A PPE NDIX 6.

Gross and Net Capital Stocks

It was noted in chapter 6, section I, that the notion of capital value is quite different from
that of capital-as-physical-goods. This difference has important implications for the appropri-
ate measure of the capital stock. Consider a computer costing $2,000 which lasts four years, and
suppose annual depreciation is calculated as $700, $505, $432, and $365 over the four years. I
will return to the method by which depreciation was calculated, but for now it should be noted
that the numbers shown are rounded off from more detailed calculations, so that adding them
may occasionally give small differences from the listed numbers. Then over the four years, the
beginning-of-year capital tied up in the machine itself will be $2,000, $1300, $796, and $365,
while the accumulated depreciation will be $700, $1205, $1635, and $2,000, respectively. At
any moment of time, the sum of the corresponding flows in these two streams is always $2,000.
From the point of view of an ongoing business, which Marx adopts, the capital value initially
invested in plant and equipment ($2,000) returns gradually to its money form as the fixed as-
sets depreciate. These accumulated depreciation allowances may be held in the form of cash or
financial assets, or even reinvested. But, in either case, they count just as much as part of total
capital value as does the depreciated value of the machines, for it is the recovery of the sum of
the two which allows for the continuation of the enterprise. Thus, for each year of the life of the
machine the capital value invested in it is 2,000.1
In national accounts, this concept is known as the “gross capital stock.” It is independent
of the manner in which depreciation allowances are allocated, which is precisely its vir-
tue. As noted in the OECD manual on capital stock estimation, in this case a capital good
is “valued at ‘as new’ prices—i.e. at the prices for new assets of the same type” over its
whole useful life. These “‘as new’ prices are obtained by revaluing assets acquired in earlier
periods using price indices for the relevant type of assets.” The resulting measure “has sev-
eral analytic uses in its own right . . . [since it] is widely used as a broad indicator of the
productive capacity of a country . . . is often compared with value added to calculate capital–
output ratios . . . [and is used] to give measures of profitability for a sector or the economy”
(OECD 2001, 31).
The depreciated value of a machine, on the other hand, corresponds to the “net capital stock.”
In general both the unit value added and the unit profits on a machine will decline as it ages, due

1
Incidentally, if some of the depreciation allowances were held as interest-bearing assets, this would
not change the profit stream from the computer use, although it would raise the “other income”
stream for lenders and lower it for borrowers. The profit rate would not be altered thereby, al-
though part of it may take the form of (positive or negative) net interest paid. Businesses understand
this well.

801
 802 Appendix 6.3: Gross and Net Capital Stocks

to loss of efficiency, more frequent repairs, and so on.2 Suppose gross unit value added is $1,200,
$900, $700, and $500, and unit profit $1,000, $700, $550, and $420, over the lifetime of the
machine.3 Subtracting depreciation from each of these will give the corresponding net outputs
and net profits, as shown in appendix table 6.3.1. The first row shows the initial investment,
which is carried on the books for the lifetime of the machine. Hence, this is the beginning-of-
year gross stock. The second row is depreciation, whose calculation will be addressed shortly.
The third row is beginning-of-year net capital stock, which in the first year is the same as the
gross stock, and in subsequent years is the previous year’s net stock minus the previous year’s
depreciation4 (the numbers shown are rounded off, so they do not add exactly to the whole
numbers shown). The next two rows are gross value added (output minus cost of materials)
and gross profits, that is, cash flows (gross value added minus labor costs). The remaining four
rows are the output–capital ratios and profit rates for gross and net stock measures, respectively.
The table illustrates a case in which the gross stock measures of the output–capital ratio and
the rate of profit fall as the machine ages. Yet the corresponding net stock measures show a rising
output–capital ratio and an exactly constant profit rate (15%) because in this example the rule
used to calculate depreciation happens to yield a net value for the machines which declines in
proportion to its mass of profit. This is precisely the manner in which fixed capital is treated in both
neoclassical theory and Sraffian theory. It follows that over the lifetime of a single capital good the
net stock output–capital ratio and rate of profit will generally be biased upward relative to their
gross stock counterparts.
The neoclassical rationale for calculating a net capital stock whose movements are tied to
those of profits rests on the claim that under “the assumptions of equilibrium, perfect compe-
tition, and perfect foresight” (Harper 1982, 38), the price of any capital good is equal to the
present value of its future income stream.5 Given a particular stream of profit, the machine’s use-
ful life is determined by the point at which its profit drops to zero. The corresponding internal

