Chapter 2

Theories of Investment
INTRODUCTION

Two facts make this one of the most important topics in macroeconomics. First,investment is
usually the most volatile component of GDP/GNP. In many recessions, the fall in investment
is of the same magnitude as the fall in GDP itself. Second, since physical capital is accumulated
through investment, a high level of investment is a necessary condition for high level of
economic growth.

First, let us simply assume the amount of work (capital services) a firm can get from its capital stock
is proportional to the stock. These capital services are then combined with labour, raw materials,
energy, and any other factors to produce output. For macroeconomic purposes it is worth
imagining that capital services (and thus the capital stock) and labour combine to produce value-
added output, Q, so we can write:
(1)
Q = Q(K , L),
QK , QL  0.

This is a production function, familiar from microeconomics. We assume positive marginal

products that decline with the level of both inputs. Next, we need to think about the process of
accumulating capital. First in words:

End-of -period capital stock = Beginning-of-period capital stock – scrapping +

investment.

Now in maths notation:

K t = Kt −1 − St + I t ,

The easiest way to model scrapping it is to assume that a fraction d (for depreciation rate) of the
capital stock is scrapped per period. Assuming that, the above equation becomes:

K t = K t −1 − dKt −1 + It = (1 − d )K t −1 + It ,

5.2.1 CATEGORIES OF INVESTMENT

Before developing any theories about investment choices by people it is important to define what
is meant by investment.

Investment: is the formation of real capital, tangible or intangible, that will produce a stream of
goods and services in the future.

Investment undertaken in an economy is classified according to the following categories:

1. Business Fixed Investment — plant and machinery, office buildings.

 2. Residential Construction Investment — houses, and significant additions to houses (that
require building permits).
3. Changes in Firm’s Inventories — as they provide revenue in the future, not today.
4. Purchases of Durable Goods by Households — cars, fridges.
5. Gov’t Purchases of Investment Goods and Buildings — roads, hospitals, etc.
6. Investment in Human Capital — schooling, university study, apprenticeships etc.
7. Knowledge — things we know about scientific and other areas.

1. BUSINESS FIXED INVESTMENT

Many people are intensely interested in business fixed investment and it is not difficult to understand
why; it constitutes the basic equipment used by firms to produce output whether it be computers,
factories, machine tools, or offices. We will learn about two theories developed to explain this form of
investment.

A. THE ACCELERATOR THEORY OF BUSINESS FIXED INVESTMENT

The first coherent theory for explaining the level of aggregate investment and why it behaves as it does
is called the accelerator theory of investment. Its initial focus is on what firms might do and then applies
the results to aggregate investment.
Theory behind the Accelerator Model

The theory’s line of argument goes as follows. Firms produce output and they need capital to produce
this output. It is likely that a firm has some desired stock of capital in mind when producing any given
amount of output. If the desired capital stock differs from what the firm actually has, then it must
change its capital stock and how much it changes it is the amount of investment. When would a firm
change how much capital it desired? Following this line of reasoning the answer is easy, when output
changed. Investment is thus the result of changes in output.
The Formal Model

We will now write the basic idea described above as a formal model. To do this define the
following variables:
kt = the actual capital stock of the firm at time t.
kdt = the desired capital stock of the firm at time t.
yt = output produced by the firm at time t.
it = the amount of net investment by the firm at time t.
ά = the desired capital to output ratio by the firm.
Next, we need to specify the two key assumptions used by the model:

1. There exists a long-run desired amount of capital related to the amount of output, or,

There may be short-run deviations from this amount because of output fluctuations, but on average,
this relationship holds.
2. All investment undertaken today is assumed to be ready for use today (note that this differs from the
“standard” assumption that investment today only becomes productive in the future). In symbols we
can show this as:

and notice the different time subscripts as to why this is true. This is a strong behavioural assumption
that businesses know what is going on all the time and adjust for it very quickly.

