Question

consider a firm’s desire to invest in its capital stock and answer the following questions:

A) Describ the concept of diminishing marginal product of capital and why it is a common property for a production function to have.

b) Describe the firm’s user cost of capital.

c) explain how the firm selects its desired capital stock.

d) explain how the firm’s investment is related to its desired capital stock.

e) Why is the desired level of investment a decreasing function of the real interest rate?

Answer 1

a) The marginal product of capital refers to the ability of the capital to produce each units of products at every level when additional capital was used. By using of such additional capital will tend to increase the level of production. The firms can able to produce the output at the decreasing rate when additional capital was utilized at each set of production. For example if company A fixed the plant machine x and produces 10 units in one hour. When additional plant machine Y was erected, 7 units are produced in another hour. In third additional plant Z, 4 units are produced. At the end of the three hours though the pieces of production are increased from 10 units to 21 units. But the firms will actually experience the decreasing trend in producing the units. This production concept is called as diminishing marginal product of capital. This concept is the common property for a production function because of following mentioned reason. The efficiency of the productive capacity is depends usually on the marginal unit of output tends to decrease when the same ratio of inputs like raw materials, source of power and skills of labor are used in every level by using by the common way of production function.

b) Firms user cost of capital refers to optimum choice of investing the capital in order to earn expected returns over specific period of time. Employing skilled laborers by paying flexible salary compensation is also considered as one among the factor of production. So firms need to incur and plan the budget for paying separate cost for the employees in order to employ them in scale of production output. This is known as Firms user cost of capital.

c) Firm selects the desired capital stock by means of considering the investing the capital through optimum utilization of resources without effect of overhead cost on paying rent to the capital in the form of real interest rates, taxes, and depreciation. The firm thus selects the cost of capital by the way of optimal mix of real interest rates, taxes and depreciation.

d) Firms investment plays vital role in determining desired capital stock. This can be achieved by calculating the marginal product of capital by employing the capital investment at regular period of time by following external and internal economies. Internal economies includes the factor production cost which can be used for the long-run period by employing the optimal mix of factor of production. External economies is the availing the benefits collectively along with another firms. Industrial Estates is the fine example of having advantages of external economies in which cost of power, raw materials, infrastructure facilities can be reduced by getting the incentive from the government in the form of entrepreneur subsidies scheme.

e) The desired level of investment is considered as a decreasing function of the real interest rate is because of the following reason. The real interest rate of interest is not only includes the cost to be incurred in order to achieve the rate of return but also it need to calculate after the affect of inflation prevailing among the price making decision. Huge prices leads to effect the total average production of the goods and services. This is not the constant situation by the uncertainty in the rate of inflation may create the follow up of decreasing function of the real interest rate.