The firm in the table below produces denim jeans and each unit of capital represents one sewing machine.The MRP for each of machines 10 through 14 is provided.Each sewing machine delivers a stream of MRPs beginning one year from now,for a total of 2 years.Assume that after 2 years each sewing machine is worth nothing.
TABLE 15-2
-Refer to Table 15-2.Suppose the interest rate is 4%,the purchase price of a sewing machine is $3000,and the firm is holding its optimal capital stock.If the interest falls to 2%,how will this firm adjust its capital stock?

Question

The firm in the table below produces denim jeans and each unit of capital represents one sewing machine.The MRP for each of machines 10 through 14 is provided.Each sewing machine delivers a stream of MRPs beginning one year from now,for a total of 2 years.Assume that after 2 years each sewing machine is worth nothing.
  TABLE 15-2
-Refer to Table 15-2.Suppose the interest rate is 4%,the purchase price of a sewing machine is $3000,and the firm is holding its optimal capital stock.If the interest falls to 2%,how will this firm adjust its capital stock?

Quizplus · Accepted Answer

The firm's optimal capital stock is the level of capital where MRP of each additional sewing machine is equal to its cost. At an interest rate of 4% and a purchase price of $3000, the firm's optimal capital stock is 12 sewing machines (since MRP for machine 12 is $3180, which is greater than the cost).

If the interest rate falls to 2%, the MRP stream for each machine remains the same, but the present value of the stream increases. This means that the MRP for each machine will be higher, and therefore the optimal level of capital stock will also increase. However, the MRP for machine 14 is still less than its cost even at a lower interest rate, so the firm will not choose to purchase it.

Therefore, the firm will not adjust its capital stock and will remain at 12 machines, since this is still the optimal level of capital given the new interest rate.

The Firm in the Table Below Produces Denim Jeans and Each