Investment Theory Is Unsatisfactory

“Investment theory is unsatisfactory because too little attention is paid to business expectations and unless you do this it is hard to explain what happened to investment rates in many Western economies since 2008.” Discuss.

In this essay I will describe the key aspects behind the basic neoclassical model of investment and explain how it can be considered a satisfactory model, sufficient in explaining the changes in the investment rates since 2008 of Western economies. I will then develop the discussion further to include other elements of investment theory, such as cost adjustments and investment irreversibility, showing that it would indeed be difficult to explain the investment rates. The basic neoclassical investment models all rely on the maximisation of all future cash flows with an infinite horizon, in terms of present value. It is therefore a dynamic intertemporal belief based on the available information and may be updated in each period. We assume cash flow arises from revenue which is a function of output and is subject to the associated costs of employing input factors, simply; labour & capital.

Where the firm or individual is a price taker in a highly competitive market, they will only demand the level of labour that will not reduce their net-present-value. Demand for labour will always be set to a level where the revenue generated by an additional worker is not more than the wage they are being paid. The level of capital demanded by the firm will also be subject to the marginal-revenue-product-of capital equalling the costs of employing an additional unit of capital. These include the rental price of the unit, the depreciation incurred over the time period employed and any change in real purchase price of the capital, essentially the user-cost. With this theory I can now more easily discuss the original statement. Investment decisions are made on the firm’s expectation of future cash flow, a function of consumer demand. However, future consumer demand is difficult to accurately determine even in a period of economic stability, where 2008 onward has been particularly volatile. Because we live in a world without perfect information, business’ expectation is the driving factor behind the level of capital held in order to obtain optimal cash flows, which can often result in adverse selection or a self-fulfilling-prophecy.

The years up to 2008 were economically strong for Western economies and it stands to reason that investors believed this would continue. Of course this expectation of high levels of future demand for their output resulted in their accumulated capital being greater than if they were expecting the credit crisis and global recession which were to follow. When the realisation that there was to be the biggest recession since the Great Depression hit, the firms inevitably updated their beliefs on the present value of future cash flows and found that a proportion of accumulated capital would generate a loss due to lower demand causing revenue to fall. The convexity of the marginal-revenue-product of capital with positive, diminishing returns suggests that firms would reduce their accumulated capital until no longer loss making. It is now possible to incorporate investment. Investment is one of the three factors of output within a closed economy. It can be Business, Residential and Inventory investment, increasing in volatility.

The optimal investment in a given period depends upon the real user cost of capital, expected shadow-price of capital and the adjustment costs, costs that increase greater than proportionally with investment. If a firm invests too much at once, the adjustment costs overcome the following period’s revenue and reduce the net-present-value of cash-flows. In a situation where there is an unexpected positive demand shock, by forgoing the revenue that would have been generated by additional capital below the optimum level of capital, the investor can increase the NPV by spreading the required investment to reach optimal accumulated capital over a number of periods, avoiding high adjustment costs. Adjustment costs are realistic and help to avoid theoretical situations in which a corner-shop becomes a multinational retailer in a single period if the NPV of being a multinational is higher than a corner-shop’s. Investment can also be seen as the level of accumulated capital in a given period, subtracting the depreciated capital of the previous period. For example, if capital in period1 equals period0, the investment in period0 must be equal to depreciated capital during period0.

It is possible to have a negative figure which is reversing an investment. We assume there is a “time-to-build” of 1 period to convert an investment in to usable capital. It is therefore likely that a negative demand shock such as the one that began in 2008 not only causes investment to fall but makes it negative, significantly reducing aggregate investment. Contrary to the assumption that business expectation is being given little attention, it and its inherent inaccuracy appear to be among the key drivers of investment and its volatility. Governments can try to curtail this by lowering interest rates, the opportunity cost of investment, but due to the irreversibility of some investment decisions, it is inevitable that even firms with a positive NPV from investing during a recession will not invest, preferring instead to wait for the uncertainty to pass.

With these strong incentives not to invest, government tries to stabilise the situation with investment credits to boost the NPV for firms. Unfortunately banks reduce lending for similar reasons that businesses reduce capital and these further drop the investment level as it is harder to obtain credit for those left wanting to invest. The basic model tends to overlook limits in the capital markets such as this, which would suggest it underestimates negative shocks by assuming liquidity and overestimates positive shocks, assuming capital is freely available to generate cash-flows with. Having discussed briefly some key aspects, I conclude that it is difficult to explain investment rates in Western countries post-2008 without considering business’ expectation because it is the most plausible and significantly contributing explanation to the excessive volatility and sporadic investment rates.