Chap 12 Capital, Investment and New Technology

Because capital is a produced input, it is a renewable resource.

A profit-maximising firm will continue hiring capital until its MRP = rental price (or ‘implicit price’) or
purchase price. i.e. the equilibrium capital stock of the firm is such that the present value of the stream of
net income that is provided by the marginal unit of capital is equal to its purchase price.

The rental price of capital is an amount that a firm pays to obtain the services of a capital good for a
specific period of time.

The implicit price: when a firm owns and uses its own capital goods, it does not pay out a rental fee,
however the rental price is the opportunity cost to the firm of using its capital good vs the amount that the
firm could charge if it had leased its capital to another firm. It is not the same as purchase price which is
the price a firm pays to buy capital goods.

An implicit cost is a cost that has occurred but it is not initially shown or reported as a separate cost. On the other
hand, an explicit cost is one that has occurred and is clearly reported as a separate cost.
An example of an implicit cost is the opportunity cost of a sole proprietor working in her own business. For example,
Gina works as a sole proprietor and her business reported a net income of $30,000 for the year. Since a sole
proprietor does not receive a salary or wages, there is no explicit cost reported for Gina's work in her business.
However, if Gina is foregoing a salary of $40,000 from another company, that is an implicit cost for her business.
After considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.

Whether the firm pays the rental price explicitly or calculates it as an implicit cost of using its own capital,
the profit-maximising firm will employ capital up to the point where the rental price of a capital good is
just equal to its marginal revenue product.

MRP= the addition to a firm’s revenue resulting from the sale of output produced by the additional unit of
capital.

Gross return on capital = market value of output minus all non-capital costs:
Gross return on capital is the sum of the 4 below components (the net return is the sum of the last 3 i.e.
gross return minus depreciation):

- Depreciation
- Pure return on capital = the amount that capital could earn in a riskless investment in equilibrium.
When expressed as a return per £1 worth of capital invested, the result is called pure rate of
interest.

Real risk-free rate of return: An interest rate that assumes no inflation and no uncertainty about future
cash flows or repayments. Treasury bills are one example of an investment with a risk-free rate of return,
because the U.S. government is perceived to be stable and guarantees payment. This also can be called the
pure time value of money.

- Risk premium. Compensates owner for actual risk of the enterprise.

- Pure/ economic profit. (Residual after all deductions have been made from the gross return.)

In a competitive economy, +ve and –ve pure profits are a signal that resources should be reallocated
because earnings exceed and fall short of of opportunity cost.
Economic profit a.k.a. pure profit takes into account both explicit cost and implicit cost. Explicit costs are
those that are actually paid out to other people. Implicit costs are the opportunity costs incurred by the
owner of the business. For example, if that owner quits his or her job to start a new company, the pay
they got at the old job would be part of the implicit costs because the owner is foregoing that in order to
start the new company.  accounting profit.
Pure profit, then, refers to what is left over after all conceivable costs (including implicit costs) are
subtracted from gross revenue.

Present Value (PV) is the value now of 1+ payments to be received in the future.

1
PV = C x (1+𝑅)𝑡

PV is negatively related to both t and R i.e. PV of a given sum will be smaller the more distant the payment
date and the higher the rate of interest.

Future value of present sum:

C = P x (1+ 𝑟)𝑡

The present value of a stream of indefinite (lasting for an unknown or unstated length of time) future
payments.
𝐼
=𝑟

NPV (net present value) = the present value of the extra revenue and deduct the present value of the
costs. Profit-maximising firms should undertake any investment project for which the NPV is +ve. Firms are
faced with diminishing returns to capital, therefore will invest up to the point where the net present value
of the investment is zero.

Internal rate of discount = each firm will discount present value on future income flows at a rate which
reflects its own opportunity cost of capital.

With perfect capital markets, the internal rate of discount is equal to the market rate of interest.

Perfect capital market

A market in which there are never any arbitrage opportunities.

Arbitrage
The simultaneous buying and selling of a security at two different prices in two different markets, resulting
in profits without risk. Perfectly efficient markets present no arbitrage opportunities. Perfectly efficient
markets seldom exist, but, arbitrage opportunities are often precluded because of transactions costs.

It is always worthwhile for a firm to buy another unit of capital whenever the present value of the stream
of future MRP’s that the capital provides exceeds its purchase price.
What would cause a firm in equilibrium capital stock to buy more capital?
1. The MRP of the capital may rise. E.g, if technology increases the productivity of the capital which
increases the MRP and thus future income streams generated.
2. If interest rates fall = an increase in present value of any streams of future MRP.

The size of the firm’s desired capital stock increases when the rate of interest falls, and decreases when
the rate of interest rises (see above). The firms demand curve for capital is a.k.a the marginal efficiency of
capital curve.

MRP of economy = addition to total national output (GDP) caused by adding another unit of capital to the
economy’s total stock.

Capital stock = some aggregate amount of capital.

In the short-run, the economy’s capital stock is given, but for the economy as a whole, the interest rate is
variable. Whereas the firm reaches equilibrium by altering its capital stock, the whole economy reaches
equilibrium through variations in interest rates. See p251

Price of capital  PV of flow of future MRP = increased D to borrow money to invest in capital = increased
in interest rates = PV of MRP equal to P.
Changing technology in the very long run:

Elements involved in choice of discount rate (opportunity cost of capital):

1. Pure time-value of money measured by the market rate of interest on a risk-free investment e.g.
government bonds. (Must take into a/c that yield varies with the bond’s time to maturity.)
2. Return in excess of the risk-free rate that is necessary to compensate for the risk (risk premium).

In economics and business decision-making, a sunk cost is a cost that has already been incurred and
cannot be recovered. Sunk costs (also known as retrospective costs) are sometimes contrasted with
prospective costs, which are future costs that may be incurred or changed if an action is taken.

Sunk costs should not influence a firm’s future investment decision.

An investment that involves significant sunk cost should only be undertaken if the NPV of the proceeding
exceeds the value of the wait-and-see option.

New technologies:

Long-term economic growth is driven by technological change = that is, by changes in the products that are
produced (product technology), the process by which they are produced (process technology) and the
ways in which productive activities are organised (organisational technologies).
(GPTs) are technologies that can affect an entire economy (usually at a national or global level). GPTs have
the potential to drastically alter societies.

General purpose technologies:

- Information and communication technologies (ICT)
- Materials
- Power-delivery systems
- Transportation
- Organisational technologies e.g. lean production, mass production, flexible manufacturing.