output. Machine tools wear out, trucks break down, electronic equipment becomes obsolete. When an asset reaches a point at which it is no longer economical to repair and maintain, it is withdrawn from service. As the physical deterioration and retirement of assets cause the productive capacity to decline to zero, a parallel loss in asset financial value occurs. This depreciation of value is a cost that must be subtracted from gross revenue in order to determine the income accruing to the asset. It is also the amount that must be added to the balance sheet in order to keep wealth intact.

These are relatively straightforward distinctions that are routinely used in various fields of economics: in studies of economic growth, particularly in the new growth theory with its focus on the role of capital formation; in environmental economics, with its concerns about sustainable growth; in production theory with the study of capital formation; in industrial organization with issues involving the rate of return to capital; and in public finance, with its interest in the taxation of income from capital. It is therefore perplexing that these important distinctions have been the source of much confusion and error. It is common, for example, to see "deterioration" called "depreciation," though the former is a quantity concept and the latter refers to financial value. Other confusions have led to the inference that there are two logically separate concepts of capital, one appropriate for wealth accounting and the other for the study of productivity and growth.

Part of the problem lies with the historic confusion and controversy within capital theory itself. The controversy is manifest in academic debates over the role of capital in economic growth (viz. the "Cambridge Controversies" in capital theory). A major source of difficulty arises from the fact that, by definition, a capital good yields its services over the course of several years and the fact that capital goods are generally owner utilized. This leads to a fundamental difference vis a vis non-capital inputs like labor and materials that complicates the measurement problem enormously and necessitates the use of imputational methods and approximations to get at the underlying economic prices and quantities. Unlike labor, which is purely an input, capital goods are both inputs and outputs of the production process, and this fact adds yet another dimension to the analysis.

In the spring of 1992 the current state of research on capital, wealth, and depreciation was the subject of a one-day Conference on Research in Income and Wealth symposium, held in Washington D.C. at the Board of Governors of the Federal Reserve under the auspices of the National Bureau of Economic Research. This symposium ranged over many of the issues in the measurement of economic depreciation, and presented both an appraisal of past research and an important set of new results. The five following papers of this issue of Economic Inquiry are devoted to the proceedings of the workshop in the hope that further research interest will be stimulated in this crucial and under-researched branch of economics.

II. ISSUES IN DEPRECIATION ANALYSIS

Given the history of confusion surrounding the concept of economic depreciation, it would seem useful to precede the conference papers with a few introductory remarks about the problem of depreciation. We will start with the simple example of a small manufacturing company that owns three machines: one that was purchased at the beginning of the current year (1996) at a cost of $100,000, one purchased five years ago at a cost of $80,000, and one purchased twenty years ago for $40,000. The three machines are intended to perform the same set of tasks and are essentially the same, except for wear and tear due to age and to design improvements that have occurred over time. …

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