What is “depreciation” in economics?

Question

I have no background in Economics and I am just starting with it. I was reading about the basic terminologies like domestic output, income, and etc. Then, I encountered a term "depreciation" -- It was described with a "machinery" example of a car, like this:

"You purchase a car worth \$5000 with a shelf life of 10 years. It means the consumption rate of the car is $500 per year. This consumption rate is actually the "depreciation" rate. Thus if an output of an economy ignores consumption of its machine stocks, it is referred to as 'gross' concept"

Please answer with respect to this example, and explain what the example is saying.

Thank you.

Answer 1

Depreciation is the loss in value of something. Take the car example. When you buy the car, it is worth 5000 dollars. Your net worth equals the value of the car: 5000 dollars. If you needed to use the money, you could just re-sell the car and you'd get \$5,000 (in theory).

But what about the second year? You are technically still worth \$5,000. But if you try to sell the car, nobody would buy it after you used it for one full year at the same price: the car lost part of its value. In a perfect world, the car would lose \$500 because since you can use it for ten years max, and you used a tenth of that. Thus, the car would sell at \$4,500.

From then on, the same keeps happening: the car losses 10% of its value each year, until the tenth year when it becomes valueless (at least in this perfect world). This periodic fall in value is called depreciation.

When calculating the GDP, the government sums all the goods and services consumed in a given year regardless of its depreciation. If you purchased the car on January 1st, then the GDP increses by \$5,000. The government will most certainly publish the country's gdp by the end of the year. Although the car lost some of its value during that period, this is not taken into account in the GDP. If you took away the depreciation, then it would be the NDP (Net Domestic Product).

The depreciation is also known as "capital consumption" for a simple reason. Imagine that you want to have the same value (in cars) all your life. To achieve this, you would have to save \$500 each year to replace your car every 10 years. So, you could say that each year, you consume \$500 worth in cars. This is obviously not true, but it is a way of simplifying it.

Answer 2

According to your example, the car is purchased for $5000. The problem gives the car a lifespan of 10 years. The 10 year lifespan implies that, at the completion of 10 years, the car won't be useable. It will therefore be valueless. That's not entirely true, but the problem has been simplified. Usually, equipment has some non-zero "salvage value". But skip that idea for now.

After one year of use of the car, the problem tells you that the car has lost 500 dollars of value. This is because of wear and tear. Cars get punished on American roadways because the roadways are in such a state of disrepair. The car could have other problems caused by other factors as well. $500 per year is an average number over the 10 year life of the car.

So, basically, at the end of one year, the owner of the car has "consumed" one year of usefulness of the car and that is equated to $500.