Now, put everything together. The logical implication of the second assumption is that the capital stock
each period equals the desired capital stock, or that,

This means that we can rewrite the above equation for net investment in the following way:

So, what we find is that investment is determined by changes in output. This is called the naive
accelerator model, since all the change happens in one period.

B. Neoclassical Theory of Investment

Our next theory of aggregate investment, and the one that is currently used by economists, builds on
the accelerator theory but includes the possibility that firms can substitute between capital and in more
sophisticated (and more mathematically complex versions) of this model also take expectations into
account as well, but we will leave that for this course as it requires more maths than you currently have.
The key difference between it and the accelerator theory is that whereas the accelerator theory did not
explore where the desired capital to output ratio came from, the theory we are about to learn explicitly
invokes the optimization principle used in economics.

Underlying Theory
An important underlying assumption of the accelerator model is that firms do not change their
production techniques. In effect they employ the same proportions of capital and labour
independents of their prices. The neoclassical theory of investment looks at investment decisions as
being affected by output, as with the accelerator model, but on the basis of a cost-benefit decision.
That is, firms may have a desired output level they wish to produce, given the price the output can be
sold at, but the bundle of inputs they use will depend on their relative costs and benefits so as to
maximize the profits of firms.

The Formal Model

We will now write the basic idea described above as a formal model. To begin with define the
following variables:
y = the quantity of output produced by the firm.
k = the quantity of capital used by the firm.
l = the quantity of labour used by the firm.
f [·, ·] = the production function which relates how the inputs capital and
labour are used to produce outputs.

Next, we need to specify the key assumption used by the model:

Firms act to maximise their profits where profits equal revenue less costs.
If firms maximise profits by hiring labor and capital, then the amount they choose to hire will
satisfy the condition MB (Marginal Benefit) =MC (Marginal Cost) for each factor, or in this case
their Marginal Revenue Product (MRP) equals their cost. Let,
W = the marginal nominal wage cost paid to employees.
R = the marginal nominal “rental” cost that firms incur in using capital.
where it is important to note that the implicit or explicit cost of using capital is not simply the actual
price of the capital, since the capital can be resold. The cost of using the capital is the implicit (or explicit
if rented from another firm) cost of renting the capital over the period it is used we are calling R (e.g.
if we build a dam and use it to produce electricity then the capitalcost per unit of electricity is not
the total cost of the dam, but some fraction of it relating towhat portion of it was used to produce
the unit electricity). Given our assumption, we know thatthe logical implication is that capital and labour
are employed up to the point where:

There are three cases to consider:

1. MPK > cost of capital means there are potential profits a firm could earn by increasing itscapital
stock.

2. MPK < cost of capital means the firm is making losses on the last units of capital it is usingand it
could increase profits by reducing its capital stock.

3. MPK = cost of capital means the firm is maximizing the amount of profits it can earn fromusing
capital and does not want to change its capital stock (ie. kt+1 = kt).
A firm’s decision about whether to add to its capital stock, or reduce it through depreciation depends
upon the profit rate or the difference between the MPK and the cost of capital. Note that unlike the
accelerator theory, the neoclassical theory shows us what determines the optimal or desired capital
stock, it is the amount of capital where MB=MC, or no more profits can be made from changing the
firm’s amount of capital.

Investment and the Capital Stock

A logical conclusion from the neoclassical theory of investment is that both net and gross investment
of firms are a negative function of R because the cost of capital is positively affected by changes in R,
which negatively affects the profit rate of capital.

And a change in any other variable that affects the MB or MC of using and owning capital by firms in
an economy other than R can be shown by a shift of the investment function (e.g. an
increase in the MPK, say from a technological innovation, causes a rightward shift in the
investment schedule.