2
Unit value added = unit price – unit materials costs, and unit profit = unit value added – unit labor
costs. Thus, if physical output falls off for given material inputs, the rise in unit materials costs will
squeeze unit value added. The same thing will occur if the unit price of a given type of machine falls
over time due to cost-reducing technical change and/or its growing obsolescence in the face of new
types of machines. Unit profits will be squeezed for the same reason. Insofar as unit labor costs also
rise due to loss of efficiency and increasing repairs, and so on, unit profits will fall faster than unit
value added.
3
For the sake of illustration, we assume that there is an identifiable flow of value added and profit
with a single machine. But since this kind of separation can seldom be accomplished in practice, it is
more appropriate to think of “the machine” as a complex of machines or even a whole plant.
4
Equivalently, current net stock is current gross stock minus accumulated depreciation
(OECD 2001, 35).
5
“If an asset is offered for sale at a price that does not seem likely to generate a satisfactory rate of
return, there will be no market for that asset. If an asset is offered at a price that seems likely to gen-
erate a very high rate of return, demand for the asset will rise and bid up the price until the rate of
return falls to a ‘normal’ level. In practice, manufacturers of capital goods will themselves calculate
the rates of return that assets are likely to earn and will not produce assets that are unlikely to gen-
erate rates of return that are sufficiently high to ensure that there will be a market for them. . . . [The
determination of asset prices as the present discounted value of future profit streams] can, therefore,
be seen as a very plausible explanation of how asset prices are determined in a market economy”
(OECD 2001, 17).
 803 Appendix 6.3: Gross and Net Capital Stocks

Appendix Table 6.3.1 Gross Stocks, Net Stocks, and Profitability

Year 1 Year 2 Year 3 Year 4
Gross Stock $2,000 $2, 000 $2,000 $2,000
Depreciation $700 $505 $431 $365
Net Stock $2,000 $1,300 $796 $365
Gross Value Added $1,200 $900 $700 $500
Gross Profit (Cash Flow) $1,000 $700 $550 $420
Net Value Added $500 $395 $269 $135
Net Profit $300 $195 $119 $55
Net Output/Gross Stock 25% 20% 13% 7%
Net Profit/ Gross Stock 15% 10% 6% 3%
Net Output/Net Stock 25% 30% 34% 37%
Net Profit/Net Stock 15% 15% 15% 15%
Note: Gross and net stocks are for the beginning of the year.

rate of return on the capital good is defined as that constant “rate of discount” which would
make the present value of the profit stream equal to the price of production of the machine.6
Thus, in table 6.3.1 the initial investment ($2,000) and the gross profit (cash) flow defines the
internal rate of return as that constant which would make the present value of this cash flow
equal to the initial investment. It should be noted that there is absolutely no reason to assume
a constant rate of return. If one were to instead settle on any particular pattern of depreciation
over the assets lifetime (say a constant fraction of the initial investment as is often assumed in
business accounting), then in conjunction with the given gross profits flow this will define net
profits and a generally variable annual rate of return. On might argue that the appropriate de-
preciation pattern is one that reveals the assets declining viability as it ages, not one that covers
it up. In any case, in the present example the putative constant internal rate of return happens to
be 15%. With this in hand, one can calculate the net present value of the profit flows in each year,
which is the net depreciated value of the machine (i.e., the net capital stock). The first year net
stock calculated in this manner is $2,000, simply because the internal rate of return of 15% was
itself derived so as to make the first-year present-value equal to the initial investment (the initial
gross stock of $2,000). Finally, depreciation is defined as the difference between the net capital
stock as the beginning of the year 1 ($2,000) and the net capital stock at the end of the year 1,
which is the same as that at the beginning of year 2 ($1,300), and so on. Note that depreciation
is endogenous here, arising as it does as the difference between successive present values. In this
illustration, the maximum and actual rates of profit (net output–gross capital ratio and net profit
rate) are shown to be declining as the machine ages. Yet on the net stock calculation, the very
same machine will appear to have a rising net output–capital ratio as it ages, as well as a perfectly
constant profit rate (the internal rate of return) up to the very moment of its demise.

6
The present value of a gross profit (cash flow) stream Pt of lifetime L is given by the present value
L
Pt+j–1
PVt = (1+r)j
. With given initial investment K1, the internal rate of return (r) is calculated as that
j=1
assumed-to-be-fixed rate which will satisfy make the PV = K1 for the new machine. Then in each
subsequent year, the PV is calculated with this r and the remaining profit flows.