Chapter Summary

Our task in this chapter was to examine the market for services of capital inputs. Many of the results from our study of labour inputs apply to capital as well. Thus, for example, the demand for the services of a capital input by a perfect competitor in the input market is the marginal revenue product of that input-which, for a perfect competitor in the output market, is the same as the value of capital's marginal product.

One feature that often sets capital apart from other inputs is that while other inputs are usually hired on a period-by-period basis, capital equipment is often owned outright by the firm. In considering whether to purchase a machine, the firm must ask how much its output will increase not only in the current period, but also in future periods. The firm's decision rule is to acquire the machine if and only if the present value of the current and future increases in net revenue made possible by the machine exceeds its purchase price. This rule illustrates the factors that determine the rental rate of capital. These include the interest rate, or the opportunity cost of borrowed funds, maintenance costs, the rates of physical and technological depreciation, and expected future movements in the price of the capital good.

The real rate of interest measures interest in terms of equivalent quantities of real goods or services. If, for example, a bank lends 100 oz of gold and requires a repayment of 105 oz after 1 year, the real interest rate would be 5 percent per year. When the rate of inflation is small, the nominal rate of interest is approximately equal to the real rate of interest plus the rate of inflation. This relationship helps make clear why the interest rates charged by banks and other lenders tend to rise hand in hand with the overall rate of inflation.

A firm's demand for borrowed money depends on how the amount of capital equipment it would like to have compares with the amount it actually does have. The supply of loanable funds is highly responsive to interest rates because of the international nature of capital markets. The market interest rate and equilibrium level of borrowing are determined by the intersection of the supply and demand curves for loanable funds.

The market for stocks and bonds is one of the principal sources of funds to finance new capital equipment. A corporate bond is essentially a loan from the purchaser of the bond to the corporation. As a bond nears maturity, its price must converge to its face value. But for bonds that are far from maturity, there will be a significant inverse relationship between current interest rates and the price of the bond. The price of a given stock is the present value, suitably discounted for risk, of the current and future profits to which it provides a claim.

The "efficient markets hypothesis" says that, holding risk constant, all available information about current and future earnings of a firm is immediately incorporated into the price of its stock. The implication is that an investor should do equally well no matter which stocks he or she purchases. The efficient markets hypothesis thus helps explain why the investment tips of "experts" are of little or no value.

Tax policy has numerous effects on capital market decisions. Differing marginal tax rates yield different after-tax rates and can thus affect savings decisions. Tax policy also sometimes induces firms to lease, rather than buy, their capital equipment. And tax policy provides an incentive for firms to reinvest their profits, rather than pay them directly to shareholders as dividends.

The term "rent" as used by economists has a somewhat different meaning from the one familiar from everyday usage. It is the payment to a factor of production in excess of the minimum value required to keep that factor in its current use. A significant share of the payments received by owners of capital constitutes economic rent under this definition. Rents often constitute a large share of incomes generated in the labour market as well.

In peak-load pricing schemes, firms and regulatory agencies must decide how much to charge for the use of capital equipment when the intensity of demand varies greatly. As ever, the rule for efficient allocation is to set prices on the basis of marginal cost. Peak-load pricing enables firms to serve their markets while using significantly smaller amounts of capital equipment.

The appendix to this chapter discusses the use of natural resources, both renewable and exhaustible, as inputs in production.