The amount of investment that is undertaken depends on whether or not firms are using and owning
the optimal amount of capital, that is, whether or not the profit rate is zero or non-zero.In the long-
run equilibrium, with the profit rate equaling zero, we would expect that the amountof net investment
is zero with gross investment being positive and just offsetting the amount of depreciated capital each
period. Once a firm is in its long-run state, only a change in R, or
MPK, or some other variable, will affect the demand for capital and thus the amount of
investment demanded. This will cause net investment to stop being zero and the capital stock will
adjust to get back to a new long-run equilibrium situation.

Extended version of the neoclassical model of investment

Here we will see the standard model of business fixed investment which is known as the neoclassical
model of investment. It examines the benefits and costs of owning capital goods.

The Rental Price of Capital

Let’s first consider the typical production firm. A firm decides how much capital to rent by comparing
the cost and benefit of each unit of capital. The firm rents capital at a rental rate R and sells its output at
a price P; the real cost of a unit of capital to the production firm is R/P. The real benefit of a unit of
capital is the marginal product of capital MPK—the extra output produced with one more unit of capital.
The marginal product of capital declines as the amount of capital rises: the more capital the firm has, the
less an additional unit of capital will add to its output. To maximize profit, the firm rents capital until
the marginal product of capital falls to equal the real rental price.

Figure 1. Shows the equilibrium in the rental market for capital. For the reasons just discussed, the
marginal product of capital determines the demand curve. The demand curve slopes downward because
the marginal product of capital is low when the level of capital is high. At any point in time, the amount
of capital in the economy is fixed, so the supply curve is vertical. The real rental price of capital adjusts
to equilibrate supply and demand.
To see what variables, influence the equilibrium rental price, let’s consider a particular production
function. Consider the Cobb–Douglas production function which is given by

Y = AK  L1− , where Y is output, K is capital, L is labor, A is a parameter measuring the

level of technology, and  is a parameter between zero and one that measures capital’s share of output.
The marginal product of capital for the Cobb–Douglas production function is

MPK =  A( L )1−
K

Because the real rental price R/P equals the marginal product of capital in equilibrium, we can write

R =  A( L )1−
P K

This expression identifies the variables that determine the real rental price. It shows the following:

✓ The lower the stock of capital, the higher the real rental price of capital.
✓ The greater the amount of labor employed, the higher the real rental price of capital.
✓ The better the technology, the higher the real rental price of capital.
Events that reduce the capital stock (an earthquake), or raise employment (an expansion in aggregate
demand), or improve the technology (a scientific discovery) raise the equilibrium real rental price of
capital.

The Cost of Capital

Next consider the rental firms. These firms, like car-rental companies, merely buy capital goods and rent
them out. Because our goal is to explain the investments made by the rental firms, we begin by
considering the benefit and cost of owning capital.

The benefit of owning capital is the revenue earned by renting it to the production firms. The rental firm
receives the real rental price of capital R/P for each unit of capital it owns and rents out.

The cost of owning capital is more complex. For each period of time that it rents out a unit of capital,
the rental firm bears three costs:

1. When a rental firm borrows to buy a unit of capital, it must pay interest on the loan. If PK is the
purchase price of a unit of capital and i is the nominal interest rate, then iPK is the interest cost.
Notice that this interest cost would be the same even if the rental firm did not have to borrow:
if the rental firm buys a unit of capital using cash on hand, it loses out on the interest it could
have earned by depositing this cash in the bank. In either case, the interest cost equals iPK .
2. While the rental firm is renting out the capital, the price of capital can change. If the price of
capital falls, the firm loses, because the firm’s asset has fallen in value. If the price of capital rises,
the firm gains, because the firm’s asset has risen in value. The cost of this loss or gain is −PK .
3. While the capital is rented out, it suffers wear and tear, called depreciation. If  is the rate of
depreciation—the fraction of capital’s value lost per period because of wear and tear—then the
dollar cost of depreciation is  PK .
The total cost of renting out a unit of capital for one period is therefore
 Cost of capital=iPK − PK +  PK = PK (i − PK / PK +  )

The cost of capital depends on the price of capital, the interest rate, the rate at which capital prices are
changing, and the depreciation rate.

