Articles on Islamic Economics

Some Observations on User Cost of Capital

Salman Ahmed Shaikh

Mainstream economics defines physical capital stock as things that are ‘produced means of production’. Examples of physical capital stock include machinery, tools, equipment, buildings, fixtures, infrastructure, installations and production plants, for instance.

In a market economy, physical capital is either traded or rented. But when it comes to the price of capital, the user cost of capital along with depreciation takes real interest rate as the price of capital.

UC = Pk (r + d)

UC is user cost of capital,

Pk is purchase price of capital stock,

r is real rate of interest,

d is the depreciation rate.

In the intertemporal transfer of money in the loanable funds market, interest is legally regarded as the price of capital. However, it does not answer the philosophical and deep question of Thomas Aquinas as to what is the right price of money.

The contemporary view takes interest based financial intermediation as a given and exogenous. Given the existence of interest based financial intermediation, real interest could be used as the price of use of physical capital stock with opportunity cost concept.

If Rs 1,000 earn 10% rate of interest in bank account, then Rs 1,000 invested in machinery should yield at least 10% for justification of efficient allocation of resources. But, the legal, moral and philosophical base of ‘interest based financial intermediation’ still needs justification.

From the economic standpoint, there are following problems in interest based financial intermediation and its subsequent effects on goods markets and resource markets.

i)            It ignores the negative externality imposed through inflation on people. Interest paid is added in cost and through transfer pricing, it is paid by the people eventually.

ii)          It discourages investment in socially optimal profitable projects, but which are not favored because of relative cost comparison from the market interest rate.

iii)        It compels firms to engage in aggressive advertising and promote consumerism to meet interest cost. In most cases, selling small number of units will not allow benefit from leveraging and meeting interest cost. Hence, firms have no choice than to promote as much sales as possible.

iv)        If sales do not increase, it may lead to business cycle fluctuations with unplanned increase in inventories.

v)          With increased pressure to service debt, the environmental degradation and human resource exploitation may become common and secondary concerns.

vi)        It results in skewed distribution of income and wealth with guaranteed return to capitalists and uncertain return to the real sector entrepreneurs who are burdened to provide incessant increase to capitalists.

vii)      It supports only the wealthy entrepreneurs who are able to afford interest payments right from the start through their entrepreneurial pursuits and who already own capital that can be used as collateral. This will affect the kinds of entrepreneurial investments they make and hence allocation of resources.

viii)     With barriers to entry due to restricted availability of funds for investment in real sector, the real sector could result in increased market concentration in large scale businesses.

ix)        It may result in other negative externalities. For instance, increased income inequality, poverty and below full employment use of real scarce resources resulting by artificially making capital scarce.

x)          Increased printing of fiat money by borrowing on interest will jeopardize the welfare of future generations. With no afterlife accountability, no policy maker or institution can incorporate infinite decision horizon and accountability to future generations. This may create the problem of moral hazard.

1 reply »

  1. Interest rate is economically not viable and it is only the exploitation of borrower and in case of factors of production, if we consider it as a cost of capital, then there will be guaranteed return on it even in case of loss. So in this case, it will be the exploitation of labor. So interest rate is not the cost of capital.

    Cost of capital is money which is paid by the entrepreneur and reward will be the profit. In case of physical capital, the cost will be again money and depreciation of capital and in case of profit, its return will be the rent and in case of return, it will get nothing like other factors of production.


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