Term 1 Lecture 6: Investment Flashcards
What is investment, and the three types (1,3)
-Investment is the accumulation of physical capital, tangible assets used in the production process
-Business fixed investment is business spending on equipment and structures for use in production
-Residential investment is the purchasing of new housing units
-Inventory investment is the value of the change in inventories of finished goods, materials and supplies, and work in progress
Why does investment occur, and what does it depend on (2, 3)
Investment occurs to:
-bring the capital stock to its desired level
-to make up for capital lost through depreciation
Investment decisions depend on:
-current sales
-real interest rates
-expectations on the future
What is the marginal productivity of capital (3)
-The MPK is the amount of extra output that can be optained when an additional unit of capital if installed
-To work out MPK, partially differentiate the production function with respect to capital
-Assuming labour is constant, declining marginal productivity will keep the production function concave
What is the opportunity cost of the investment (2)
-If investment is funded with resources which could’ve been invested in financial assets, the opportunity cost of investment = (1+r)
-If borrowing, the marginal cost of investment = (1 + r)
How do you plot the production function against cost on a graph, then profit maximise (2,1)
-With capital stock on the x axis and output on the y axis, you will have a straight upwards sloping (1+r)K line, angle (1+r), and a concave F(K, L) curve
-Then with capital stock on the x axis and MPK on the y axis, you have a straight horizontal marginal cost of capital curve, and a decreasing convex MPK curve
-To optimise, you find the point on the production function where the tangent of the curve is equal to the (1+r)K curve, or where the 2 marginal curves meet (mpk = 1 + r)
How can the MPK curve be shifted (1)
-An improvement in technology causes an outwards shift in the MPK
How do we calculate the optimal stock of capital if firms can resell equipment (2)
-MPK + 1 = 1 + r
-Benefit side is the MPK of the capital + the one unit of the capita, cost side is the opportunity cost
How do we calculate the optimal stock of capital with depreciation (2)
-MPK + (1-δ) = 1 + r, where δ is the depreciation as ana dditional cost of capital, and r + δ is the user cost of capital
-The arbitrage condition (equilibrium condition which maximises profits) is MPK = R + δ
Why does investment occur, and what is the formula for this (2,2)
Investment occurs to:
-Bring the capital stock to its desired level
-Make up for capital lost through depreciation
-Kt+1 = It + (1-δ)Kt
-(capital in the next term = investment needed to bring capital to desired level + current capital, accounting for depreciation)
What is the function of expected value of future profits (3)
-V(π^e t) = πt + πt+1/(1+r) + πt+2/(1+r)^2 …
-Present value of expected profits = profits in term 1 + profit in term 2/1 + interest rate…
-You divide by (1+r)^n to represent the value of X in n years, as the money you could’ve made if saving
What is Tobin’s q theory of investment (1,2,1)
-Tobin’s q theory of investment is where firms choose the amount to invest, with a view to maximise expected discounted profits over the lifetime of a project
-q = market value of firm/cost of capital
-q = stock market valuation/price of capital where it purchased tofay
–The Market value of the firm depends on expected present and future profits, and cost of capital is the replacement cost
How may firms act in accordance to their q value (2)
-If q>1, managers can raise the market value of their firms stock by buying more capital
-If q<1, managers won’t replace capital as it wears out
