Capital Deepening

An increase in the capital-labor ratio

What is Capital Deepening?

Capital deepening refers to an increase in the capital-labor ratio. The capital-labor ratio can go higher either due to an increase in the capital stock or through a decrease in the number of workers. Capital deepening increases the marginal product of labor – i.e., it makes labor more productive (because there are now more units of capital per worker).

Capital deepening typically increases output through technological improvements (such as a faster copier) that enable higher output per worker. In short, capital deepening improves the productivity of labor.

 

capital-deepening

 

Capital Deepening and Standard Economic Growth Theory

Popular theories of growth such as the Solow Growth Model assume that capital and labor are complementary in the production process. It is a very strict assumption because it rules out cases where labor and capital act as substitutes in the production process – for example, robots and manual labor can serve as substitutes in the production of cars. Modern theories of growth tend to distinguish between skilled labor and unskilled labor.

However, within the framework of the Solow Growth Model, capital and labor need to be combined together to produce output. The inputs in the production process (capital and labor) and the output are linked through the production function: Y = f(K,L), where Y is output, K is capital, and L is labor.

Ideally, capital deepening is a plus for both capital and labor. The infusion of additional capital into the production process increases output, which increases the value of labor. The business benefits from more cost-efficient production. Hopefully, labor benefits, too, when a company with improved profitability pays its employees higher wages. This boosts the overall economy, as workers now have more discretionary income with which to buy goods and services.

As the capital-labor ratio increases, the marginal product of labor, i.e., the amount of product that can be produced by supplying one more unit of labor, increases.

 

Illustrative Example

Consider a farm that uses labor (farmers) and capital (tractors and harvesting machines) to produce output (wheat). Suppose the farm uses 100 farmers and 10 tractors to produce 2,000 tons of wheat per year. If we assume that the farm’s production function satisfies the standard assumptions, then adding one more tractor would make the farmers more productive. Replacing the existing tractors with more technologically advanced tractors that can do more work in less time would also increase productivity.

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

  • Economics of Production
  • Growth Accounting Equation
  • Labor Force KPIs
  • Production-Possibilities Frontier

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