To make the expression for the cost of capital simpler and easier to interpret, we assume that the price
of capital goods rises with the prices of other goods. In this case, PK / PK equals the overall rate of
inflation  . Because i −  equals the real interest rate r, we can write the cost of capital as

Cost of capital=PK (r +  )

This equation states that the cost of capital depends on the price of capital, the real interest rate, and the
depreciation rate.

Finally, we want to express the cost of capital relative to other goods in the economy. The real cost of
capital—the cost of buying and renting out a unit of capital measured in units of the economy’s output—
is

Re al cost of capital=(PK / P)(r +  )

The Determinants of Investment

Now consider a rental firm’s decision about whether to increase or decrease its capital stock. For each
unit of capital, the firm earns real revenue R/P and bears the real cost (PK / P)(r +  ) . The real profit per
unit of capital is

Profit rate=R/P- (PK / P)( r +  )

Because the real rental price in equilibrium equals the marginal product of capital, we can write the profit
rate as

Profit rate=MPK -(PK / P)( r +  )

The rental firm makes a profit if the marginal product of capital is greater than the cost of capital. It
incurs a loss if the marginal product is less than the cost of capital.

We can now see the economic incentives that lie behind the rental firm’s investment decision. The firm’s
decision regarding its capital stock—that is, whether to add to it or to let it depreciate—depends on
whether owning and renting out capital is profitable. The change in the capital stock, called net
investment, depends on the difference between the marginal product of capital and the cost of capital.
If the marginal product of capital exceeds the cost of capital, firms find it profitable to add to their capital
stock. If the marginal product of capital falls short of the cost of capital, they let their capital stock shrink.

We can also now see that the separation of economic activity between production and rental firms,
although useful for clarifying our thinking, is not necessary for our conclusion regarding how firms
choose how much to invest. For a firm that both uses and owns capital, the benefit of an extra unit of
capital is the marginal product of capital, and the cost is the cost of capital. Like a firm that owns and
rents out capital, this firm adds to its capital stock if the marginal product exceeds the cost of capital.
Thus, we can write

I=I n [MPK -(PK / P)( r +  )],

where I n is the function showing how much net investment responds to the incentive to invest.

We can now derive the investment function. Total spending on business fixed investment is the sum of
net investment and the replacement of depreciated capital. The investment function is

I=I n [MPK -(PK / P)( r +  )] +  K

Business fixed investment depends on the marginal product of capital, the cost of capital, and the amount
of depreciation.

This model shows why investment depends on the interest rate. A decrease in the real interest rate lowers
the cost of capital. It therefore raises the amount of profit from owning capital and increases the
incentive to accumulate more capital. Similarly, an increase in the real interest rate raises the cost of
capital and leads firms to reduce their investment. For this reason, the investment schedule relating
investment to the interest rate slopes downward.

Keynesian Explanation
The Keynesian Theory lays emphasis upon interest rate importance in investment decisions. Other
factor considered is the expected profitability on a project. Change in interest rates affects the
planned investments done. A fall in interest rates would bounce the profits from a planned
investment and the rise in interest rates would make the profits fall. An inverse relationship exists
between the Investment and the Rate of Interest.
 2. INVENTORY INVESTMENT

Another category of investment that we will study is inventory investment. It is not that large
compared to the other forms of investment, but as mentioned at the beginning of this topic there
is a strong relationship between changes in inventory investment and changes in output over the
business cycle.

A. REASONS FOR HOLDING INVENTORIES

Before developing a theory of inventory investment, we will study the reasons why inventories are
held. Knowing the reasons for holding inventories will help us understand better the factors which
influence the level of inventory investment. There are four reasons for holding inventories:
– 1) Production Smoothing.
Often it is cheaper to produce goods at a steady rate, than to continually alter production runs.This
means that during slow periods inventories build up and during boom periods inventories are run
down.
– 2) Inventories as a Factor of Production.
Firms carry inventories of spare parts in case a machine breaks down, so that the entire
assembly line does not come to a stop. E.g., Car assembly factory.
– 3) Stock-Out Avoidance.
To avoid lost sales and profits when sales may be unexpectedly high. E.g., a book retailer may carry
multiple copies of a book if they are not sure how popular the book will be.
– 4) Work In Process.
Partly completed products are counted as inventories.

