Capital is a factor of production, along with labor and land. It consists of the infrastructure and equipment used to produce goods and services. Capital can include factory buildings, vehicles, plant machinery, and tools used in the production process. Firms may buy, rent, or lease infrastructure and tools in the capital market, but even if the firm owns these factors of production, the opportunity cost of using this capital is the foregone rent that the firm could receive if it rented the capital to somebody else rather than using it for production. Because of this, we say that the price of capital is the rental rate.
A firm decides how much of each factor input to use and how much output to produce based on the market prices for outputs and inputs, as well as exogenous technological determinants represented by the production function. The production function describes the relationship between the quantity of inputs used in production and the quantity of output. It can be used to derive the marginal product for capital, which is the increase in the amount of output from an additional unit of capital. The value of marginal product (VMP) of capital is the marginal product of capital multiplied by price. The downward-sloping demand curve for capital, which is equal to the VMP of capital, reflects the fact that the production process exhibits diminishing marginal product. A firm will continue to add capital up to the point where the rental rate is equal to the value of marginal product of capital , which is the point of equilibrium.
Firm Demand for Capital
Firms will increase the quantity of capital hired to the point where the value of marginal product of capital is equal to the rental rate of capital.