We use cookies to give you the best experience possible. By continuing we’ll assume you’re on board with our cookie policy

Investment Theory Is Unsatisfactory Essay Sample

essay
The whole doc is available only for registered users OPEN DOC

Get Full Essay

Get access to this section to get all help you need with your essay and educational issues.

Get Access

Investment Theory Is Unsatisfactory Essay Sample

“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.

We can write a custom essay

According to Your Specific Requirements

Order an essay

You May Also Find These Documents Helpful

The Environment for Foreign Direct Investment (FDI)

The environment for foreign direct investment (FDI) has become very competitive and it is important for countries to critically examine their investment policies and ensure their relevance and effectiveness in attracting and benefiting from FDI. Foreign direct investment (FDI) has the potential to generate employment, raise productivity, transfer skills and technology, enhance exports and contribute to the long-term economic development of the world�s developing countries....

Why Foreign Direct Investment Does Not Enter...

FDI can be described as international capital flows in which a firm in one country creates or expands a subsidiary in another. Its basic function is to provide capital to developing countries that face capital inadequacy due to and consequent of structural problems in the finance of economic development. Today, an increasing number of countries are using FDI and showing tremendous effort to attract FDI...

Impact of FIIs on Investment Portfolio

This paper aims to shed light on the behaviour of individual investors when foreign investments inject in the economy. The focus is to study the role of foreign institutional investors in changing the investment decisions of the individual investors and their contribution to economic growth through Capital accumulation in the economy , scope of the study is limited to India. Individual investor we mean by...

The Fabian Advertising

1.Executive Summary This report is commissioned to examine the new business strategies of Fabian Advertising. It draws attention to the facts that the sales revenue has been decreasing dramatically in recent years. The decrease in profits was because its clients have chosen its competitors’ services over theirs. As clients’ expectations and needs have changed, Fabian Advertising has to change to a new business mission -...

Finance Homework

Capital stock 1. The aggregate production capacity of existing capital goods in the economy. Zero or net change 2. Means a constant level in both the capital stock and output. Investments 3. Adjusts the capital stocks to maintain and even increase production and the level of the economic activities. Savings 4. The unspent portion of income during the period intended for spending. Simple savings equation...

Get Access To The Full Essay
icon
300+
Materials Daily
icon
100,000+ Subjects
2000+ Topics
icon
Free Plagiarism
Checker
icon
All Materials
are Cataloged Well

Sorry, but copying text is forbidden on this website. If you need this or any other sample, we can send it to you via email.

By clicking "SEND", you agree to our terms of service and privacy policy. We'll occasionally send you account related and promo emails.
Sorry, but only registered users have full access

How about getting this access
immediately?

Become a member

Your Answer Is Very Helpful For Us
Thank You A Lot!

logo

Emma Taylor

online

Hi there!
Would you like to get such a paper?
How about getting a customized one?

Couldn't Find What You Looking For?

Get access to our huge knowledge base which is continuously updated

Next Update Will Be About:
14 : 59 : 59
Become a Member