69 Main characteristics of Asset market. Demand for capital. Interest rate.

As we know, capital is more than just machinery, but it may be helpful to think in terms of a specific kind of machine. We may think of a tractor to be used on the potato farm. As we increase the number of machines in use, with the same amount of land and labor, output will increase, but at a decreasing rate. Capital, like the other inputs, is subject to diminishing returns. Once again, we will focus on the "marginal productivity" of the machines. On the other hand, the costs of using the machinery will also increase as the number of machines increases.

The machines will gradually wear out and will have to be replaced.

It is customary to deduct wear and tear from the output, so that the total and marginal productivity are net of wear and tear. But, for practical applications, we should remember that wear and tear is a real cost and must be taken into account.

The resources "tied up" in the machine have an opportunity cost.

The money laid out to buy the machines pays for the resources used in producing the machines. The money (and resources) will be recovered only gradually, using the machines to produce goods and services. However the money (and the resources) could be used for other purposes. For example, the investor might instead have bought a vineyard, which would produce a crop of wine grapes every year. It will not make sense to invest in the machine unless the net revenue from using the machine to produce goods and services is worth at least as much as the wine grapes. Similarly, the investor might instead have leant his money to someone else, to finance either production or consumption expenditures. It will not make sense to invest in the machine unless the net revenue from using the machine to produce goods and services is worth at least as much as the interest the investor could get on the loan.

Of course, capital includes many kinds of producers' goods, from tractors and other machines through grapevines and orchards and many intangible assets. What they all have in common is the opportunity cost corresponding to the interest rate. With that in mind, we identify the price of capital as the interest rate. The demand for capital is the marginal productivity of capital (net of wear and tear) times the price of output.

As for the supply of capital, that will depend on the decisions made by savers. Many economists believe that an increase in interest rates will result in an increase in saving and so in the quantity of capital supplied, giving an upward sloping supply curve of capital. However, for capital as for labor, it is logically possible that the supply curve (in the economy as a whole) could be backward sloping. For an individual industry, however, the supply of capital will probably be horizontal and correspond to the opportunity cost of capital in other industries.

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.