What Is Marginal Product of Capital?
Definition: Marginal product of capital is the additional output that comes into being, in any production process, from each additional unit of capital used. It is also the incremental increase in total production arising from one unit increase in capital, as other factors of production remain constant.
Understanding Marginal Product of Capital
It is important for manufacturing companies to understand how each additional unit of capital affects the level of production. Contrary to perception, the relationship between capital and output is not always linear.
In the initial stages of production increase in the capital, oftentimes trigger an increase in output depending on the investments made. However, as times fades, output tend to slow down even with an additional unit of capital. In such cases, it would not make any sense to continue injecting additional capital.
Identifying the marginal product of capital is important as it allows firms and high-level managers to make informed investment decisions by comparing the cost of capital as well as potential output. An increase in the marginal product of capital as the cost of capital remains constant provides an ideal operating situation, which can allow a firm to generate a substantial amount of profits. Measuring marginal productivity of capital thus allows firms to maximize their output and profit.
Conversely, whenever marginal product of capital falls below the cost of capital, it would not make any sense for a business to ramp up production. What this means is that the addition of any new capital does not have a positive impact on the overall output, thus no reason to continue pumping in additional units of capital.
Marginal Product of Capital Importance
The concept of marginal product of capital comes in handy when businesses need to make decisions on whether additional capital is needed to ramp up production. While additional capital can have a positive impact on the overall production operations, there comes a time when no amount of capital would be able to accelerate the production process. In this case, the output may remain the same or decrease even with the additional of a new unit of capital.
When the law of diminishing productivity happens, a change in tact is necessary if a business is to remain operational. Instead of focusing on capital injection, a firm may have to carry out changes on other production variables to revitalize production and output. The situation is also known as negative marginal productivity of capital as injection of additional capital does not end up adding to production.
Marginal Product of Capital Example
Company XYZ is a car tire manufacturer. The company started operations several decades ago and has consistently ramped up capital investments. Faced with strong demand and large orders to fill in the market, the company is forced to make new investments in machinery to ramp up production.
The addition of new machinery triggers an increase in production levels. However, after buying similar machinery for the fourth time, managers realize that production levels have flatten out even though more machinery was expected to fuel production activities leading to an increase in output.
Upon carrying out marginal productivity of capital analysis, it becomes evident that the company XYZ does not have enough workforces to ensure the machines operate at their maximum capacity. Likewise, the company would have to hire additional manpower, which in this case, is the additional unit of capital to have any chance of raising production for higher production output.
Summary
Marginal of product capital analysis is an important tool for ascertaining how efficient capital is being utilized. The analysis provides insights on the best time to inject new capital and the appropriate areas to invest in, in a bid to ramp up output volume.