Definition: The change in output that takes place when one additional unit of capital is deployed is referred to as the marginal product of capital. This change is measured by keeping all the other factors of production constant.
What does Marginal Product of Capital mean?
It is useful for a manufacturing company to understand how each additional unit of capital affects its level of production. It is logical to utilize more capital as long as this results in added production. However, the relationship between capital and output is not always linear. In the initial stages, each unit of additional capital will lead to higher output. But this increase will taper off as more capital is deployed. In fact, after a certain stage, additional capital may result in negative output. Firms seek to maximize their output and profit. Measuring the marginal productivity of capital helps them to do that. The management of a company would increase its investments up to a point where it can raise output. When output starts declining, it will stop making additional investments.
Allied Extrusion Company is a plastic container manufacturer. It started operations several decades ago and has established itself as a high quality and reliable producer of plastic containers. All its production is sold to bulk buyers. Recently Allied has received several large orders. To fulfill these, it needs to make new investments in machinery. As it adds extra equipment, its production level rises. But after buying its fourth plastic extrusion machine, it notices that the production level has flattened out. It realizes that it does not have the manpower to run all its machines at their maximum capacity. Allied’s marginal productivity of capital has tapered off. It decides to hire additional manpower in its effort to raise production.
The marginal product of capital is the extra output that results from additional investments being made. Each additional dollar of investment will lead to greater output, but after a certain point, the marginal productivity of capital will start falling or even become negative.