Investment
Accumulation of physical capital – tangible assets used in the production
process and not for direct consumption (houses – used as a service to live
somewhere, computers, machine tools, as well as increases in inventories
of goods to be sold at a future date – stocks)
Business fixed investment: businesses’ spending on equipment and
structures for use in production
Residential investment: purchases of new housing units (by
occupants or landlords)
Inventory investment: the value of the change in inventories of
finished goods, materials and supplies, and work in progress (minor
part)
Investment reduces during recessions, and increases during booms and is
primarily made up of business fixed investments. Investment is procyclical
(moves with cycle of economy or GDP – while unemployment is
countercyclical)
Investment occurs to bring capital stock to the desired level, but also to
make up for capital lost through depreciation (replace or repair broken
machinery – computers lose value after use, second hand vs new).
Investment decisions by firms depend on current sales, real interest rate
and future expectations. They need to decide the optimal capital stock,
we are now endogenizing investment (where before we looked at it as
exogenous) by looking at it as a function of income (+ve) and real interest
rates (-ve).
We determine optimal amount of capital for one firm, then aggregate it.
Marginal productivity of capital (MPK) is the amount of extra output that
can be obtained when an additional unit of capital is installed (return from
an additional unit of capital). MPK is the slope of the production function
(benefit of investment)
Investment is funded (cost of investment):
If done with resources that could have been invested in financial
assets – opportunity cost of investment (1 + r)
By borrowing – marginal cost of investment (1 + r)
Profit = F(K,L) – (1 + r)K [real terms]
Profits are maximised when the vertical distance between the production
function and the total cost curve is maximised. This is when the slope of
both curves is equal:
MPK = (1 + r)
We assume firms can resell some of their equipment.
Without depreciation: MPK = r
However if installed capital depreciates in value:
MPK + (1 – d) = 1 + r
where (1 – d) is the resale value – one unit of value becomes 0.8 units of
value if d = 0.2 when reselling
MPK = r + d (this is the arbitrage condition)
Where d is the depreciation as an additional cost of capital and (r + d) is
the user cost of capital.
Optimal capital stock depends positively on expected effectiveness of
available tech (MPK) and negatively on user cost of capital.
Kt+1 = It + (1 - d)Kt
Thus It = Kt+1 – (1 – d)Kt
If d = 0, It = Change in Kt+1 or Kt+1 – Kt
Investment demand is negatively related to real interest rate as a rise in
interest reduces investment: (1 + r) rise, Kt falls, It falls
Investment decisions of firms depend on expectations about the future, as
they only undertake investment if it offers a return higher than its costs.
Present value (v) SEE NOTES. If cost is greater than present value of the
flow of revenues, it is not profitable.
Q theory of investment: James Tobin
Forward looking as firms choose the amount to invest with a view to
maximizing expected discounted profits over the lifetime of the project.
'
Market Valueof the Firm Value of the fir m s capital as determined by the stock market
q= =
Cost of Capital Price of that capital if were purchased today
Market value depends on expected present and future profits, captured by
the firm’s stock market valuation. Cost of capital is the replacement cost
today.
If q > 1: managers can raise the market value of their firm’s stock by
buying more capital (firms should invest, is performing better than the
cost of capital)
If q < 1: managers will not replace capital as it wears out (firms should
disinvest as they aren’t making enough profits)
Positive correlation between Tobin’s q and investment amount in Japan
(with some delay). Investment and profit moves together, as well as
investment and the recession/booms. Investment is now a function of
output and real interest rates, thus endogenous: I(y,r) – positive for output
and negative for interest.
