• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

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

Extracts from this document...

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.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our University Degree Accounting section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related University Degree Accounting essays

  1. Management Accounting. A number of factors will influence the outcome of an investment appraisal ...

    First, there will be overemphasizing decision making. Cost centre managers may receive much information regarding the cost accounting transactions, such as both direct and indirect labour cost, material cost, administrative cost and etc from different departments in the company to make budgets for the company.

  2. Two-page report if an aggressive takeover should occur on Fortescue Metals Group Ltd (FMG)

    The pace of new exploration initiatives in the Indian mining industry has been rather slow - often as a result of excessive paperwork and confusing regulations. The new mining policy is expected to address these gaps in the industry and encourage private players to go beyond exploring traditional minerals to fully leverage the richly endowed natural diversity of the country.

  1. Entity theory

    media businesses which were uncovered after his mysterious death in November 1991. The Serious Fraud Office had led an investigation into his businesses uncovering fraud worth to be over �400million. He had accomplished this through funding his personal businesses; Headington Investments and Robert Maxwell Group using the pension funds of his media businesses.

  2. Accounting note 1

    - 12 + 12 = a2. - 2 = - 2 (increase rent expense) b1. - 3 + 3 = b2. - 3 = - 3 (increase supplies expense) c1. - 4 + 4 = c2. - 4 = - 4 (increase advertising expense)

  1. Value Chains Versus Supply Chains

    Economische Zaken ontwikkelt zelf projecten of zet anderen (gemeentelijke diensten, stadsdelen of partijen buiten de gemeente) er toe aan projecten te ontwikkelen die in het economisch beleid passen. Ook worden projecten direct door initiatiefnemers bij Economische Zaken aangemeld voor een bijdrage.

  2. Agency Theory

    the "Impartial spectator".1 This moral problem has been a matter of concern for shareholders, as the complications to monitor all managerial decisions is not practical or easily achieved, with that in mind mangers goals may be motivated with the desire to pursue their self interest by securing their own position.

  1. Critical Review on The Demand for and Supply of Accounting Theories: The Market for ...

    The basic structure of the paper is shown in the below diagram. Introduction Section I: The demand for accounting theories Section II: In a regulated economy In an unregulated economy The supply of accounting theories Section III: The empirical examples Section IV: Conclusion Section V: Section II analysed the demand

  2. Free essay

    The purpose of this coursework is to collect stock data, use statistical tools and ...

    Statistical analysis We have undertaken analysis. This section contains the main observations and conclusions from the data processing. 1. Scatterplot & Time series graph - stocks vs. the market Scatter plots and Time series graphs of stock vs. market have been added in Appendix III and IV.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work