Investment

Business Fixed Investment
The largest piece of investment spending, accounting for about three-quarters of the total, is business fixed investment. The term “business” means that these investment goods are bought by firms for use in future production. The term “fixed” means that this spending is for capital that will stay put for a while, as opposed to inventory investment, which will be used or sold within a short time. Business fixed investment includes everything from office furniture to factories, computers to company cars.
The standard model of business fixed investment is called the neoclassical model of investment. The neoclassical model examines the benefits and costs to firms of owning capital goods. The model shows how the level of investment—the addition to the stock of capital—is related to the marginal product of capital, the interest rate, and the tax rules affecting firms.

The Rental Price of Capital
To see what variables influence the equilibrium rental price, let’s consider a particular production function. Many economists consider the Cobb–Douglas production function a good approximation of how the actual economy turns capital and labor into goods and services. The Cobb–Douglas production function is

Y = AKα L1-α

where Y is output, K is capital, L is labor, A is a parameter measuring the level of technology, and α is a parameter between zero and one that measures capital’s share of output.

The marginal product of capital for the Cobb–Douglas production function is
MPK= αA(L/K )1-α

Residential Investment
The Stock Equilibrium and the Flow Supply

There are two parts to the model. First, the market for the existing stock of houses determines the equilibrium housing price. Second, the housing price determines the flow of residential investment.


Panel (a) of Figure 18-5 shows how the relative price of housing PH/P is determined by the supply and demand for the existing stock of houses. At any point in time, the supply of houses is fixed. We represent this stock with a vertical supply curve. The demand curve for houses slopes downward, because high prices cause people to live in smaller houses, to share residences, or sometimes even to becomehomeless. The price of housing adjusts to equilibrate supply and demand.

Panel (b) of Figure 18-5 shows how the relative price of housing determines the supply of new houses. Construction firms buy materials and hire labor to build houses and then sell the houses at the market price. Their costs depend on the overall price level P (which reflects the cost of wood, bricks, plaster, etc.), and their revenue depends on the price of houses PH. The higher the relative price of housing, the greater the incentive to build houses and the more houses are built. The flow of new houses—residential investment—therefore depends on the equilibrium price set in the market for existing houses.

Inventory Investment
Reasons for Holding Inventories

Atrill, McLaney, Harvey and Jenner (2003) identify four key reasons why companies hold inventories:
  • Firstly, companies ‘stockpile' their goods to avoid the effect shortages might have on customer good will. This could influence the said customer to source his/her needs from elsewhere, usually at the expense lost sales.
  • Secondly, by holding an inventory, the company is actually hedging against the possibility of future price increases.
  • Thirdly, companies that hold goods inventories above a normal level are better suited to ‘ride out' market fluctuations based on irregular or seasonal demand, thus avoiding lost production or supply (Atrill & McLaney, 2009:415).
  • Fourthly, companies maintain inventories for strategic reasons. For example, the use of quantity discounts to promote greater customer goodwill and help the turnover of stock being held

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