The Marginal Product of Capital
By Steve Bain
Mainstream economics holds that the marginal product of capital, given the existing interest rate in the economy, is a major determinant of the level of investment that the economy generates.
There are, of course, many different factors that play an important role in determining what the actual level of investment will be and as a starting point I would encourage you to have a read of my main article about this:
I should also point out that the term ‘investment’ itself sometimes means slightly different things to different people. In economics we use it in terms of additions/subtractions to the economy’s stock of capital. This stock of capital will usually form the productive capacity of the economy e.g. new plant and equipment, but we also include inventory levels within the definition of investment.
Marginal Product of Capital Definition
The marginal product of capital is focused on the productive capacity of the last additional unit of capital that a firm adds to its business.
So long as that last unit of capital adds enough output to the firm such that its overall revenue rises by more than the cost of purchasing that last unit of capital, the firm will wish to invest in more of it. At the break even point, where revenues rise at an equal amount as costs, the marginal productivity of capital will be zero. Below that rate it is negative.
The Desired Capital Stock
Firms do not, of course, only use capital to produce goods and services. Labor is the other main contributing factor that gets much of the analysis in the neoclassical growth models, but the full list would also include land and enterprise.
As with the marginal productivity of capital, the is an equivalent term that considers the marginal productivity of labor, and a firm will consider different combinations of all these factors of production in order to derive what it believes is the most cost-efficient means of production, and thereby maximize its profits.
Different levels of taxation on the different factors of production will have an impact on their cost effectiveness and will therefore influence the firms desired capital stock.
This raises the pertinent question of why it is that governments choose to heavily tax firms for employing people, but effectively subsidize them for their capital expenses (capital costs are usually paid out of retained profits, and the extent to which those profits are reinvested there is an avoidance of corporation taxes owed).
Taxation is an important determinant of desired capital stock, but even more important than that is the level of interest rates. Many firms of all sizes use bank loans for their capital purchases, and the cost of financing that loan is equal to the interest rate that is payable on it.
Even firms that use retained profits or new issues of equities/bonds to raise finance for their capital expenditures will be influenced by the interest rate. This is because a higher interest rate will mean that there are foregone opportunities to earn money from alternative ventures like lending, or reduce existing debts, compared to when rates are low.
If the interest rate is high enough that it will cost the firm more money to take out a loan than it can generate from the extra output that an additional unit of capital will produce, then the marginal product of capital will be negative.
I think you can probably guess that the relatively variable rates of interest that an economy experiences over time means that this is the main variable that influences short-term investment decisions – or at least it is according to the Keynesian demand-management model.