Measure of Capital

While labor is measured in terms of the number of workers hired or the number of hour worked, it is difficult to measure capital in terms of physical units because there are so many different types of capital goods. Capital goods, therefore, are simply measured in terms of their market or currency value.

Capital stock. The market value of capital goods at a given point in time, for example, at the end of a year, is referred to as the capital stock. A firm's capital stock is the market value of its factory, equipment, and other capital goods at a given point in time. A household's capital stock is the market value of its residential structures, human capital, and other capital goods at a given point in time. Firms' and households' capital stocks will vary over time due to investment and depreciation.

If the firm borrows $ 20, 000 for two years at an annual interest rate of 5%, it will have to repay the lender $ 22, 050 at the end of two years. After one year, the firm will owe the lender $2 1, 000 as explained above; however, because the loan is for two years, the firm does not have to repay the lender until the end of the second year. During the second year, the firm is charged compound interest, which means it is charged interest on both the principal of $ 20, 000 and the accumulated unpaid interest of $ 1, 000.

The equilibrium interest rate is determined in the loanable funds market. All lenders and borrowers of loanable funds are participants in the loanable funds market. The total amount of funds supplied by lenders makes up the supply of loanable funds, while the total amount of funds demanded by borrowers makes up the demand for loanable funds.

Present Value and Investment Decisions. Firms purchase capital goods to increase their future output and income. Income earned in the future is often evaluated in terms of its present value. The present value of future income is the value of having this future income today.

The firm's investment decision is to determine whether to purchase new capital. In determining whether to purchase new capital — for example, new equipment — the firm will take into account the price of the new equipment, the revenue that the new equipment will generate for the firm over time, and the scrap value of the new equipment. The firm will also take into account the interest rate, which represents the firm's opportunity cost of investing in the new equipment. It will use the interest rate to calculate the present value of the future net income that it expects to earn from its purchase of the new capital equipment. If the present value is positive, the firm will choose to purchase the new equipment. If the present value is negative, it is better off forgoing the investment in new equipment.

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