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Neo Classical Approach

• Modern business investment is based on economist Dale Jorgenson's neo-classical investment theory.
• Jorgenson's theory provides the aggregate investment function's micro-foundation.
• Firms are classified into two categories:
  • Production firms: Produce goods/services using capital owned by others, paying lease rentals.
  • Rental firms: Buy capital and lease it to production units.

Rental Price of Capital

• Focuses on the typical production firm.
• Profit-seeking firms compare the cost and benefit of each capital unit when deciding how much capital to lease at a fixed rental per period.
• The rental price of capital is the periodic payment made to the leasing firm for hiring equipment.
• The real cost of capital to the production firm is R/P (rental R, output price P).
• The real benefit is the marginal product.
• Marginal Product of Capital (MPK) adds to a firm's product by one extra unit of real capital.
• Firms make extra profit as long as MPK exceeds the rental price of capital.
• MPK declines as more capital is used, and a production firm maximizes profit when MPK equals the real rental price.
• A profit-maximizing firm leases capital until the MPK equals the real rental price.
• The demand curve slopes downward because MPK falls with increased capital use.
• Real capital supply is fixed in the short run, represented by a vertical supply curve.
• The equilibrium rental price is the rate that aligns capital demand with a fixed supply.

Cost of Capital and its Determinants

• The rental firm's benefit is revenue from renting capital to production firms, receiving the real rental price of capital (R/P) for each unit.
• There are three cost types in owning/renting out a unit of capital:
  • Interest on loan: A rental firm borrowing funds to buy capital pays interest on the loan, where i is the nominal interest rate and Pk is the purchase price
  • Capital loss: The price of capital can fall, resulting in a loss for the rental firm, and the cost of this loss is -∆Ρκ.
  • Depreciation: The depreciation rate is a component of owning and renting out real capital; the rate of depreciation (d) measures the value proportion lost each period due to wear, dPk.
• Total renting cost for one period: Cost of capital = iPк – ДРк + dPк = Рк(і – ДРк/Рк + d).
• Four cost determinants: Pk, i, the rate at which PK is changing, and d.
• A negative sign is put before ∆Рк/Рк because Pk is assumed to be falling.
• Capital goods prices are assumed to rise with other goods' prices during inflation, then (∆Pk/Pk) interprets as the overall rate of inflation (π).
• The real interest rate (r) is the nominal interest rate (i) less the rate of inflation (π); cost of capital (CK) is Ск = Рк(і – п + d) = Pk(r + d).
• Three cost determinants: Pk, r, and d.

Real Cost of Capital

• Expressed as Cr = (PK/P) (r + d), where P is the overall price index (weighted average of all prices).
• The cost of acquiring and leasing a capital unit in real GDP units is measured by Equation (3); PK/P (relative price), r, and d are 3 determinants.

Determinants of Investment

• Rental firms make decisions on whether to increase or decrease its capital stock based on benefit-cost calculations.
• Revenue (R/P) earnings and the real cost (PK/P) (r + d) make up profit per capital unit or profit rate, p = (R/P) – (PK/P) (r + d).
• Rate of profit = Real revenue from capital – real cost of capital.
• Rate of profit is shown as p = MPK – (PK/P) (r + d).
• The rental firm profits (p > 0) if MPK exceeds the capital real cost also the converse is true.
• Net investment is the stock absolute change, I = ΔK = Kt – Kt-1.
• Investment decision depends on the profitability of owning/leasing out capital.
• It's profitable to invest (MPK exceeds (PK/P) (r + d)) and add to the existing capital stock.
• If MPK is less than (PK/P) (r + d) the firm will not care about its existing capital stock and let it depreciate and shrink.

Investment Function

• What is true of a firm which owns and rents out capital is equally true of a firm which both owns and uses capital, so we can write ΔK = In[MPK – (PK/P) (r + d)].
• In depends on or is a function of the difference between the MPK and the real cost of capital.
• Incentive to is present if MPK >/(PK/P) (r + d).
• The investment function is I = In[MPK – (PK/P) (r + d)] + dK , where I (gross investment) equals net investment plus depreciation dK.
• Total spending depends on MPK, the capital real cost, and depreciation amount.

Shift of the Investment Schedule

• Favorable development in the economy which raises the MPK increases the profitability of investment and causes investment schedule I to shift to I'.
• Increased capital goods demand for lease-renting firms occurs with technological changes that raise the MPK at the same real interest rate.

