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Inverse relationship between capital price and returns

See how the value of private capital can change due to income, more capital chasing fewer projects, and people's risk tolerance. Increasing capital value doesn't always mean higher returns, and the future of capital returns is uncertain. Created by Sal Khan.

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  • leafers tree style avatar for user Joel Doutch
    I'm guessing that the dip on the initial chart during the 1930s could also be due to the Great Depression? Folks during that time would have found it a lot harder to invest, which would have driven the value of capital downwards?
    Not sure though, which is why I'm asking :)
    (17 votes)
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    • leaf green style avatar for user Kagan D.
      I think that the situation during the Great Depression is very similar to the situation during World War 1 and World War 2 that Sal had mentioned at . People are worry about the future and want to get a high return for investment, hence fewer capital is being invested and you see the result on the graph
      (11 votes)
  • blobby green style avatar for user Hugh Jones
    Sal is using "Capital" in 2 slightly different ways. The economics sense of the word is things like equipment and land and other resources that are used in production. The finance sense of the word is basically money - money that people have available for investing in business.

    I think that's something to be aware of - that people use the word in these two different ways.
    (14 votes)
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  • piceratops seedling style avatar for user Zoey
    Could it also be that value of capital/% national income increases due to inflation over the years?
    (5 votes)
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    • aqualine ultimate style avatar for user Stefan van der Waal
      No. Inflation causes the value of capital to go up with the same percentage as the income.
      If I currently have an asset that's worth $100 and it gives me an income of $10 the return on assets is 10%.
      If over the next year the inflation is 100%, my asset is now worth $200 and it gives me an income of $20. So the return on assets is still 10%.
      (10 votes)
  • blobby green style avatar for user James T
    At , if there is more capital chasing fewer projects, than wouldn't supply and demand tell us that the value of capital would fall as more capital-holding investors compete for fewer projects?
    (6 votes)
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  • piceratops seedling style avatar for user Mukul Sankule
    At , How will the price of capital bid up if there are lot of capitals available.
    (2 votes)
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  • leaf green style avatar for user Destine E
    Wouldn't he have a greater return on his capital since the original value of his asset moved from 100-200 dollars?
    (3 votes)
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  • orange juice squid orange style avatar for user theyoungjon
    At , Sal says that there is a situation when people want to pay more money for an object, but then it won't produce the 10% return for the income, but instead less return. Why would people want to pay more for an object, but get less benefit in the end?
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Sal is not saying that people want to get less than 10%, but the problem is that only a finite amount of money will give a 10% return. Beyond that, any additional dollar will give a diminishing return. So, if they try and put more money, they will get less of an average return, but the absolute return will still be increasing.
      (3 votes)
  • piceratops seed style avatar for user Rohit Bastian
    Sal points out that the rising graph might not be so bad, because r would get lower, and we wouldn't return to the Gilded age. But he also states that there was a dip in the capital to income ratio when there is more capital chasing products - which he says might be the case in the future. Then shouldn't the graph go down.

    And what exactly i the capital to income ratio? Whose capital to whose income?
    (2 votes)
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  • spunky sam blue style avatar for user Nikhil A kumar
    i still dont get it.. With more capital inflowing into the economy, shouldnt its value decrease since more of it easily available?
    (1 vote)
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    • blobby green style avatar for user Guigoz
      Yes, obviously the value decreases as can be shown in the Sal example in which in order to get $10 of income, you will now have to invest $200 in capital. And I guess you are refering to the going up graph. It's the ratio = capital value/income. So the ratio is going up means capital value is going up and/or income is going down. In this case the Sal implies that the income is going down.
      (2 votes)
  • leafers tree style avatar for user Boyu Zhang
    Why more capital dose not mean the value of capital go down? Thank you
    (1 vote)
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Video transcript

