Principles of Microeconomics / Unit 15 MIC 1415 worked example, 60 to 90 seconds
The Investment Rule and the Demand for Capital
The idea
A firm buying a machine compares its cost now with the present value of its net returns. Discount each year's return at the interest rate, add, and subtract the cost: the net present value. Invest if positive. Then raise the rate: every present value falls, some projects turn negative, and the firm buys less capital. So capital demanded falls as the rate rises, and the rate is set where borrowers' demand for funds meets savers' supply.
In practice
Worked example: a machine costs ten thousand dollars and returns six thousand at the end of each of two years. At five percent the returns are worth five thousand seven hundred fourteen plus five thousand four hundred forty-two, eleven thousand one hundred fifty-six: net present value plus one thousand one hundred fifty-six, buy it. At fifteen percent they are worth five thousand two hundred seventeen plus four thousand five hundred thirty-seven, nine thousand seven hundred fifty-four: minus two hundred forty-six, do not. The same machine is bought at five percent and not at fifteen.
Where people slip
The interest rate is the opportunity cost of the firm's own money too, since the cash could have earned it elsewhere; a firm that pays cash still discounts. And the rule is the input rule of unit six across time: capital's marginal revenue product, in present value, against its cost.
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