An important point to notice about all of these reasons is that they have a short-term focus and not
a long-term focus as with the other forms of investment. This suggests that they will not be so
heavily influenced by short-run changes in relative prices but will instead be tied closely to output.
Another point to note is that reason 1. is not likely to be an important reason why inventories
fluctuate during business cycles since this sort of inventory investment goes up as output goes down
whereas inventory investment as a whole goes down as output goes down. This means 2-4 must be
the main causes of fluctuations in inventory investment during a business cycle.
 B. ACCELERATOR THEORY OF INVENTORY INVESTMENT

Theory Behind the Accelerator Model

You have seen this theory before applied to a different setting. The idea is the same except in the
case of inventory investment the reason that firms might hold stocks of inventories that are
proportional to their levels of output seem to have more justification than did the case of business
fixed investment, for the reasons mentioned above which are directly related to the level of output
being produced and sold. For example, say output is high and the economy is booming then
production firms require more supplies, and have more work in process and retail firms want more
merchandise to keep up with the higher sales.
Furthermore, it is likely that firms can change their inventory investment much more quickly than
they can change their fixed investments.

There may be short-run deviations from this amount because of output fluctuations, but on
average, this relationship holds.

and notice the different time subscripts as to why this is true. This is not as strong a behavioural
assumption in this context as it was in the context of business fixed investment. If we are thinking of
periods of time being a year then most firms can alter their inventories to changing conditions very
quickly if they choose to do so.
So what we find is that a firm’s inventory investment is determined by changes in output. This isagain
called the naive accelerator model, since all the change happens in one period.

3. James Tobin and the Q- theory

Many economists see a link between fluctuations in investment and fluctuations in the stock market.
The term stock refers to the shares in the ownership of corporations, and the stock market is the
market in which these shares are traded. Stock prices tend to be high when firms have many
opportunities for profitable investment, because these profit opportunities mean higher future income
for the shareholders. Thus, stock prices reflect the incentive to invest.

During a period of adjustment to a higher optimal level of capital, the marginal product of capital is
above marginal or user cost. Put another way, this means the firm’s capital is worth more (being more
productive and thus more profitable) than its user cost. James Tobin, the Nobel laureate, argued that
during such a period, the firm’s stock market value would be high, reflecting the high value of the
firm’s existing capital. Tobin defined a value q as the ratio of the present market value of the firm’s
capital to its replacement cost i.e.

q= market value of installed capital/replacement cost of installed capital

MPK − d
or, q =
r
The numerator of Tobin’s q is the value of the economy’s capital as determined by the
stock market.The denominator is the price of the capital if it were purchased today.

Tobin reasoned that net investment should depend on whether q is greater or less
than 1.
If q is greater than 1, then the stock market values installed capital at more than its
replacement cost. Inthis case managers can raise the market value of their firm’s stock
by buying more capital.
Conversely, if q is less than 1, the stock market values capital at less than its
replacement cost. In thiscase, managers will not replace capital as it wears out.

Although at first the q theory of investment may appear quite different from the
neoclassical model we developed earlier, in fact the two theories are closely related.
To see the relationship, note that Tobin’s q depends on current and future expected
profit from installed capital. If MPk exceeds the cost of capital, then firms are
earning profit from their installed capital. These profits make therental firms
desirable to own, which raises the market value of these firms’ stock, implying a high
value of q. similarly, if MPK falls short of the cost of capital, then firms are incurring
losses on their installed capital, implying a low market value and a low value of q.