Investment Flashcards
Types of investment
Business fixed
Residential
Inventory
Business fixed investment
Fixed assets used in present and future production
E.g factories, chairs, computers
What does the neoclassical model of investment look at, and how?
Costs and benefits of owning capital goods.
How? By considering at 2 types of firms, production and rental firms
Production firms vs rental firms
Production firms produce G&S using rented capital
Rental firms rent capital to production firms
Production firms problem in the neoclasical model
(how do they decide how much capital to rent?)
They choose how much capital to RENT by comparing cost and benefits of each unit of capital
How do they determine the cost/benefit of each unit?
They rent at cost R, and sell at price P.
Real cost if R/P.
Real benefit is MPK. (Which is diminishing in SR)
They will rent up until real cost=real benefit, MPK=real rental price of capital. (MPK=R/P)
Recall capital market diagram
Capital supply constant in S.R
(rmb depreciation holds constant i=δk)
MPK/capital demand downward sloping as MPK falls as capital increases.
What is the MPK equilibrium in CD form (where they hire up to)
MPK= R/P = vA(L/K) to the 1-v
So R/P=vA(L/K) to the 1-v
What does this equilibrium for production firms equation show?
(explain effect of a fall in K, increase in L, increase in A)
and diagram?
If K low, higher real rental price.
E.g after an earthquake, k is in higher demand so rental price increases. (Makes sense as when in short supply, price high)
And if L high, higher real rental price.
E.g an increase in AD, we increase labour demand, also driving demand for capital so rental price rises.
Higher A (tech) , higher real rental price
More productive so firms demand more capital so rental price rises.
Firm 2: Rental firms, what is the benefit?
What factors are considered in costs? (3)
Benefit = R/P for each unit
Factors considered in costs:
- Financing cost to purchase the capital (nominal i). Even if not borrowing, i is opportunity cost (putting in banks)
- Price of capital can change whilst on loan (up or down e.g up central London properties, down for 2nd hand cars)
- Depreciation of the capital whilst on loan
So how do we equate the cost of owning capital (accommodating for those 3 considerations)
- How do we make cost a function of the real interest rate, rather than nominal?
Cost of capital = iPk - ΔPk + δPk
Can be rewritten as
Pk(i-ΔPk/Pk+δ)
- Let growth rate of price ΔPk/Pk = π (inflation)
Pk (i - π + δ)
Pk (r + δ)
Pk is price of capital
i is nominal interest rate
δ is depreciation rate.
r is real interest rate (i-π)
Rental firms cost of capital that they then rent out
So cost of capital is
Pk (r+δ)
What is the real cost of capital ?
(Pk/P)(r+δ)
So just divide Pk by P to find relative price of capital
How do they decide whether to increase/decrease capital stock?
Real profit per unit determines net investment
Profit = Rev - Costs
R/P - (Pk/P)(r+δ) or
MPK - (Pk/P)(r+δ)
So profit exists if MPK> real cost of capital
Third type of firms
Both renters and purchasers
E.g airlines own planes and also rent their planes
For this firm, what is the benefit of an additional unit of capital, and what is the cost?
Benefit is MPK
Cost is cost of capital
From this, what is net investment for type 3 firm?
ΔK= In (MPK - (Pk/P)(r+δ)
In (net investment) is a function of benefits MPK and costs (Pk/P)(r+δ) showing how net investment respoinds to the incentive to invest.
How do firms react to depreciation, and how does the investment function change?
Firms conduct replacement investment to keep K constant. (Replacement investment to Make ΔK=0)
I = In [MPK - (Pk/P)(r+δ)] + δK
ΔK is net investment
I is gross investment (where we add replacement investment)
Different previous, where net investment includes depreciation but not the replacement investment!!!
What is bigger, net or gross investment
Gross is bigger.
Note: as diagram pg 11 shows, net investment is always smaller than gross investment as we include replacement investment, thus making gross investment bigger
Relationship between I (gross investment) and r: show this by interpreting a fall in r
I = In [MPK - (Pk/P)(r+δ)] + δK
A decrease in r, lowers cost of capital, increasing profit, and thus incentive to accumulate to accumulate capital (In) , so gross investment I increases.
Makes sense as essentially when low interest, I increases.
Summary:
What happens to capital accumulation if MPK> cost of capital, or MPK=cost
MPK>cost, capital increases
MPK<cost, capital declines
Adjusts until MPK = (Pk/P)(r+δ)
So ΔK=0 (net investment = 0) , and I=δk (gross investment I=δk)
Tobin’s q
Looked at link between fluctuations in stock market and fluctuations in investment.
He proposed firms base investment on q ratio
Q ratio and how to interpret (if >1 , <1)
Q= Market value of capital / replacement cost of capital
If q>1= market value>replacement cost: acquiring more capital increases value of the firm. At the same time remember MPK falls as K increases (DMR) so we acquire till q=1
If q<1 - market value<replacement cost, so we should reduce capital (or not replace), so MPK increases as K falls, we reduce until q=1.
What does market value of capital (from stock market valuation) show
Shows current and expected future profitability of a firm’s capital stock.
What happens to share price and q ratio if MPK>cost of capital or <cost
MPK>cost Firms make profit on installed capital, creating higher share price (since firms are in a good state) and higher q.
If less, firm incur losses on installed capital, lower share price (as firms in worse state), lower q.
For Tobin’s q (an indicator of the incentive to invest) to be useful, what needs to happen? What hypotheis shows this?
To be useful, stock market fluctuations need to be rational
Efficient markets hypothesis
Efficient markets hypothesis
Market price of a companys stock IS a fully rational valuation of the company
Why is market price of stock a rational valuation? (2)
Share price is determined by supply demand.
Share price reflects all available information
What trend do share price follow?
Share prices follow a random walk, only change with news/new information (unpredictable)
So CHANGES in share prices are impossible to predict with available information since only change with unpredictable news…
So how do fund managers beat the market? (3)
Information advantages (fund managers may have better info than average investor, illegal insider info can exist too)
Good luck
EMH may not be correct
Keynes Beauty Contest questions validity of stock market rationality
When creating valuations, we anticipate the average opinion of the average opinion.
I.e speculate upon the valuation others attach, rather than the true value.
E.g overpay as believe it will increase in value. (Just like how i wanna buy chrome hearts above resale already, to anticpate being able to sell for more)
So using KBC, what are share prices subject to? (2)
Waves of optimism and pessimism
I,e animal spirits, price bubbles can form (valuation has become detached from true value)
Thus making share prices unreliable, and Tobin’s q and EMH invalid.
Financing constraints - it can be hard to access.
When do banks provide funding
If MPK> cost.
What about firms that can’t borrow, e.g small firms.
What do these borrowing constrained firms decisions to invest depend on?
Investment decisions depend on cash flow rather than profitability.
So tobin’q relies on values being accurate. (EMH)
KBC questions this
Why is investment function downward sloping
What if r falls
R y axis
Investment I x axis
Downward sloping since investment increases as r falls.
if r falls, profit rate and i increases. so a shift.
when does the investment function shift in the diagram
If profit rate changes
(remember I = In [MPK - (Pk/P)(r+δ)] + δK)
and MPK = R/P = vA(L/K) to the 1-v
so if MPK increases, it shifts.
