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Market for Capital

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Economics

Welcome! You may have heard about markets in general. But what about the capital market? Firms acquire capital they use in production from factor markets, and capital is one of these resources. Hence the name: Market for Capital. If you are wondering whether this particular market operates differently from any usual market, then continue reading as we explain the market for capital and everything that comes with it!

Capital Market Definition

Let’s simplify the definition of capital markets by briefly explaining what is capital first.

As a factor of production, capital refers to the durable man-made goods that are used by firms in the production of products. Based on this, we can understand that things like tools, equipment, and machinery are all capital. Firms acquire them to use as inputs in their production processes.

Capital refers to the durable man-made goods that are used by firms in production.

Now that we have defined capital, we can comfortably define capital markets as the markets where capital is bought and sold.

Capital markets are the markets where capital is traded.

'Capital market' is the 'market for capital'. They are just different ways of saying the same thing.

Assuming that both the product market and the factor market are perfectly competitive, firms will be price takers. This means they do not have the power to force market prices. To focus on not running at a loss, the firm will consider the marginal benefit of acquiring an extra unit of capital to the cost of acquiring that extra unit of capital. To maximize its profit, the firm will continue to buy extra units of capital until the final unit of capital added is equal to the marginal benefit of adding it. Yes! Basic marginal analysis applies here too! Though it’s more often done for labor, don’t be surprised to see it for capital, it is done the same way).

A coffee processing plant operates in a perfectly competitive market. The plant already has one coffee processor, but at any point in time, there are three extra bags of coffee waiting to be processed. This makes the company realize it could process even more coffee at the same time by adding extra processors. So it adds an extra processor until there is no bag of coffee left at any point in time. This is where the marginal cost of adding an extra coffee processor has met the marginal benefit of processing an extra bag of coffee. If the firm goes on to add another coffee processor, this will be a waste, since that extra coffee processor will not be doing any work.

As shown in the example above, there is a point where the marginal cost of capital will exceed its marginal benefit. This is a simple way to understand the law of diminishing marginal returns as it applies to capital.

The law of diminishing marginal returns of capital states that the continued addition of extra units of capital results in smaller increases in additional output, and eventually, results in a decrease in additional output.

You may ask, “what if the company already owns the coffee processors?” Well, in economics, everything comes at an opportunity cost. So, even if the company already owns the extra coffee processors, the company is still paying the cost of what it could have owned instead of coffee processors.

Importance of Capital Markets

So, why are capital markets important? The answer is as simple as the definition of markets for capital.

Capital markets are important because they allocate capital resources to firms so they can use them in their production processes.

Capital markets provide the means for firms to buy an essential factor of production - capital, if firms hope to ever get any production going. Therefore, capital markets are very important. Just like the market for any other factor of production.

To learn more about markets for other factors of production check our explanation on - Factor Markets

Types of Capital Market

There are two types of capital. These are physical capital and human capital.

  1. Physical capital refers to the man-made resources used in production. These are what economists typically refer to when they mention "capital".
  2. Human capital refers to the knowledge and experience a worker has.

Therefore, the types of capital market are the markets for these two types of capital: the market for physical capital and the market for human capital.

However, we will be focusing only on the market for physical capital as this is the primary focus of markets for capital.

The market for capital focuses primarily on physical capital.

Demand and Supply in the Capital Market

The market for capital, just like any other market, is characterized by demand and supply. Let's look at them one by one.

Keep in mind that Economists refer to the cost of acquiring capital as the rental rate (R). the letter Q denotes the quantity of capital demanded.

Demand in the market for capital

To understand demand in the market for capital you need to keep capital demand, rental rate, and the quantity of capital demanded in mind. So, what are these three? Let's define them.

Capital demand is the willingness and ability of firms to purchase capital at any given time.

The rental rate of capital is the price at which capital is sold or rented at any given time.

OR

The rental rate of capital is the cost of using a unit of capital for a given period of time.

The quantity of capital demanded is the quantity of capital firms are willing to purchase or rent at a given price at a given time.

Demand in the market for capital is represented by the capital demand curve. This is a graph with the rental rate (R) on the vertical axis and quantity of capital demanded (Q) on the horizontal axis. It slopes downward from the left to the right because the rental rate has a negative relationship with the quantity of capital demanded. Take a look at Figure 2 below, which depicts the capital demand curve.

Remember the law of diminishing marginal returns? The more capital the firm adds to production, the less the benefit of the added capital. So, the more capital the firm adds to production, the less the firm would be willing to pay for each additional unit of capital.

Capital Demand Curve StudySmarterFigure 1. Capital Demand Curve - StudySmarter

Supply in the market for capital

Just like we did for demand, to understand supply in the market for capital you need to keep capital supply, rental rate, and the quantity of capital supplied in mind. The definition of rental rate remains the same. So, let's define capital supply and quantity of capital supplied.

Capital supply is the availability of capital for purchase or rental by firms at any given time.

