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Chapter 15
McGraw-Hill/Irwin
Copyright © 2010 The McGraw-Hill Companies, Inc. All rights reserved.
Capital
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Chapter Outline
• Financial Capital And Real Capital
• The Demand For Real Capital
• The Relationship Between The Rental Rate And The Interest
Rate
• The Criterion For Buying A Capital Good
• Interest Rate Determination
• Real Versus Nominal Interest Rates
• The Market For Stocks And Bonds
• The Anomaly Of The Investment Newsletter
• Tax Policy And The Capital Market
• Economic Rent
• Peak-load Pricing
• Exhaustible Resources As Inputs In Production
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Financial Capital And Real Capital
• Financial capital: money or some other
paper asset that functions like money.
• Real capital: productive equipment that
generates a flow of services; also called
physical capital.
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The Demand For Real Capital
• If the firm can acquire the services of as
much capital as it wishes at a constant rental
rate of r/yr, it should employ capital up to the
point at which its marginal revenue product
(MRPK) is exactly equal to the rental rate.
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The Rental
Rate And The Interest Rate
• Technological obsolescence: the process by
which a good loses value not because of
physical depreciation, but because
improvements in technology make substitute
products more attractive.
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The Criterion For Buying A Capital
Good
• The machine will bolster the firm’s rate of
production not only in the current period,
but also in the future.
• The firm should buy the machine if and only
if PV is greater than or equal to PK.
– Since PV is inversely related to the market rate
of interest the firm that owns its capital will
want to employ more of it the lower the market
rate of interest is.
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Interest Rate Determination
• A firm’s demand for capital equipment
depends on the rate of interest, the purchase
price of capital, and the rates of technological
and physical depreciation.
– Interest rates are determined by the intersection
of the supply and demand curves for loanable
funds.
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Figure 15.1: Equilibrium in the Market
for Loanable Funds
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Real Versus Nominal Interest Rates
• When banks expect the overall level of prices to rise, they
will charge an interest premium to counteract the erosion of
the real purchasing power of future loan payments.
– The actual number that appears on the bank loan contract is
called the nominal rate of interest.
– The real rate of interest is given by:
i = (n –q) / (1 + q)
– n - nominal annual rate of interest (expressed as a fraction)
– q - annual rate of inflation
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The Market For Stocks And Bonds
• A bond is essentially a promissory note
issued by the firm.
– The face value of the bond is the amount for
which it was sold to the investor who bought it
from the firm.
– Short-term bonds: often promise to return their
face value in full within 90 days.
– Long-term bonds: reach maturity only after 30
years, and some have even longer lifetimes.
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The Market For Stocks And Bonds
• Perpetual bond: a bond that pays a fixed
payment each year in perpetuity; also called a
consol.
• Risk premium: a payment differential
necessary to compensate the supplier of a
good or service for having to bear risk.
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Figure 15.2: The Trade-Off between
Safety and Expected Return
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The Efficient Markets Hypothesis
• Efficient stock market: the price of a stock
embodies all available information that is
relevant to its current and future earnings
prospects.
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Tax Policy And The Capital Market
• The interest earned on municipal bonds is
exempted from the federal income tax.
– The interest earned on federal government
bonds, by contrast, is fully taxable, as is the
interest on bonds issued by corporations.
• Which kind of bond you should buy depends
on the marginal rate at which your income is
taxed.
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Economic Rent
• Economic rent: the difference between what
a factor of production is paid and the
minimum amount necessary to induce it to
remain in its current use.
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Figure 15.3: Economic Rent
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Peak-load Pricing
• Peak-load pricing: the practice whereby
higher prices are charged for goods or
services during the periods in which they are
consumed most intensively.
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Figure 15.4: The Effect of
Peak-Load Pricing
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Exhaustible Resources As Inputs
In Production
• An exhaustible resource is one that cannot be
replenished by people.
• How does a competitive market allocate
exhaustible resources?
• The owner of an exhaustible resource has two
options:
– (1) he can hold the resource for the time being.
• Opportunity cost is the interest that could have been
earned had the resource been sold and the proceeds
deposited in a bank (or used to purchase a stock or
bond).
– (2) he can sell it.
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Figure 15.5: The Equilibrium
Price Path for an Exhaustible Resource
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Exhaustible Resources As Inputs
In Production
• Because the demand curves for exhaustible
resources are downward sloping the gradual
rise in price will cause a gradual reduction in
the quantity of the resource demanded.
• Rising prices also stimulate the production of
substitutes for the exhaustible resource.
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Figure A15.1: The Growth Curve
for a Tree
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Figure A15.2: The Optimal Time
of Harvest
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Figure A15.3: The Effect of Rising Prices on the
Use of an Exhaustible Resource
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Figure A15.4: The Stock Exhaustion Path
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Figure A15.5: Adjustment When Investors Expect
to be Stuck with Excess Oil
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Figure A15.6: Adjustment When Investors Expect
Oil to Run Out Too Soon
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Figure A15.7: Response to a Fall
in the Price of Solar Energy
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