What is Capital Deepening?

Explanation

Capital is the fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more such as plants and machinery or equipment used by the labor to produce goods and services. Production can be increased in the short run by increasing the number of labor employed or by increasing the shifts in production. However, if the scale of operations has to be increased, the fixed investment needs to be increased.

If there is only one machine, only a few workers can work on it without leading to overcrowding, but if the number of machines increases, more workers can work on them and produce more products per unit of time.

Further, mechanization increases the productivity of labor as compared to that when the output is produced manually. It again adds to the output produced.

Capital deepening differs from technological innovation, and the two should not be confused or used interchangeably.

Example

A small car manufacturer with ten workers in his plant could produce five cars a day in an 8-hour shift per day. He expected the demand for cars to grow shorter, and therefore after making a few calculations, he found out that the monthly production would fall short of the monthly demand he could expect.

To capture a greater proportion of the expected increased demand, he bought another assembly line for his factory. This assembly line was in addition to the one already existing, but it doubled its production to 10 cars a day with the same number of workers employed for the same number of hours per day.

It is an example of capital deepening because the assembly line technology was not new for his plant; it was just an increase in the amount of money invested in the fixed assets, which led to an increase in production.

Had the assembly line been a complete innovation for the factory, it would have switched to a more productive technology and would not fall under capital deepening.

One important point here is that the number of workers has not increased, and therefore the capital to labor ratio has increased. Had the number of workers also increased in the same proportion, keeping the capital to labor ratio unchanged, this would have been an example of capital widening instead of deepening capital.

Capital Deepening and Standard Economic Growth

The Standard Economic growth model is, at times, also referred to as the Solow-Swan Model. To understand the model, we need to, first of all, understand what is meant by the Total factor productivityTotal Factor ProductivityThe total factor productivity (TFP) is a number that showcases the productivity of a business by determining how much it produces versus what it needs to spend to achieve that result.read more.

Below is the Cobb-Douglas production function:

Y = AKαL1-α

  • Y stands for outputK is the capital employedL is the labor employedis the elasticity of capitalis the elasticity of labor

Any increase in output due to increased K, L, or will not lead to a technological change. A capital increase would lead to capital deepening.

However, the A is the measure of the state of technology. It represents the total factor productivity of labor. As explained earlier, increasing the investment in the plant, machinery, and equipmentPlant, Machinery, And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more already being used in the manufacturing process are all examples of capital deepening. But the adoption of improved technology is represented by A, increasing the total factor productivity.

For example, using a manual blender versus an electronic blender in a cooking establishment is an example of an increase in total factor productivity. The labor can produce greater output, and the older method becomes obsolete.

Advantages

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  • Better Utilization of Labor: When labor produces manually, their marginal product is lower. However, if the same labor is given the equipment, which can increase his marginal productMarginal ProductThe marginal product formula can be ascertained by calculating the change in production level and then dividing the same by the difference in the factor of production. In most cases, the denominator is 1, based on every 1 unit of increment in an aspect of production.read more, then the total output per unit of labor or per unit of time increases.Higher Contribution Margin: The same labor is employed, so the wages are not impacted. More machinery, tools, and equipment are employed so greater output. Therefore, the variable cost falls per unit, and the contribution margin or the difference between the selling price and variable cost decreases.Lower Taxes: Increase in investment in fixed assets increases the depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.
  • read more charges shown on the income statement. It can lead to a reduction in taxable profits, and therefore the firm has to pay lower taxes if the increase in gross profit is lower than the impact of an increase in depreciation.

Conclusion

Capital deepening implies investing more money in increasing the plant, machinery, tools, and equipment, thereby increasing the production unit’s capital to labor ratio. It aims to increase the marginal productivity of the labor employed and increase the total output produced by the same labor.

This has been a guide to what capital deepening is and its definition. Here we discuss an example and economic growth of capital deepening and advantages. You may learn more about financing from the following articles –

  • Economic Growth vs Economic DevelopmentCost of LaborLabor IntensiveDirect Labor Costs