The quantity of capital supplied is the quantity of capital made available for firms to purchase or rent at a given price at a given time.

Economists illustrate capital supply with the capital supply curve. The capital supply curve is plotted with the rental rate (R) on the vertical axis and the quantity of capital supplied (Q) on the horizontal axis, just like the capital demand curve. However, it slopes upward from the left to the right because the rental rate has a positive relationship with the quantity of capital supplied. The capital supply curve is presented in Figure 3.

The curve slopes upward because suppliers of capital want to supply more capital as the price of capital goes up.

Capital Supply Curve StudySmarterFigure 2. Capital Supply Curve - StudySmarter

Equilibrium in the market for capital

Equilibrium in the market for capital is where the supply of capital meets the demand for capital.

To make this simple to understand, the equilibrium in the market for capital is best shown in the capital market graph which shows both the capital demand and capital supply curves. The equilibrium rental rate is denoted by R* whereas the equilibrium quantity of capital is denoted by Q*. Figure 4 below shows the equilibrium in the capital market.

Note that the graph that shows an equilibrium is the capital market graph showing both the capital demand curve and the capital supply curve.

Equilibrium in the Market for Capital Study SmarterFigure 3. Equilibrium in the Market for Capital - Study Smarter

The equilibrium in the capital market is where the demand and supply curves intersect.

Examples of Capital Markets

Let's take a look at the five examples of capital markets:

  1. The market for tractors
  2. The market water pumps
  3. The market for sewing machines
  4. The market for excavators
  5. The market for cranes

We could give countless examples because the market for any tool, machine, or equipment used by a firm to produce goods is an example of a capital market.

Great! We're at the end of the topic of Market for Capital. Have you already checked out the markets for the other factors of production?

To learn more about the markets for the other factors of production, see our explanations on - Land Market and Labour Market.

Market for Capital - Key Takeaways

  • Capital refers to the durable man-made goods that are used by firms in production.
  • Capital markets are the markets where capital is traded.
  • The law of diminishing marginal returns of capital states that the continued addition of extra units of capital results in smaller increases in additional output, and eventually, decreases in additional output.
  • Capital markets are important because they allocate capital resources to firms so they can use them in their productive processes.
  • Capital demand is the willingness and ability of firms to purchase capital at any given time.
  • The rental rate of capital is the cost of using a unit of capital for a given period of time.
  • The quantity of capital demanded is the quantity of capital firms are willing to purchase or rent at a given price at a given time.
  • Capital supply is the availability of capital for purchase or rental by firms at any given time.
  • The quantity of capital supplied is the quantity of capital made available for firms to purchase or rent at a given price at a given time.
  • Equilibrium in the market for capital is where the supply of capital meets the demand for capital.

Market for Capital

Capital markets are the markets where capital is traded.

The capital market primarily focuses on the trading of capital.

Equilibrium in the market for capital is where the supply of capital meets the demand for capital.

The types of capital market are the market for physical capital and the market for human capital.

  1. The market for tractors.
  2. The market water pumps.
  3. The market for sewing machines.
  4. The market for excavators.
  5. The market for cranes.

Final Market for Capital Quiz

Question

What is capital?

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Answer

Capital refers to the durable man-made goods that are used by firms in production.

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Question

There are two types of capital

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Answer

True

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Question

What are the two types of capital

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Answer

Physical capital and human capital

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Question

What is the law of diminishing marginal returns of capital?

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Answer

The law of diminishing marginal returns of capital states that the continued addition of extra units of capital results in smaller increases in additional output, and eventually, decreases in additional output.

Show question

Question

Why are capital markets important?

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Answer

Capital markets are important because they allocate capital resources to firms so they can use them in their productive processes.

Show question

Question

What is capital demand?

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Answer

Capital demand is the willingness and ability of firms to purchase capital at any given time.

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Question

Define the rental rate of capital

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Answer

The rental rate of capital is the cost of using a unit of capital for a given period of time.

Show question

Question

What is the quantity of capital demanded?

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Answer

The quantity of capital demanded is the quantity of capital firms are willing to purchase or rent at a given price at a given time.

Show question

Question

What is capital supply?

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Answer

Capital supply is the availability of capital for purchase or rental by firms at any given time.

Show question

Question

What is the quantity of capital supplied?

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Answer

The quantity of capital supplied is the quantity of capital made available for firms to purchase or rent at a given price at a given time.

Show question

Question

What is equilibrium in the market for capital?

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Answer

Equilibrium in the market for capital is where the supply of capital meets the demand for capital.

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Question

In which direction does the capital demand curve slope?

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Answer

It slopes downward from the left to the right

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Question

In which direction does the capital supply curve slope?

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Answer

It slopes upward from the left to the right 

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Question

On which axis do we plot the rental rate?

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Answer

Vertical axis

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Question

For marginal analysis, firms compare the marginal cost of adding an extra unit of capital to

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Answer

the marginal benefit of adding an extra unit of capital 

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