Business Firms As Spending Units

Investment is defined as

All spending by business firms for newly built equipment and business structures.

All changes in business inventories of raw materials, semifinished articles, and finished goods.

All spending by households for newly constructed residential housing

Business Fixed Investment, 1982-97

billions of chain-weighted 1992 dollars

Source: Economic Report of the President

Year

199719941991198819851982

bill

ion

s of

19

92

dol

lars

1200

1100

1000

900

800

700

600

500

Components of Business Fixed Investment, 1982-97

billions of chain-weighted 1992 dollars

Source: Economic Report of the President

Year

199719941991198819851982

billions

of

1992 d

ollars

700

600

500

400

300

200

100

0

Structures

Durable equipment

Computers

Why do firms invest--that is, take positions in

long-lived tangiblecapital goods?

Because they expectto gain access to

a future income streamby employing the capital

to produce goods and services

Let I = f(Pk, Q, i), where:

Pk Supply price or acquisition cost of capital goods;

Q Expected revenues, net of running expenses , from the sale of output of capital goods;

¡ is the interest rate.

The marginal efficiency of capital ( r) is the discount rate that makes the capitalized (net) income stream equal to the supply price of the capital good. Thus we have:

n

in

ik

r)(Q

P1 1

Pk = $103,077.00 (Tractor = $83,077; Trailer = $20,000)

n = 3 years

Expected revenue from shipping goods (per year) = $168,000

Expected running expenses: Driver salary and benefits $54,000

Diesel fuel 36,000Repairs (including tires) 16,000Insurance 11,750

Total $128,000

Thus Q1 = Q2 = Q3 = $40,000

Now solve for r

Solution:

r = 0.08, meaning that if the prevailing interest rate is above 8 percent, then the present value of the asset is less than its supply price.

)1()1(32

000,40000,40

)1(

000,40077,103$

rrr

If, for a specific investment project, r > i, then the present value of the asset exceeds its acquisition cost and the investment will be made.

if, however, r < i, then the acquisition cost of the asset will

exceed its supply price and the investment will not be made.

If r for the project with the highest expectedreturn is 9 percent, but the interest rate is

10 percent, then gross I will be zero. If thereis $20 billion in investment with an r of 10 percent

or higher, then gross I will be $20 billion.

“Spontaneous urge to action rather than inaction.”

“The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible.” (Keynes 1936, p. 147).Estimates of Q1, Q2, . . . , Qn are subject to revision based on new information or the capricious nature of business confidence.

What looked like a winner yesterday could be a turkey today.

A H

B

60 850 Investment

Interest (%)

9

6.5

I1

I2

As r falls,firms can make

investmentswith lesser

expected returns

I1 to I2: risingexpected profitability of spending for capital goods

i (%)

Investment

Note that:

Qi, cet. par.r, and investment shifts to the right.

10

020

8

27

Also note:

PK, , cet. par.r,

and function shifts left

And vice-versa

0YD

I

60

85 Ia2

Ia1

Function could shift down due to:

•Increase in the interest rate, ceteris paribus.

•Diminished confidence about the future profitability of investment.