© Edco Positive Economics Chapter 16 Capital

© Edco Positive Economics Capital is anything manmade that assists in the production of wealth. Demand for capital is a derived demand, i.e. the demand for capital arises because of the contribution it makes to the production process. Introduction to Capital

© Edco Positive Economics How is interest the payment for capital? The rate of interest is the payment to capital, as those who sacrifice present consumption must be rewarded by those who need funds for present use. The better capital a worker possesses, the higher the MRP and MPP are likely to be.

© Edco Positive Economics Different Types of Capital Social capital Working capital Fixed capital Private capital Note: Capital is what’s owned by a society (i.e. its stock of wealth), whereas income (a flow of wealth) is what’s earned or the wealth produced by a society over a period of time.

© Edco Positive Economics Marginal Efficiency of Capital (MEC) The extra profit earned as a result of employing one extra unit of capital is known as the marginal efficiency of capital, i.e., the marginal revenue productivity of additional capital goods minus their cost.

© Edco Positive Economics MEC (Continued) An entrepreneur will invest in projects where the MEC is highest. The more expensive the capital (the higher the rate of interest), the lower the demand for capital. Thus, the MEC curve is downward sloping from left to right, indicating an inverse relationship between the rate of interest and the level of investment.

© Edco Positive Economics What factors influence MEC? Cost of capital goods Rate of Interest Selling price of the good being sold Fall in productivity of the extra capital being used

© Edco Positive Economics What factors influence MEC? (Continued) Capital widening – a scenario whereby the amount of capital per worker remains unchanged. An increase in the capital stock leaves the capital/labour ratio unchanged. Capital deepening – a scenario whereby the amount of capital increases, resulting in more capital per worker in the economy.

© Edco Positive Economics Saving is non-consumption/income not spent. Individuals may save for different reasons: Deferred expenditure Saving for unforeseen events Speculation Credit rating Retirement Savings

© Edco Positive Economics What influences the amount saved by individuals? Level of income Rate of interest Rate of inflation Tax on savings

© Edco Positive Economics Investment involves the production of capital goods or any addition to capital stock in the economy. Investment

© Edco Positive Economics Factors Affecting the Level of Investment in the Economy Rates of Interest Business people’s expectations of the future The cost of capital goods Government policy The international economic climate Industrial relations climate Availability of credit The marginal efficiency of capital

© Edco Positive Economics The Importance of Investment and Production of Capital Goods in an Economy Increased productive capacity Increased labour productivity Increased employment Increased GNP Investment generates future wealth for the economy Increased government revenue

© Edco Positive Economics Loanable Funds Theory of Interest Rates: Classical Theory The demand for funds was created by people who wanted assets now rather than in the future. The supply of funds was given by people who were prepared to forego present consumption. A criticism of the theory is that it attributes too great an influence to the rate of interest.

© Edco Positive Economics The Keynesian Theory: Liquidity Preference Theory The supply of money was taken as fixed by the Central Bank and did not depend on the rate of interest. According to Keynes, people desire money for its own sake and wish to hold it in liquid form such as cash and current account bank balances, including: – Transactions motive – Precautionary motive – Speculative motive

© Edco Positive Economics The Keynesian Theory (Continued) If interest rates are low, there will be a high demand for money. If interest rates are high, there will be a low demand for money.