Demand for Capital

Here is a diagram the demand for capital by an individual firm as it is sketched in the previous page. We assume that the firm uses a given quantity of labor and land and that the quantity of capital used varies. The quantity of capital used (measured in dollars' worth) is marked off on the horizontal axis. On the vertical axis is the rate of interest, which we understand as the price of capital.

Figure 7: Marginal Net Productivity as the Demand for Capital

In the diagram, the horizontal red line, corresponding to the market interest rate, is the supply curve of capital to the firm. The green line is the demand for capital, that is, the marginal productivity of capital (net of the cost of wear and tear of specific capital goods) times the price of the output -- the value of the marginal product of capital. The profit-maximizing demand for capital for the firm is shown by K. That is, it will be profitable to expand the capital stock of the company until diminishing returns reduces the value of the marginal product to r, the market rate of interest, at K.

Some economists criticize this approach to the supply and demand for capital on the grounds that "capital" really consists of many different kinds of capital goods and cannot be expressed as a single amount of "capital." If we accept that argument, we would have to think of a marginal productivity curve and demand for each respective capital good, measure the capital goods in natural units (number of machines, number of grapevines, and so on), and treat the price in a little more complicated way. But, for microeconomics, the results would be pretty much the same: the demand for a capital good, like the demand for any input, depends on marginal productivity.

Now let's look at an important application of the marginal productivity approach in the economics of factors of production.