Demand
The analysis of the demand for the services of capital parallels closely that of labour demand: The rental rate for capital replaces the wage rate and capital services replace the hours of labour. It is important to keep in mind the distinction we drew above between capital services on the one hand and the amount of capital on the other. Capital services are produced by capital assets, just as work is produced by humans. Terms that are analogous to the marginal product of labour emerge naturally: The marginal product of capital (MPK) is the output produced by one additional unit of capital services, with other inputs held constant. The value of this marginal product (VMPK) is its value in the market place. It is the MPK multiplied by the price of output.
The MPK must eventually decline with a fixed amount of other factors of production. So, if the price of output is fixed for the firm, it follows that the VMPK must also decline. We could pursue an analysis of the short-run demand for capital services, assuming labour was fixed, that would completely mirror the short-run demand for labour that we have already developed. But this would not add any new insights, so we move on to the supply side.
The marginal product of capital is the output produced by one additional unit of capital services, with all other inputs being held constant.
The value of the marginal product of capital is the marginal product of capital multiplied by the price of the output it produces.
Supply
We can grasp the key features of the market for capital by recognizing that the flow of capital services is determined by the capital stock: More capital means more services. The analysis of supply is complex because we must distinguish between the long run and the short run, and also between the supply to an industry and the supply in the whole economy.
In the short run the total supply of capital assets, and therefore services, is fixed to the economy, since new production capacity cannot come on stream overnight: The short-run supply of services is therefore vertical. In contrast, a particular industry in the short run faces a positively sloped supply: By offering a higher rental rate for trucks, one industry can bid them away from others.
The long run is a period of sufficient length to permit an addition to the capital stock. A supplier of capital, or capital services, must estimate the likely return he will get on the equipment he is contemplating having built. To illustrate: He is analyzing the purchase or construction of an earthmover that will cost $100,000. Assuming that the annual maintenance and depreciation costs are $10,000, and that the interest rate is 5% (implying that annual interest cost is $5,000), it follows that the annual cost of owning such a machine is $15,000. If the entrepreneur is to undertake the investment she must therefore earn at least this amount annually (by renting it to others, or using it herself), and this is what is termed the required rental. We can think of it as the opportunity cost of ownership.
The required rental covers the sum of maintenance, depreciation and interest costs.
Prices and returns
In the long run, capital services in any sector of the economy must earn the required rental. If they earn more, entrepreneurs will be induced to build or purchase additional capital goods; if they earn less, owners of capital will allow machines to depreciate, or move the machines to other sectors of the economy.
As an example, the price of oil on world markets fell by half during 2015; from about $100US per barrel to $50US. At this price, many oil wells were no longer profitable, and oil drilling equipment was decommissioned. Technically, the value of the marginal product of capital declined, because the price of the good it was producing declined. In the near and medium term, no new investment in capital goods will take place in the oil drilling sector of the economy. If the price of oil should increase in the future, some of the decommissioned capital will be brought back into service. But some of this capital will deteriorate or depreciate and simply 'die', and be sold for scrap metal – particularly the older vintage capital. Only when the stock of oil drilling equipment is reduced by depreciation and decay to the required level will any new investment in this form of capital take place.
Note that the capital in this example is sector-specific. Drilling equipment cannot be easily redirected for use in other sectors. In contrast, earth movers can move from one sector of the economy to another with greater ease. An earth mover can be used to dig foundations for housing or commercial buildings; it can be used for strip mining; to build roads and bridges; to build tennis courts, golf courses and public parks. Such equipment may thus be moved to other sectors of the economy if in one particular sector the capital no longer can earn the required rental.
The prices of capital goods in the long run will be determined by the supply and demand for the services they provide. If the value of the services, as determined by supply and demand is high, then the price of assets will reflect this.
