Definition: Marginal product of capital is the additional production a company experiences by adding one unit of capital. In other words, it shows the additional units produced when one unit of physical capital, such as machinery, is added to the company.
What Does Marginal Product of Capital Mean?
This concept helps businesses and economists make a decision on whether or not each additional unit of capital is worth the purchase price and the investment by the company. As the amount of capital increases, MPK decreases and can eventually become negative. This is the scenario where adding an additional unit of physical capital can actually decrease production instead of increase it. This is evident in the law of diminishing productivity.
Let’s look at an example to see how it works.
Example
Mark is the factory boss at Ford Motors, and has just been chosen to oversee the purchase and installment of the physical machinery that will be creating the cars. His boss suggests he should fill the factory with as much equipment as possible to maximize the number of cars created, but Mark decides to add machinery as needed. As he is purchasing the equipment, he sees the total production of his factory increasing: the first machine adds 100 cars, the second adds 60 cars, and the third adds 20 cars, for a total of 180 cars produced. He then purchases the fourth machine, but notices total production is only 160 cars.
How could this happen? He looks at the purchase dates and production levels, and realizes the purchasing of the fourth machine coincided with the dip in production. Now, he looks onto the manufacturing floor, and sees that the fourth machine is taking up space and actually hindering the production of the other machines.
This situation is known as negative marginal productivity of capital. It occurs when adding more equipment would not make sense because it doesn’t add to production. This is a great tool that allows business owners to see how efficiently their capital is being used, and helps them realize the most efficient number of machines or equipment, given all other resources remain constant.
