15.3 The Demand for Capital

As we said earlier, a firm’s demand for financial capital comes from its
demand for physical capital. Economists assume that the amount of
physical capital the firm chooses to use comes from its objective of
maximizing profit. We now examine this decision in detail.

The Firm’s Demand for Capital

An individual firm faces a given interest rate and a given purchase price
of capital goods. The firm can vary the quantity of capital that it employs
and, as a result, the marginal revenue product of its capital varies. The
hypothesis of diminishing marginal returns (see Chapter 7 ) predicts that
the more capital the firm uses, the lower its MRP.

The Decision to Purchase a Unit of Capital

Consider a profit-maximizing firm that is deciding whether or not to add
to its capital stock and is facing an interest rate of i at which it can borrow
or lend money. The first thing the firm has to do is to estimate the
expected stream of MRPs from the new piece of capital over its lifetime.
Then it discounts this stream at the interest rate of i per year to find the
present value of the stream of benefits the machine will generate. Having
computed the PV of the stream of MRPs, the firm can then compare this
PV with the purchase price of the capital good. The decision rule for a

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