A firm needs more capital only when its output has to grow
Firms buy capital goods, such as machines and vans, to produce output. Suppose a bakery needs £2 of equipment for every £1 of bread it sells in a year: its capital-output ratio is 2. While sales stay at £100,000 a year, its £200,000 of equipment is enough, and it only replaces what wears out. If sales rise to £110,000, it needs £220,000 of equipment, so it invests £20,000 in new capital.
Predict first
The bakery's sales keep rising, but by £5,000 this year instead of £10,000 last year. What do you think happens to its spending on new equipment?
New equipment is needed only for the extra sales. A £5,000 rise needs £10,000 of new equipment, half last year's £20,000, even though sales are at a record level.