Business Firms As Spending Units

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Business Firms As Spending Units
Investment is defined as

• All spending by business firms for newly built
  equipment and business structures.
• All changes in business inventories of raw
  materials, semifinished articles, and finished
  goods.
• All spending by households for newly constructed
  residential housing

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Theory of investment
Why do firms invest--that is, take positions in
long-lived tangiblecapital goods?
Because they expectto gain access to a future
income streamby employing the capitalto produce
goods and services
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The marginal efficiency of capital (r)
Let I f(Pk, Q, i), where Pk ? Supply price or
acquisition cost of capital goods Q ? Expected
revenues, net of running expenses , from the sale
of output of capital goods ? is the interest
rate. ?The marginal efficiency of capital ( r)
is the discount rate that makes the capitalized
(net) income stream equal to the supply price of
the capital good. Thus we have
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Example MDR Cartage
Pk 103,077.00 (Tractor 83,077 Trailer
20,000) n 3 years Expected revenue from
shipping goods (per year) 168,000 Expected
running expenses Driver salary and
benefits 54,000
Diesel fuel
36,000 Repairs (including tires)
16,000 Insurance

11,750 Total
128,000 Thus Q1 Q2 Q3 40,000
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Now solve for r Solution r 0.08,
meaning that if the prevailing interest rate is
above 8 percent, then the present value of the
asset is less than its supply price.
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Relation between r and i
? If, for a specific investment project, r i,
then the present value of the asset exceeds its
acquisition cost and the investment will be
made. ? if, however, r cost of the asset will exceed its supply price
and the investment will not be made.
If r for the project with the highest
expected return is 9 percent, but the interest
rate is 10 percent, then gross I will be zero. If
there is 20 billion in investment with an r of
10 percent or higher, then gross I will be 20
billion.
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"Animal Spirits"
Spontaneous urge to action rather than inaction.
The outstanding fact is the extreme
precariousness of the basis of knowledge on which
our estimates have to be made. Our knowledge of
the factors which will govern the yield of an
investment some years hence is usually very
slight and often negligible. (Keynes 1936, p.
147).

• Estimates of Q1, Q2, . . . , Qn are subject to
  revision based on new information or the
  capricious nature of business confidence.
• What looked like a winner yesterday could be a
  turkey today.

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As r falls,firms can makeinvestmentswith
lesserexpected returns
Aggregate investment
Interest ()
?I1 to I2 risingexpected profitability of
spending for capital goods
A
H
9
B
6.5
I2
I1
60
85
0
Investment
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And vice- versa
Note that ?Qi, cet. par.??r, and investment
shifts to the right.
i ()
Also note?PK, , cet. par.??r, and function
shifts left
10
8
0
Investment
20
27
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Investment in spending-income space
I

• Function could shift down due to
• Increase in the interest rate, ceteris paribus.
• Diminished confidence about the future
  profitability of investment.

Ia2
85
60
Ia1
0
YD