Graphical Analysis of the Return on Capital

We can illustrate capital theory by concentrating on a simple case in which all physical capital goods are alike. In addition, assume that the economy is in a steady state with no population growth or technological change. In Figure i4-5, Dl) shows the demand curve for the stock of capital; it plots the relationship between the quantity of capital demanded and the rate of return on capital. Recall from, Chapter 12 that the demand for a factor like capital is a derived demand the demand come’s from the marginal product of capital,
which is the extra output yielded by additions to the capital stock. ‘

The law of diminishing returns can be seen in the fact that the demand-for-capital curve in Figure 14-5 is downward-sloping. capital is very the most profitable roundabout projects have a very high rate of return. Gradually, as the community exploits all the high-yield projects by accumulating capital, with total labor and land fixed, diminishing returns to capital set in. The community must then invest in lower-yield projects as it moves  the demand-for-capital curve.

on capital exactly equals the market interest rate. Any higher interest rate would find firms unwilling to borrow for their investments; an}’ lower interest rate would find firms clamoring for the too, scarce capital. Only at the equilibrium interest rate- , of 10 percent ate supply and demand equilateral. (Recall that these are interpenetrates because there is no inflation.)

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