1 Investment

In the previous class, we discussed theories of consumption demand and consequently savings
supply. In this section, I will consider the demand for investment. Recall that the GDP
identity says = + + + . If there is no foreign sector and no government (to
extreme simplifications Ill admit) then savings must equal investment = = .
Capital refers to the machines and equipment used in the production of goods and services.
Factories, warehouses, delivery trucks, printing presses, cell phone towers, irigation systems,
etc. are all examples of capital. Investment is the purchase or production of new capital
goods. If is the economic rate of depreciation (0 1) then the stock of capital evolves
according to
+1 = (1 ) +

Thus, the future ( + 1) capital stock is the current capital stock less depreciation ( (1 ))
plus any new investment. Depreciation rates vary substantially across types of capital. For
instance, the depreciation rate for vehicles is typically quite high between 15 and 20 percent
per year. The depreciation rate for structures (buildings, factories, etc.) are much lower
between 2 and 4 percent per year. Typical equipment depreciates at roughly a 10 percent
annual rate.

1.1 The Marginal Product of Capital ( )

The reason firms purchase (or rent) capital is for its use in production. Although the actual
production process for most activities is likely quite complex, it is natural to assume that
total production increases with capital. Moreover, it is natural to assume that the marginal

product of capital is a decreasing function of total capital. This is particularly likely
if other factors of production (e.g., labor, land, etc.) are held constant. The marginal product
of captial is the increase in output associated with a one unit increase in the capital stock.
Thus, if a new plow causes total farm production to increase by 20 tons of wheat, the marginal
product of the plow is 20 tons of wheat. If the is decreasing then subsequent additions
to the capital stock will add to total production by a smaller and smaller amount. Formally,
if we write the production function as = (), then the marginal product of capital is
= = 0 (). If the marginal product is decreasing then 0 () is a decreasing
function of the capital stock (which would require 00 0).

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 Often we use production functions which include two inputs capital () and labor ().
A common functional form used in economics is the Cobb-Douglas production function

= 1

Here is a scaling parameter and the parameter is between zero and one (0 1) This
production function exhibits diminishing marginal products of both labor and capital. To find
the marginal product of capital, simply dierentiate the production function with respect to
capital . This gives
= 1 1

This marginal product is decreasing in (since 1 0). In addition, the Cobb-Douglas

production function is a Constant Returns to Scale (CRS) function meaning that if you scale
up all of the inputs by a common factor, say 0, then output also scales up by the same
factor. To see this, suppose that initially capital is 1 and labor is 1 and output is 1 so

1 = 1 1
1

Now suppose we scale up (or down) the inputs by so 2 = 1 and 2 = 1 . Then,

2 = 2 1
2

= (1 ) (1 )1
= (1 ) 1 (1 )1
= 1 1
1 = 1

1.2 The User Cost of Capital

Consider the following example. Suppose that the owner of a firm is deciding whether to
purchase a piece of capital for $10,000 or whether to save the money instead. If the owner adds
to her capital stock then total production rises by the marginal product of captial. Moreover,
after production, she will also own the undepreciated capital. Thus, if she purchases the
capital she will get + 10 000 (1 ). Alternatively, if she simply saves the money (say
by purchasing a treasury bond) then she gets $10,000 times (1 + ).
If 10 000 (1 + ) + 10 000 (1 ) then she will strictly prefer to save with the

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bond. In fact, she will have a strong incentive to sell any existing units of capital (for $10,000
each) and save the proceeds. By selling o her existing capital, she causes the marginal
product of the remaining machines to rise. She will continue to sell the capital until either she
has completely depleted her capital stock or until 10 000 (1 + ) + 10 000 (1 ).
On the other hand, suppose 10 000 (1 + ) + 10 000 (1 ). In this case, the
owner of the firm has a strict incentive to purchase the new capital and increase her capital
stock. In fact, she has an incentive to borrow (at the interest rate 1 + ) to finance more
and more capital. By accumulating more and more capital, she drives down the marginal
product of capital. She will continue to accumulate capital until 10 000 (1 + ) +
10 000 (1 ).
Thus, if 10 000 (1 + ) + 10 000 (1 ) the owner reduces the capital stock and
drives up the . If 10 000 (1 + ) + 10 000 (1 ) the owner increases the
capital and drives down the . In the equilibrium it must be that both sides are equal so
10 000 (1 + ) = + 10 000 (1 ).
This example illustrates a simple concept called the user cost of capital. Let the real price
of one unit of capital be . Then in equilibrium, we would require, + (1 ) = (1 + )
or
= ( + ) (1)

The expression on the right-hand-side is called the user cost of capital. If a firm hires a worker
it has to pay the worker his or her wage to get the benefits of the work. If a firm rents oce
space then it pays a landlord for the use of the oce. It might seem like if the firm owns capital
there are no costs to using the capital. This is not true however. The costs to owning capital
are opportunity costs. The user cost of capital quantifies the opportunity cost of owning and
using capital.
Suppose that, for one years time, a firm uses some oce space that it owns. The costs
of using the space for one year are (1) the interest that it would get if it sold the property
and put the proceeds in the bank (), plus (2) any depreciation experienced by the oce ()
Equation (1) says that the marginal product of capital (i.e., the benefit to using the oce)
should be enough to oset both the forgone interest and the depreciation. If the marginal
product is less than this, the firm should sell the capital. If the marginal product exceeds
( + ) then the firm should purchase more capital.

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1.3 The Demand for Capital and the Investment Demand Function
Assuming that the marginal product of capital is decreasing, there is at most one level of
capital at which () = ( + ) Figure 8.1 shows the determination of the equilibrium
capital stock (1 ) given the user cost ( + ). Not surprisingly, if the price of capital ,
the real interest rate or the depreciation rate fall, the equilibrium capital stock increases.
Since +1 = (1 ) + , any increase in the desired capital stock requires an increase
in investment. This suggests that there is an investment demand function () which is a
decreasing function of (and and ). Given the investment demand function () the new
equilibrium condition in the market for loanable funds is ( ) = ().