In the case of a bond, the issuer guarantees to pay fixed interest and repay
the principal regardless of the future earning stream generated by the assets
that issuer owns. Bonds are thus indirect claims on real capital goods. A
wide range of nominally fixed assets other than bonds also exist as generalized
claims on the earning streams of individuals and institutions. These
individuals and institutions may themselves hold the bulk of their assets in
indirect form. Personal loans, for example, represent indirect claims on the
earnings from human capital (as well as from other assets the debtor might have
claim to). Direct ownership of human capital is often evidenced by
university or college degrees or apprenticeship certificates.
Assets that represent indirect claims on the earnings of capital goods are
called intermediate assets. Institutions that borrow from one group of
people and lend to others are called financial intermediaries---an
obvious example is a bank that borrows people's savings by issuing savings
deposits, and lends these funds to firms to finance inventories or capital
expansion.
Two different types of markets are involved in setting the prices of real
capital goods. The first is the market for capital services---the rental
market for homes, apartments, bulldozers, etc. This market establishes what
the sizes of the income streams produced by the capital goods will be. The
second is the market for ownership of these income streams---the market for
these "sources of income". On the demand side of this second
market are individuals and institutions that are willing to pay the present
value of the income streams from the assets to purchase them. On the supply
side are producers of bulldozers, trucks, buildings, etc., who are willing to
produce new additions to the stocks of these capital goods if the cost of
production is below the market price. Of course, the production response to a
rise in price takes time.
Sometimes there is no formal market for the services of particular types of
capital but a well-functioning market for ownership of the capital goods
themselves. For example, one normally does not rent shoes and clothing
(except for weddings) but markets for purchase and sale of clothes are very well
developed. In other cases, there is an excellent market for the services of
particular types of capital but a poor market for the capital itself. Labour
markets provide ample opportunities for the purchase and sale of labor services,
for example, but there is very little opportunity for the purchase and sale
of the human capital that generates these services.
In still other cases there is no market for either the services of the capital
or the capital itself. Consider the market for ideas. One who possesses an
idea has automatic use of the services of it because knowing the idea is all
that is necessary for using it. If one rents the idea out, one gives ownership
of it away at the same time. Moreover, unlike the case of an automobile or
machine, the owner of an idea can sell it to someone else while continuing to
use it himself. The opportunity cost of selling it is therefore zero, and once
a few people have ownership of it, competition drives its price to zero---the
idea becomes free to everyone.
In all of the above cases where the market does not perform
properly---that is, market failure---the problem is one of writing appropriate
enforceable contracts and monitoring performance.
Sale of one's human capital would make one a slave. The slave-owner has to
persuade the slave to provide services on demand for no wage. Apart from
activities like picking cotton or breaking rock, it is difficult to determine
when the slave is doing his job. Did damage to a machine occur, for example,
because of structural failure or because of misuse? A civilized society can
give a slave-owner little recourse in the event of deliberate
non-performance.
One reason why a rental market for everyday clothes does not exist is the
inability of the owner of the clothes to monitor the proper use of them.
Were the pants ripped unavoidably because of wear and tear, or does the
renter, unbeknownst to the owner, make a practice of crawling through barbed
wire fences? Had the owner known the latter to be true, he would have
demanded a higher rent to cover the greater risk of damage.
The absence of a market for human capital is the reason why interest rates
are higher on personal loans, and the borrowing limits as a fraction of the
present value of the future income stream smaller, than in the case of loans
secured by physical capital. If the borrower does not pay a loan secured by
physical capital the lender forecloses and takes the capital. If the only
security is human capital and the borrower refuses to pay, foreclosure is not
possible. Recovery of the amount lent is costly at best and impossible at worst.
Fortunately, there are a wide range of asset markets that function quite
well. The stock, bond, and real estate markets are good examples. We will
consider the functioning of these markets in more detail in Topic 3 below.
O.K.! It's test time. Make sure that you have thought up your own answers
before looking at the ones provided.
Asset markets represent markets for the sources of income---they
are markets for the capital that produces income. The ownership of
capital that produces income may be direct or indirect. In the case of
capital goods like trucks, bulldozers and buildings, immediate ownership is
evidenced by a bill of sale or other legal document. The immediate owner,
however, may not be the ultimate owner. The capital items may be owned
indirectly by a lien holder or by someone who owns shares in a corporation
that has direct ownership. Or the indirect owner may hold bonds or other
IOU's issued by the person or corporation that holds direct title to the
capital goods.