The Marginal Product of Capital

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.

The Investment Accelerator

When the interest rate falls significantly, the desired capital stock should rise significantly, and if this happens then there should be a very large increase in business investment as firms take action to build their capital base. The larger the increase in desired capital, the greater that the increase in investment should be, which gives rise to the term ‘Investment Accelerator’.

I would tend to agree that interest rates are an important determinant of business investment, but as I’ve argued on my page about Investment Spending, it has been the housing market and household investment that has been the main driver of fluctuations in overall investment in recent decades, and any short-term demand management policy that ignores this fact is seriously impaired.

Also keep in mind that when discussing the interest rate, the applicable rate accounts for inflation. If inflation is non-zero, then the ‘real’ rate of interest is the rate over and above inflation.

If the nominal interest rate is 5%, and inflation is also running at 5%, then money can effectively be borrowed for free. For example, if I borrow $100 today at a 5% annual interest rate payable in one year whilst inflation is also running at 5%, then after one year I will pay $105, but the value of the payment will have been reduced to $100 because of inflation eroding it.

Other complicating factors include the rate of capital depreciation, which might mean wear and tear on the additional unit of capital, or it could mean the rate at which it is being antiquated by technological developments. For example, any investment in copper wire production at a time when fibre optics were being introduced to the market would have incurred significant loss of earnings.

Conclusion

The marginal product of capital is an important determinant of a firm’s desired capital stock, and in times when interest rates fall significantly then that desired amount can increase significantly. If so then the level of business investment can rise by a large amount giving rise to the investment accelerator.

The applicable interest rate must reflect real costs, and so any investment decision must account for inflation in future years. This will present some problems, because predictions of future inflation are imprecise at the best of times.

Interest rate movements are only one of many complicating factors that a firm must account for before arriving at an investment decision. Many of those factors are unpredictable, and all of them impact on the marginal product of capital, so the firm will have to accept some level of risk no matter what decision it arrives at.

Most importantly, mainstream economics ascribes a role for active fiscal and monetary policy in managing the economy in the short-term because of their impact on interest rates, and therefore investment. This is a credible position, but it is not a complete position.

Evidence from recent decades has shown that other forms of investment (i.e. from households in times of property market booms) have been more volatile and more influential on the business cycle, and yet it is not included within the government’s fiscal policy calculations or the central bank’s monetary policy calculations (or at least not with regard to their impact on CPI inflation - see my main article about Investment Spending for more info on that).

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