Whats investment and capital????

One of the factors to produce is capital and is simply everything firms use to supply. From vans to factories to presses to offices to computers to kitchen equipment, depending on what you’re business is. Here we look at investment, which is the buying of capital to produce. For example the goverment invests in a new Ashford-London railink, Audi invests in a new £8million factory. Here we look at the economic models which attempt to show how much investment will take place at any time.

There is one thing we need to clear up which I was puzzled with at first. You hear of investment you think of buying up shares or putting money in an ISA. This is not what we are talking about. By buying shares you are letting a business invest, or buying ownership of money already invested. This is the simple 1-2 business investing for themselves.

The Marginal Efficiency of Capital.

This is the rate of return a business expects to earn off it’s next planned investment project(buying up a plant, building a retail outlet etc), due to the revenues forecast from the goods it is expected to make. The important thing to note is that this purely depends upon entrepreneurs expectations of demand in the future, hence is largely confidence oriented and subject to the animal spirits.

You’ve heard of business confidence, this is pretty much the same thing, the higher the rate of return expected, the more confident the enterprise will be, and the more investment will probably take place.

So how is the MEC calculated? Well, we need to think of the process capital goes through. Typically it is bought, then it has a yield it adds to the firm than it becomes depreciated and must be replaced. How much yield it will produce depends on the value of the output it helps to make over it’s lifetime before it must be replaced. So it’s marginal effciency is that yield minus the replacement cost of the capital once it is worn.

Think, you buy a factory, make a £1million yield then spend £500000 on repairs, at the end of the day it has reaped £500k. Typically, the efficiency is a % of the original investment, so it can be compared with other things that money could do…

MEC and the Rate of Interest

Keynes made a great point when, in his General Theory 1936 he explained the limiting effect of the interest rate on investment. In the graph above, it shows that MEC diminishes as more is made on aggregate. If the MEC is higher than the rate of interest in the latest project, there will be investment. If it is lower, the business would rather put money in the bank or bonds, where you need do nothing, and there will be no investment. So investment will take place up to where MEC=Rate of Interest. If it is lowered, more investment has MEC>RI, vice versa higher. This part of monetary policy hence has a big effect on business investment.

Why does MEC slope down??

Remember it is defined by the yield of the goods it makes minus the replacement cost. Well, when there is more investment, there is greater pressure on builders/manufacturers of the capital wanted. This increases the price of capital which rises the repalcement cost. Investing becomes less lucrative when costs to replace are huge.

Also, it is based on expectation. Huge periods of investment make entrepreneurs skeptical about the future, surely it can’t continue at this rate. Expectations can lower as to the future in a boom, which is one theory of economic cycles. Because more is produced, you may think that a lower price recieved per unit to clear lowers the yield expected, however Say’s Law(supply creates it’s own demand) means this has a smaller effect.

The Accelerator Theory….

Simply that the change in investment(buying capital, more or less decided) is proportional to changes in total income in the economy. This can be shown by MEC shifting i.e when more income-more yield- more investment given RI.

Remember, there will always be replacement investment(assumed constant with const incomes here), this only shows the change in investment. Replacement investment shown below is fairly stable, even in the 1990-92 and 2008-10 recessions. It is planned changes in capacity which is volatile.

Investment isn’t always proportional to income but is in most cases….. The theory is not perfect like any, but shows to hold good for long run changes in income. This is how changes in income may not see an exactly proportionte increase in investment……

Re-use of Excess Capacity: If a computer manufacturer has an unused production line due to it cutting back in a recession, if incomes rise again, it may simply re-use the excess capacity it had to produce to incraesing orders, rather than invest more. So capital upkeep can be a fixed cost, altough in longer run it will be shed(variable) if orders stay low(capital demand changes, why accelerator good for longer run income changes).

Strains on Capital Suppliers: If there are twofold increases in income, we need two times the capital stuffs to manufacture we are told. But what if builders of factories and makers of office equipment are already working full time, and there are no more unused rescources capital makers can use. Sometimes the markets cannot respond to the demand by entrepreneurs, capital becomes expensive, bottlenecks.

The Animal Spirits and Business Confidence: Just because incomes rise doesnt mean the MEC forecast will rise in equal portion. There could be a rise in incomes, but a fear of war leaving entrepreneurs reluctant to invest. Or, as in the great depression, political confusion(could we be entering communism, meaning my factory will be seized by the government!) can hurt confidence to invest greatly, irrespective of income changes.

Changes in Technology: Incomes may rise threefold, which with old equipment would probably see a 3fold rise in investment. But we have changed from cable to wireless, from boat to plane, and more efficient ways of producing are founded over time. So to satisfy 3 times the demand we may not need to spend 3x as much on capital, if it can be produced easier(and cheaper) over the time incomes have risen.

 And so it works in the long run, ceteris paribus(other things constant).

These two theories are all you need to get high marks….any questions or if you want me to explain another theory you have heard just contact me.


One Response to Investment

  1. Pingback: My Space. « Zahablog's Economic Page

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