Question

Capital in competitive markets is priced by the interest rate. Explain how the conceptual definition of capital is related to the interest rate and the process by which the interest rate clears this market.

Answer 1

Capital is an input used in production of output. Capital is anything that can be used to enhance productivity.

And interest rate is the price for buying capital. Higher the inputs of capital demanded higher is the price needed to be paid, i.e. higher interest rate.

Firm using capital is bearing it's cost in the form of interest rate that it has to pay either annually or monthly.

Market clearing condition for capital

r=P*MPk

r= interest rate

P= price of output

MPk= marginal productivity of capital

P*MPk is the marginal revenue that firm is getting from using additional unit of capital.

r is the marginal cost of using one more unit of captial

If marginal productivity of capital is higher than interest rate, more capital will be demanded, which would increase its price, that is interest rate to the level where r= P*MPk

So the market clears when marginal revenue is equal to marginal cost.