Tuesday, December 21, 2010

On knowledge capital depreciation

Accounting principles have defined depreciation schedules for different types of physical capital. However, depreciation for knowledge capital, which form an increasingly larger share of wealth, is more controversial.

In an interesting post, Micheal Mandel has attributed America's declining economic prosperity and current travails to its misplaced economic priorities. He feels that instead of building on the country's leadership in knowledge-based industries and knowledge capital creation, successive American governments over the past two decades, supported policies that favored debt-led consumption. And he points to the

"The value of knowledge capital depends, in part, on how rare it is. The more companies or countries that possess the same knowledge (say, about how to make a commercial airliner), the less valuable that knowledge is. This is just Economics 101, applied to intangibles.

Over the past 10-15 years, the strengthening of information flows into developing countries meant that knowledge capital was being distributed much more quickly around the world. As a result, the normal process of knowledge capital depreciation greatly accelerated in the US and Europe – beneath the radar screen, because no statistical agency constructs a set of knowledge capital accounts."

Tyler Cowen while agreeing with Mandel's conclusion, differs with him on the arguement that globalization is responsible for the increased depreciation rate of knowledge capital. Instead, he points to the inherent nature of knowledge capital and its general propensity to diminish faster in value (to its users) compared to physical capital. He takes the example of an imaginary economy with two sectors, music and bathtubs, and writes,

"My bathtub is over thirty years old, yet for me it works fine and I have no desire to buy a new one. When it comes to music, most people want to listen to what is new and hot, not Bach's B Minor Mass... The more that your economy "looks like" the music sector, the more rapid the rate of depreciation for production capital and knowledge capital. This means we may be overestimating our national wealth."

There may be some nuances to the knowledge capital depreciation story. There are two opposing forces at work here. One is the classic demand-supply issue - as the supply (or access) increases, the value decreases. The other is the contribution of network effects on the value of the service or good - as more people have the good/service, its value increases.

The rate of appreciation or depreciation depends on the amplitude of these two effects. If the former is larger and disruptive technolgies emerge quicker (like in the music), then depreciation rate will be higher. On the contrary, if the entry barriers are too large (like in pharma sector, as Bill Gates Foundation is finding out), the rate of depreciation will be smaller, even positive.

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