Intertemporal Adjustment of Capital Stock

• The capital stock rises and the MPK falls if MPK is initially above the real cost of capital.
• The capital stock falls and MPK rises if MPK is initially below the capital real cost
• The MPK approaches the real cost of capital and the steady-state level of capital, and therefore it is expressed as: MPK = (PK/P) (r + d).
• The total profit from capital is at maximum and marginal profit is zero. Therefore, no addition are made. ΔΚ = I = 0 No incentive for further fixed capital investment because MPK – (PK/P) (r + d) = 0.
• In the long run the MPK equals the capital real cost.
• The adjustment speed toward the state depends on the firm speed in adjusting their capital stock and the cost in new capital.

Marginal Productivity Theory

• Oldest and most significant theory of factor pricing, also known as Micro Theory of Factor Pricing.
• Propounded by T.H. Von Thunen, with contributions from Karl Menger, Walras, Wickstcad, Edgeworth, and Clark.
• Remuneration of each factor of production tends to equal its marginal productivity.
• Marginal productivity is the addition makes to the production with the use of one extra unit of the factor.
• The entrepreneur employ more units of the factors until the marginal cost a factor is less than the marginal productivity.
• He will stop giving further employment as soon as the marginal productivity of the factor is equal to the marginal cost of the factors.
• “Distribution of society's income is controlled by a natural law; if this law is friction free, it would give every production agent the amount of wealth that agent creates.” - J.B. Clark
• Marginal productivity theory contends that each productive agent will be rewarded in accordance with its marginal productivity in equilibrium.

Assumptions of the Theory

• Perfect Competition: Prevents unequal bargaining power between buyers and sellers.
• Homogeneous Factors: Units with same efficiency, implying consistent productivity across workers.
• Rational Behaviour: Desiring to maximize profits, producers combine production factors to equalize marginal productivity from a unit of money across all factors.
• Perfect Substitutability: Between same factor units and various factor units.
• Perfect Mobility: Ensures factor rewards tend to equalize across regions and employments.
• Interchangeability: All units are equally efficient and interchangeable.
• Perfect Adaptability: Production factors adapt between different occupations.
• Knowledge about Marginal Productivity: Producers and owners of production have means of knowing the value of factor's marginal product.
• Full Employment: Factors are fully employed, except those seeking above-value wages.
• Law of Variable Proportions: Applicable in economy.
• Amount of Factors of Production should be Capable ofbeing varied: Units can increase or decrease before factor remuneration, and units can increase or decrease.
• The remuneration of a factor becomes equal to its marginal productivity.
• Law of Diminishing Marginal Returns: Marginal productivity diminishes as production factor units increase.
• The theory seeks explain the long run determination of factor remuneration only.

Explanation of the Theory

• States under competition, price of each production factor equals marginal productivity.
• Industry determines the price, and firms employ a number where price equals its marginal productivity.
• It is a factor demand theory for a firm and a factor pricing theory.

Analysis of Marginal Productivity Theory from the Point of View of an Industry

• Under perfect competition, price of each production factor is determined by equality of demand and supply.
• Facto price is determined by its demand, which itself is determined by the marginal productivity.
• It becomes crucial to shed light on the curve / marginal productivity in the curve.
• The industry curve can be drawn with demand curves all firms in the curve.
• Factor marginal revenue productivity constitutes firm demand curve only due to this.
• A firm employs labourers at which their marginal revenue productivity is equal to the prevailing wage rate.
• The price will fall and can shift if commodity curve.
• The demand for labour will increase if wages curves.
• The summation of demand of all the firms shows demand curve and industry of Labour.
• Since the number of firms is not constant under perfectly competitive, it’s not possible to estimate the summation curves of all. However, the one thing certain demand.
• Determine the wage, rates equal.

Analysis of Marginal Productivity Theory from Firm point of View

• Under perfect competition, firms are act as a price taker to accept price
• Firm employ when other paying.
• The firm is called Theory of Factor Demand.
• The firm is the price, price of the wage rates.
• The price of the is product by the labor is, it is 100.
• The marginal of the labor will increase.
• Each labor is their wage rate.

Factor Pricing under Imperfect Competition

• Marginal theory has Chamberlin Robinson analyze pricing competition.
• Under perfect a monopsony have total profit by labourers labour.

Product Exhaustion Theorem

• The product exhaustion that, when there is a reward to equal is the to.

Adding-Up Problem Coordination

• The adding-up a competitive a price their a, their income as Q * (MPL* L+ MPC).
• importance roles theorem.

Modern Distribution

• The marginal what in.
• The pricing the factor also product

Demand for the Supply Side

• The marginal be.

Factor Pricing in Imperfect Product

• The theories perfect different