- [Instructor] So much of Piketty's book is about this idea of more and more returns to capital, that the return to capital is going to grow faster than the growth of the economy. We see charts like this, where we have the value of private capital as a percentage of income. And we see this dynamic, and we see this dynamic played out in multiple charts, where as we go through the Gilded Age, we hit kind of a peak right over here, at least a local peak, and then as we get into the beginning of the 20th century it drops down and then starts to pick back up until the present time. And this is the present time right over here, this data point. And then everything we see after that, this is Piketty's projections, really based on this idea of returns to capital be growing faster, that R is growing faster than G. But one thing to think about is why this dynamic might be happening. And then that might inform how we think about what the projections might be. So let's think about why the value of private capital could go down and why the value of private capital could go up. So one reason, so let's just say we have some asset, some capital asset right over here, and let's say its current value, I went on to some market and I bought it, and its current value is $100. Let me just write this, this is today. Today it has $100, and let's say it gives an income, an annual income, of $10, of $10. So for this asset my return on asset right over here is 10%. I get $10 on $100 investment. Now there are several reasons why the value of this could go up. One reason is that this asset starts producing more income. So this would be in line with the idea of more, of maybe income, of capital becoming more and more valuable. It's able to capture more and more income, or maybe it's utilized in a better way. And so, let's write this as the future. So in the future, you could have a situation where it's generating an income, it's generating an income of let's say $20. And let's say that the return is the same, so the expected return is the same, so people are still willing to say I'm willing to pay as much for things so I still get a 10% return. So people are saying okay I'll pay as much so I still get a 10% return, so that means that they're going to pay, in the market they'll pay $200 for it. So this is one reason why you could have an increase in the value of something. And you could go the other way. Maybe the value was $200, but because the income goes in half and the return stays constant, the value goes in half. So this is one scenario. This is one reason why the price of an asset could go up. But it's not the only reason why the price of an asset could go up. Another reason why a price of an asset could go up is maybe there's more and more capital and maybe there's fewer and fewer projects to put it to, especially if the growth of the economy isn't growing. So more capital, capital chasing, chasing fewer, fewer projects, or fewer things for it to produce. And in this world, what is going to happen? Well, this, we'll just assume that this continues to produce $10 of income. So the income continues to be $10 a year, but people, let's say you and I were able to buy this for $100, but let's say the next person who has $100 of capital to invest in capital, says well I can't find something with $10 of income, I can't get $10, so hey I'm willing to take 9%, so I'm gonna bid this up, I'm willing to buy this from you for $101, or $102, or maybe it goes all the way where they can't get anything, they can't get better than a 10% return, anything better than a 5% return on their incremental $100 and so they're willing to do a 5% return for this asset. So they would bid this thing up, the more and more capital you have chasing, or more and more money you have chasing this project, I guess you could say, this asset, could just bid the value of this up. So the value could go to $200, it's still producing the same income, and now the return is 5%. And so the reason to point this out is increasing value of capital doesn't necessarily mean increasing returns. In fact normally in the market, they move inversely with each other. When bonds have higher returns, then you have lower, then their prices are lower. When their prices are higher, for bond prices, that means that they have a lower, a lower return. So when we look at something like this, when we look at something like this, this could be speaking to more and more capital accumulation chasing fewer and fewer potential projects or whatever it might be, especially because you have slowing economic growth, but this would be a story of capital accumulation but with R slowing down, with the actual potential return slowing down, and probably starting to converge to G, to the rate of growth. Another similar idea, this is more capital chasing fewer projects, but you also have, might have a reality is that the reason why this is getting a 10% return is people find this scary. They've been burned on investments before, there have been wars. They don't want to put their money into some kind of factory they want to stuff it into their mattress. But then over time, maybe people become a little bit less risk averse and they're willing to invest in the market they're willing to invest in a project or start a business or whatever it might be. And so people become more risk tolerant. So maybe this is a world that is very risk averse. Risk averse, so if you want me to invest in capital, you have to give me a high return. But maybe the future is going to be more risk tolerant. Risk tolerant, risk tolerant, and then in a more risk tolerant world, you could also go to something like this. So this is risk, in a more risk tolerant world, you might say hey okay, well okay, I don't have to stuff it in my mattress, I'm getting 0%, or in my bank account, I'm not getting a lot, but hey now I'm willing to take my money and invest it more in capital. And so once again, they will bid up capital, and they will have a lower expected return. Here they need a high expected return because there was a lot of risk, they were scared of things, hey you better give me a lot of return on my capital if you want my capital because it's a scary world out there. Hey okay, maybe now I'm less worried about wars and my wealth disappearing and whatever else, so I'm more willing to invest. And so that also is in line with this more capital, and so there is a lower expected return, and so you have the value going up. And actually this is consistent with what we see happening right over here, is that this, this period right over here was a period, this is a period of major unrest. You have the two largest wars in global history right over here, you can imagine people becoming very very very risk averse. You can imagine people starting to stuff money in their, putting their, trying to sell their assets, worried what might happen. And so you're going to have less and less capital, more and more risk aversion driving that reality. But then as we go into the post-war period, the memories of those wars go away, people become more risk tolerant, more capital comes into the system. Because of the productivity, you have more and more capital accumulation. If we go back into even pre-Industrial Revolution times, if we go to Medieval Times, and all the rest, you had a limited amount of capital, it was mainly land. As you go into the Industrial Revolution, and especially the 20 and 21st centuries, land represents a smaller and smaller percentage of the value of total capital. Now you have created capital, you have technology, you have intellectual property. And so this could be a trend, once again I'm not sure, it's up for you to make the judgment. This trend isn't necessarily a return to a Gilded Age, it could be more and more capital chasing fewer and fewer projects, which actually could be a sign of lower returns, or it could be just people's risk premium is going down. They're becoming more and more risk tolerant, and so they're willing to accept lower and lower returns. So it's not clear what the trajectory is, but I just want to make it very clear that this isn't necessarily saying that hey because this graph looks the same as here that we're necessarily going into a second Gilded Age. But it's up for you to decide.