INVESTMENT

Dominique Stewart, Alyssa Biggs,

Jevaughn Carter, Brittany Miller
 What is investment?

– In Economics, an investment is the purchase of goods/capital equipment that

are not consumed right “now” but are used in future wealth/gain.
– Investment decision is usually governed by output and/or the rate of interest.
– There are two types of investment:
 Autonomous
 Induced
 Autonomous Investment

– If investment does not depend either on income/output or the

rate of interest, then such investment is called autonomous.
– Autonomous investment is independent of the level of income
– consists of expenditures in a country or region that is independent
of economic growth. They are investments made for the good of
society and not for the goal of making profits.
– Autonomous investment is the opposite of induced investment,
which is not mandatory or compulsory.
 Autonomous Investment
– Autonomous investments include inventory replenishment,
government investments on infrastructure items, such as roads
and highways, and other investments that keep the economic
engine running.
 Induced investment

– Induced investment responds to the changes in national income

– Increase in national income results in an increase in the level of

investment undertaken, while a fall in the level of national income
results in a fall in the level of investment undertaken.
 Induced investment

– The slope of the investment line is the MPY (Marginal Propensity

to Invest)
 The Investment Demand Curve

– In short, the Investment Demand Curve is a graphical representation that

illustrates the fact that investors will invest less when capital costs more and
how they will be willing to invest more when the capital costs less.
What Might Cause Shifts in the
Investment Demand Curve?
– Changes in Technology—A business will be more likely to increase investment
in an industry where technology is changing than in an industry with a more
fixed technology. Businesses recognize the need to keep up with competitors’
utilization of modern technology. At any given level of the real interest rate you
would expect Investment Demand to be higher the more technology is
advancing.
– Goods on Hand—Businesses that already have a significant stock of capital on
hand are less likely to invest in additional capital. For instance, a company that
has excess office space or idle plants is not as likely to invest in additional
capital as a business that is operating at or beyond capacity. At any given level
of the real interest rate, you would expect more investment by a firm that is
short on capital goods than by a firm that has an adequate stock of capital on
hand.
Marginal Efficiency of
Capital
 Marginal Efficiency of Capital

– At any point in time there are many potential investment projects that an
economy can undertake. Let us assume that these projects could be stacked up
in terms of their initial rates of return, starting with those projects with the
highest internal rate of return. If one were to plot these investments, the
resultant curve is the marginal efficiency of investment (MEI) also known s the
marginal efficiency of capital (MEC) function.
 Marginal Efficiency of Capital

– The theory of MEI was first introduced to economics by

John Maynard Keynes. With this theory, the rte of interest
is determined by the monetary authorities.
Factors which shift the Marginal
Efficiency of Investments
– 1. The cost of capital. If capital is cheaper, then investment becomes more attractive. For
example, the development of steel rails made railways cheaper and encouraged more
investment.
– 2. Technological change. If there is an improvement in technology, it can make investment
more worthwhile.
– 3. Expectations and business confidence.
– If people are optimistic about the future, they will be willing to invest because they expect
higher profits. In a recession, people may become very pessimistic, so even lower interest
rates don’t encourage investment. (e.g. during recession 2008-12, interest rates were zero,
but investment low)
– 4. Supply of finance. If banks are more willing to lend money investment will be easier.
– 5. Demand for goods. Higher demand will increase profitability of capital investment.
– 6. Rate of Taxes. Higher taxes will discourage investment. Sometimes, governments offer
tax breaks to encourage investment.
MARGINAL EFFICIENCY
OF INVESTMENT
 Marginal Efficiency of Investment

– expected rates of return on investment as additional units of investment are

made under specified conditions and over a stated period of time.
– A comparison of these rates with the going rate of interest may be used to
indicate the profitability of investment.
– The rate of return is computed as the rate at which the expected stream of
future earnings from an investment project must be discounted to make their
present value equal to the cost of the project.
 Marginal Efficiency of Investment

– As the quantity of investment increases, the rates of return from it may be

expected to decrease because the most profitable projects are undertaken first.
– Additions to investment will consist of projects with progressively lower rates of
return. Logically, investment would be undertaken as long as the marginal
efficiency of each additional investment exceeded the interest rate.
– If the interest rate were higher, investment would be unprofitable because the
cost of borrowing the necessary funds would exceed the returns on the
investment.
 Marginal Efficiency of Investment

– Even if it were unnecessary to borrow funds for the investment, more profit
could be made by lending out the available funds at the going rate of interest.
– The British economist John Maynard Keynes used this concept but coined a
slightly different term, the marginal efficiency of capital, in arguing for the
importance of profit expectations rather than interest rates as determinants of
the level of investment
Accelerator Theory Of
Investment
 Accelerator Theory Of Investment

– The accelerator theory is an economic postulation that investments made by

companies increase when either demand or income increases.
– The accelerator effect is when an increase in national income results in a
proportionately larger rise in investment. Consider an industry where demand is
rising at a strong pace. Firms will respond to growing demand by expanding
production and making fuller use of their existing productive capacity.
– The theory also suggests that when there is an excess of demand, companies can
meet the need in two ways:
– Decrease demand by raising prices
– Increase investment to the level of demand
 Accelerator Theory Of Investment

– The accelerator theory posits that companies typically choose to increase

production, thereby increasing profits; this growth, in turn, attracts further
investors that works to accelerate growth. Developed by Thomas Nixon Carver and
Albert Aftalion, among others, some critics argue against the accelerator theory
because it removes all possibility of demand control through price controls.
Micro Example of Accelerator Effect
– A firm will invest depending on demand for its products. The rise in demand for
iPads will cause Apple to be investing in increasing capacity to meet future
demand. If the iPad drops out of fashion, Apple could be left with a lot of spare
capacity and so would cut back investment drastically.
 Accelerator Theory Of Investment

Conclusions of the accelerator:

1. Investment will rise when there is a growth in the rate of national income
2. Investment will be constant when the growth rate is the same
3. Investment will decline if there is a fall in the growth rate
Determinants of Investment
 Factors That Account for the
Volatility of Investment
 The accelerator
 Durability
 Irregularity of innovation
 Variability of profits, expectations and interest rates