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Examine q-theory and other theories of investment. How well do they explain investment decisions?

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Introduction

"Two key aspects of the investment decisions of firms are that they are undertaken in a cloud of uncertainty, and that investment spending over the business cycle is highly volatile. Concentrating on the investment decision as the balance between the return and the cost of the investment does little towards a useful economic explanation". Examine q-theory and other theories of investment. How well do they explain investment decisions? Most of the literature that focuses on the behaviour of investment either tends to focus on the relationship between the return and cost of capital or the relationship between investment and output. With regard to the former, the most basic neoclassical theory looks at investment decisions under a situation of perfect competition. There is no uncertainty, a perfect elastic supply of capital goods and the firm can adjust their capital stocks costlessly. If these assumptions hold the firms profits can be written as follows: In the above equation, 'K' is the amount of capital a firm rents, the X variables are exogenously given so as to include the cost of other inputs and the price of the firms product, and 'rK' is the rental price of capital. By taking the first derivative of the above equation, the firm rents capital until its marginal revenue product equals its rental price - a balance between the return and cost of capital. However, one can extend upon this analysis by replaced the rental price of capital with the 'user cost of capital'. ...read more.

Middle

= 0). Moreover, it is also possible to draw a function where 'q', the market value of an additional unit of capital to its replacement cost, does not change. Since '?(K)' is decreasing in K, due to the downward sloping demand curve for the industry's product, the loci of points where 'q' does not change is downward sloping in (K, q) space. This can all be shown in the diagram below: Using the above phase diagram, it is now possible to analyse the dynamics of investment. In other words, the model suggests a way to explain the volatile nature of investment behaviour. The above diagram shows that investment will always tend to the equilibrium level of capital stock 'E' as long the initial levels of q and K obey the transversality condition. If the market of value of capital is high relative to its replacement cost, investment will take place, and one will move along the saddle path to the new equilibrium at E. The reverse can also be shown if the capital stock K is too high. The higher one is above the K*=O function, the higher the level of investment; the faster new capital is being added to the existing capital stock. The phase diagram provides a useful tool of analysis to examine the dynamics of investment behaviour. Changes in aggregate output, interest-rate movements and changes to the tax system can all be analysed under a 'q-theory' framework. ...read more.

Conclusion

Therefore, given a change in the exogenous variables, such as the possibility of a new tax policy, or an interest rate reduction will cause the increase in investment to be lower than under symmetric costs. To add the economic intuition, if investment is irreversible, not investing today leaves the firm with an option to expand later, should expansion prove to be necessary. Investing in the present time period eliminates this option, and the loss of this option can be considered as part of the cost of investing. In the above diagram, before the expected change leads to a movement to B, which due to it's concave nature, means a lower level of investment than what would have been if investment was reversible. Once the outcome of the change in tax or real interest rates is realised, investment moves onto the appropriate saddle path, associated with the new equilibrium To conclude, many theories of investment focus on the balance between the return and cost of investment. In particular, q-theory has become very popular in order to explain the dynamics of investment behaviour. However, if one imposes the assumption of constant returns in the adjustment cost function, the observable average q is equal to the marginal q. However, empirical research does not support this restriction. Instead, factors such as output provide a more useful explanation. Moreover, once uncertainty is taken into account, more useful economic explanations can be found; internal finance and irreversible investment are both useful in explaining investment behaviour. Therefore, it is possible to argue that return and cost do play a vital role in determining investment decisions, but other properties must be taken into account. ...read more.

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