Business Firms As Spending Units Investment is defined as ïAïAll spending by business firms for...
-
date post
20-Dec-2015 -
Category
Documents
-
view
216 -
download
1
Transcript of Business Firms As Spending Units Investment is defined as ïAïAll spending by business firms for...
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
Business Fixed Investment, 1982-97
billions of chain-weighted 1992 dollars
Source: Economic Report of the President
Year
199719941991198819851982
bill
ion
s of
19
92
dol
lars
1200
1100
1000
900
800
700
600
500
Components of Business Fixed Investment, 1982-97
billions of chain-weighted 1992 dollars
Source: Economic Report of the President
Year
199719941991198819851982
billions
of
1992 d
ollars
700
600
500
400
300
200
100
0
Structures
Durable equipment
Computers
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 capital
to produce goods and services
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:
n
in
ik
r)(Q
P1 1
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 36,000Repairs (including tires) 16,000Insurance 11,750
Total $128,000
Thus Q1 = Q2 = Q3 = $40,000
Now solve for r
Solution:
r = 0.08, meaning that if the prevailing interest rate is above 8 percent, then the present value of the asset is less than its supply price.
)1()1(32
000,40000,40
)1(
000,40077,103$
rrr
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 < i, then the acquisition cost of the asset will
exceed its supply price and the investment will not be made.
If r for the project with the highest expectedreturn is 9 percent, but the interest rate is
10 percent, then gross I will be zero. If thereis $20 billion in investment with an r of 10 percent
or higher, then gross I will be $20 billion.
“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.
A H
B
60 850 Investment
Interest (%)
9
6.5
I1
I2
As r falls,firms can make
investmentswith lesser
expected returns
I1 to I2: risingexpected profitability of spending for capital goods
i (%)
Investment
Note that:
Qi, cet. par.r, and investment shifts to the right.
10
020
8
27
Also note:
PK, , cet. par.r,
and function shifts left
And vice-versa