Ben Bernanke
Input Demand: The Capital Market and the Investment Decision
(Part C)
by
Charles Lamson
The Demand for New Capital and the Investment Decision
We saw in parts 39 to 44 of this analysis that firms have an incentive to expand in industries that earn positive profits---that is, a rate of return above normal---and in industries in which economies of scale lead to lower average costs at higher levels of output. We also saw that positive profits in an industry stimulate the entry of new firms. The expansion of existing firms and the creation of new firms both involve investment in new capital. Even when there are no profits in an industry, firms must still do some investing. First, equipment wears out and must be replaced if the firm is to stay in business. Second, firms are constantly changing. A new technology may become available, sales patterns may shift, or the firm may expand or contract its product line. With these points in mind, we now turn to a discussion of the investment decision process within the individual firm. In the end we will see (just as we did in parts 45 to 50 of this analysis) that a perfectly competitive firm invests in capital up to the point at which the marginal revenue product of capital is equal to the price of capital. [Because we based much of our discussion in parts 45 to 50 on the assumption of perfect competition (the situation in a market in which buyers and sellers are so numerous and well-informed, that all elements of monopoly are absent and the market price of a commodity is beyond the control of individual buyers and sellers) it makes sense to continue doing so here. Keep in mind, though, that much of what we say here also applies to firms that are not perfectly competitive.] Forming Expectations We have already said that the most important dimension of capital is time. Capital produces useful services over some period of time. In building an office tower, a developer makes an investment that will be around for decades. In deciding where to build a branch plant, a manufacturing firm commits a large amount of resources to purchase capital that will be in place for a long time.  It is important to remember, though, that capital goods do not begin to yield benefits until they are used. Often the decision to build a building or purchase a piece of equipment must be made years before the actual project is completed. While the acquisition of a small business computer may take only days, the planning process for downtown development projects in big U.S. cities have been known to take decades. The Expected Benefits of Investments Decision makers must have expectations about what is going to happen in the future. A new plant will be very valuable---that is, it will produce much profit if the market for a firm's product grows and the price of that product remains high. The plant will be worth little if the economy goes into a slump or consumers grow tired of the firm's product. An office tower may turn out to be an excellent investment, but not if many new office buildings go up at the same time, flooding the office space market, pushing up the vacancy rate, and driving down rents. It follows, then, that the investment process requires that the potential investor evaluate the expected flow of future productive services that an investment project will yield. Remember that households, business firms, and governments all undertake investments. A household must evaluate the future services that a new roof will yield. A firm must evaluate the flow of future revenues that a new plant will generate. Governments must estimate how much benefit society will derive from a new bridge or a war memorial. An official of the General Electric Corporation (GE) once described the difficulty involved in making such predictions (Case & Fair, p. 224). GE subscribes to a number of different economic forecasting services. In the early 1980s, those services provided the firm with 10-year predictions of a million new units per year. Because GE sells millions of household appliances to contractors building new houses, condominiums, and apartments, the forecast was critical. If GE decided that the high number was more accurate. It would need to spend literally billions of dollars on new plant and equipment to prepare for the extra demand. If GE decided that the low number was more accurate, it would need to begin closing at several of its larger plants and disinvesting. In fact, GE took the middle road. It assumed that housing production would be between 1.5 and 2 million units which, in fact, it was.  GE is not an exception. All firms must rely on forecasts to make sensible investment and production decisions, but forecasting is an inexact science because so much depends on events that cannot be foreseen. Many believe that the Internet and the use of e-commerce have brought revolutionary change to the world economy and created "a new economy." There is a great deal of uncertainty about where the "information-age" is headed, and this makes expectations all the more important and volatile. A great deal of capital is being allocated to thousands and thousands of new technology companies. Only time will tell which will bear fruit for investors. The Expected Costs of Investments The benefits of any investment project take the form of future profits. These profits must be forecast, but costs must also be evaluated. Like households, firms have access to financial markets, both as borrowers and as lenders. If a firm borrows, it must pay interest over time. If it lends, it will earn interest. If the firm borrows to finance a project, the interest on the loan is part of the cost of the project. Even if a project is financed with the firm's own funds, instead of borrowing, there is an opportunity cost involved. A thousand dollars put into a capital investment project will generate an expected flow of future profit; the same $1,000 put into the financial market (in essence, loaned to another firm) will yield a flow of interest payments. The project will not be undertaken unless it is expected to yield more than the market interest rate. The cost of an investment project may thus be direct or indirect because the ability to lend at the market rate of interest means that there is an opportunity cost associated with every investment project. The evaluation process thus involves not only estimating future benefits, but also comparing them with the possible alternative uses of the funds required to undertake the project. At a minimum, those funds could earn interest in financial markets.  Comparing Costs and Expected Return Once expectations have been formed, firms must quantify them---that is, they must assign some dollars and sense value to them. One way to quantify expectations is to calculate an expected rate of return on the investment project. For example, if a new computer network that cost $400,000 is likely to save $100,000 per year in data processing costs forever after, the expected rate of return on that investment is 25 percent per year. Each year the firm will save $100,000 as a result of the $400,000 investment. The expected rate of return will be less than 25 percent if the computer network wears out or becomes obsolete after a while and the cost savings cease. In short: the expected rate of return on an investment project depends on the price of the investment, the expected length of time the project provides additional cost settings or revenue, and the expected amount of revenue attributable each year to the project. Table 2 presents a menu of investment choices and expected rates of return that face a hypothetical firm. Because expected rates of return are based on forecasts of future profits attributable to the investments, any change in expectations would change all the numbers in column 2. TABLE 2  Figure 3 graphs the total amount of investment in millions of dollars that the firm would undertake at various interest rates. If the interest rate were 24 percent, the firm would fund only project A, the new computer network. It can borrow at 24 percent and invest in a computer that is expected to yield 25 percent. At 24 percent, the firm's total investment is $400,000. The first vertical red line in Figure 3 shows that an interest rate above 20 percent and below 25 percent, only $400,000 worth of investment (that is, project A) will be undertaken.    Only those investment projects in the economy that are expected to yield a rate of return higher than the market interest rate will be funded. At lower market interest rates, more investment projects are undertaken. The most important thing to remember about the investment demand curve is that the shape and position depend critically on the expectations of those making the investment decisions. Because many influences affect these expectations, they are usually volatile and subject to frequent change. Thus, while lower interest rates tend to stimulate investment, and higher interest rates tend to slow it, many other hard-to-measure and hard-to-predict factors also affect the level of investment spending. These might include government policy changes, election results, global affairs, inflation, and changes in currency exchange rates.    *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 223-226* end |
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