Firms can determine the profit maximizing level of capital
stock by comparing the costs and benefits of using additional
capital. If the benefits outweigh the costs, the firm will raise its
profit by expanding its capital stock. If the costs outweigh the
benefits, the firm should not increase its planned capital stock.
The marginal product of capital (MPk) is the benefit from having
an additional unit of capital. MPk is the additional output a firm
can obtain by adding a unit of capital, all other things constant.
The cost of using capital (rental cost, rc), on the other hand, is
equal to the real interest rate times the price of the capital and
the rate at which capital depreciates.
rc = r.Pk + d
A firm’s desired capital stock is the capital stock at which the
marginal product of capital equals the rental cost of capital.
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