Investment

Investment

In general sense, investment is that part of capital which is spent on productive use. In other words, investment refers the expenditure on capital goods. The word investment is applied to the spending money on capital goods. Investment can be classified into three types:

1. Autonomous and induced investment
2. Planned, unplanned and actual investment
3. Gross investment and net investment

1. Autonomous and induced investment:

Autonomous investment is the regular of compulsory investment and it is not guided by profit motive. It is income inelastic. In the words of Peterson, “The autonomous investment is generally associated with such factors as the introduction of new technology or product, the development of new resource on the growth of population or labour force”.

When an increase in investment is due to the increase is the current level of income. It is done with the profit motive. It varies positively with the level of income.

2. Planned, unplanned and actual investment:

If investment is made intentionally to achieve pre-defined goal, then it is planned investment. If investment if made due to sudden changes or unexpected changes in economic and other factor then it is called unplanned investment.

Actual investment is the sum of planned and unplanned investment.

3. Gross and net investment:

Gross investment is the sum total of net investment and depreciation. It refers to the total expenditure on capital goods in a period of time.

Net investment is difference of depreciation from gross investment. It occurs due to increase in capital stock.

Investment function:

Investment function refers to inducement to invest or investment demand. Classical economist considered investment demand simply as a decreasing function of interest rate. Hence,

, where I = induced investment, r = rate of interest

Keynes state that the volume of investment undertaken by private entrepreneurs in the economy depends on two factors i.e. marginal efficiency of capital and rate if interest. Hence,

Marginal efficiency of capital (MEC)

The concept of MEC was introduced by Iriving Fisher. This concept was fully developed or re-defined by J. M. Keynes. It is one of the important contributions made by Keynes. The MEC refers to the expected profitability of capital assets. It is related to real investment not financial investment. It may be defined as the higher rate of return over cost expected from the marginal or additional unit of capital assets. Hence, MEC = ………………….. (i)

Where, Q = expected yields of capital assets

            r = rate of interest

            C = supply price of the assets

The value of r is equal to MEC. It can be obtained by re-arranging the term in equation (i)

= 1.5 – 1

r = 0.5

This shows that MEC = 5%.

MEC is measured with the help of two elements:

1. Prospective Yield:

It means aggregate net return from asset during its life time. Net return refers to the net yearly proceeds obtained from the sales of output produced by the capital assets.

2. Supply Price:

The cost of capital goods is called the supply price. The investor while purchasing a new plant or establishing a new factory he does not only see the expected return from it but also supply price of it. Hence, we can obtain the MEC in the following way.

, where Qn = expected rate of return, r = rate of discount / MEC

Sp = supply price

Investment demand curve:

The MEC falls as investment increases. There are two reasons for this. They are:

1. The installation of large number of similar machine leads to a reduction in their perspective yields just as consumption of more units leads to a decrease in marginal utilities.
2. The price of such machine will go up as their demand increases. This will add to the cost. Thus cost will go up on one hand and the market price of their product goes down as production increases. Hence MEC goes down as investment increases. This is because with more investment the productive capacity of the economy will increase and this will decrease expected rate of profit.

This can be shown with the help of following diagram:

Investment (in million)	MEC
$10,000	12%
$12,000	10%
$14,000	8%
$16,000	6%
$18,000	4%
$20,000	2%

Determinants of MEC (induced invest)

1. Level of income
2. Liquid assets
3. Taxation
4. Business optimism and pessimism
5. Economic policies
6. Political climate

1. Level of income:

If the level of income raises in the economy through rise in wage rates and other factor prices, the demand for goods will rise this will give rise to MEC and on the contrary, the inducement to invest or MEC will fall with the lowering of income level.

2. Liquid assets:

The amount of liquid assts with the investor also influences the inducements to investment. If they posses large liquid assets, the inducement to invest is high and vice-versa.

3. Taxation:

MEC is also affected by the rates if taxation. Heavy doses of direct and indirect tax adversely affect the MEC. On the other hand low rates of taxation tend to raise MEC and encourage investment.

4. Business optimism and pessimism:

Business psychology plays on important past in determining the MEC. If the business person is optimistic then the majority of entrepreneur would estimate a high MEC and pessimism a low MEC is estimated.

5. Government policy:

If the government levis heavy progressive tax the MEC is low and vice-versa. If the government sector regarding private sector is liberal (in terms of credit facilities and other necessary legal environment, the private sector participation will be enhanced and MEC will increase.

6. Political climate:

If there is political instability in the country, the inducement to investment is adversely affected.