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TYPES AND DETERMINANT OF INVESTMENT

This unit discusses the concept of investment with special reference to graphical 
and functional analysis. It also explored the determinant of investment function.
At the end of this unit, the student should be able to;
i. Understand the concepts of Investment Expenditure 
ii. Explain clearly the two types of investment.
iii. Identify and explain the function and curves of the investment types. 
iv. Understand those factors that determine Investment expenditure.

TYPES OF INVESTMENT

Induced Investment - Real investment may be induced investment, when it is 
profit or income motivated. Factors like price, wages and interest change which 
affect profits, influence induced investment. Similarly demand also influences it. 
When income increases, consumption demand also increases and to meet this, 
investment increase. In the ultimate analysis, induced investment is a function of income i.e. I = f(Y). It is income elastic. Meaning that it increases or decreases 
with the rise or fall in income as shown in figure 3.2. I1 I1 is the investment 
curve which shows induced investment at various levels of income. Induced 
investment is zero at Oy1 income. When income rises to Oy3‘ induced investment 
is I3 Y3. A fall in income to Oy2 also reduces induced investment to I2 Y2.
Induced investment may be further divided into (i) the average propensity to 
invest, and (ii) the marginal propensity to invest:
(i) The Average propensity to invest is the ratio of investment to income, 
i.e., I/Y. if the income is N40 and investment is N4, I/Y =4/40=0.1, in 
term of the above figure, the average propensity to invest at OY3 
income level is I3Y3/Oy3.
(ii) The marginal propensity to invest is the ratio of change in investment
to the change in income, i.e. ∆I/∆Y. if the change in investment, ∆I = 
N2 and the change in income, Y = N10, then ∆I/∆Y = 2/10 = 0.2, in 
figure 4.2 ∆I/∆Y=I3a/Y2Y3



Autonomous investment - Autonomous investment is independent of the level 
of income and is thus income inelastic i.e. it has low or no responses to changes 
in income. It is influenced by exogenous factors like innovations, inventions, 
growth of population and labour force, researches, social and legal institutions, 
weather changes, war, revolution, etc. but it is not influence by change in demand. Rather, it influences the demand, investment in economic and social 
overhead weither made by the government or the private enterprise is 
autonomous. Such investment includes expenditure on building, dams, roads, 
canals, schools, hospitals, etc. since investment on these project is generally 
associated with public policy, and autonomous investment is regarded as public 
investment. In the long-run, private investment of all types may be autonomous 
because it is influenced by exogenous factors. Diagrammatically, autonomous 
investment is shown as a curve parallel to the horizontal axis as curve in figure
4.2, it indicate that all levels of income at the amount of investment OI1 remains 
constant. The upward shift of the curve to I2I2‖ indicates an increased steady 
flow of investment at a constant rate OI2 at all levels of income. However, for 
purpose of income determination, the autonomous investment curve is 
superimposed on the curve in a 45
o
line diagram


Self Assessment Exercise
i. Explain clearly you understanding of Business investment 
expenditure

DETERMINANTS OF PLANNED INVESTMENT SPENDING

Planned Investment in this context is defined as planned spending devoiced 
toward increasing or maintaining the stock of capital. The determinant of 
investment spending are many but the first two enumerated below are the crucial 
ones.
Anticipated Rate of Return: Businesses invest because of profit. This implies 
that investment spending is based on profit motive: the business sector buys 
capital goods, when it anticipates such purchases to be profitable.
The Real Interest Rate: Business firms at times borrow funds for investment. 
These borrowed funds are repaid out of future revenues. The annual opportunity 
cost of using a naira to make an investment is represented by the real interest 
rate. Thus, the higher the real interest, the lesser will be the profits to the 
business after paying interest and the less it will want to invest and vice versa.

Factors other than the Interest Rate Affecting Inducement to Invest

There are a number of factors other than the rate of interest which affect the 
inducement to invest. They are as follow:
(1) Element of uncertainty. According to Keynes, the MEC is more volatile than 
the rate of interest. This is because the prospective yield of capital asset depends 
upon the business expectations. These business expectations are very uncertain.
―They may change quickly and drastically in response to the general mood of the
business community, rumors, news of technical developments, political events, 
even directors‘ ulcers may cause a sudden rise or fall of the expected rate of 
yield‖.

(2) Existing stock of capital goods. If the existing stock of capital goods is Large, 
it would discourage potentials investors from entering into the making of goods. 
Again, the induced investment will not take place if there is excess or idle 
capacity in the existing stock of capital asset. In case the exiting stock of 
machine is working to its full capacity, an increase in the demand for goods 
manufactured by them will raise the inducement to invest. But it is capital stock 
which influences the MEC. The MEC and the capital stock are inversely related

(3) Level of income. If the level of income rises in the economy through rise in 
money wage rate and other wage rate and other factor price, the demand for 
goods will rise which will in turn rise the inducement to investment will fall with 
the lowering of income levels.

(4) Consumer demand. The present and future demand for the product greatly 
influences the level of investment in the economy. If the current demand for 
consumer goods is increasing rapidly more investment will be made. Even if we 
take the future demand for the products, it will be considerably influenced by 
their current demand and both will influence the level of investment. Investment will be low if demand is low, and vice versa.

(5) Liquid assets. The amount of liquid asset with the investor also influences the 
inducement to invest. If they possess large liquid assets, the inducement to invest 
is high. This is especially the case with those firms which keeps large reserve 
funds and undistributed profits. On the contrary, the inducement to invest is low 
for investors having little as liquid assets.

(6)Inventions and innovations. Inventions and innovation tend to raise the 
inducement to invest. If inventions and technological improvement lead to more 
efficient method of production which reduces cost, the MEC of new capital asset 
will rise. Higher MEC will induce firm to make large investment in the new 
capital asset and related one. The absence of new technologies will induce low 
inducement to invest. An innovation also includes the opening of new areas. 
This requires the development of means of transport, the construction of housing 
etc., leading to new investment opportunities. Thus inducement to invest rises.

(7) New products. The nature of new products in term of safe and cost may also 
influence their MEC and hence investment. If the sale product of a new product 
are high and expected revenue more than the costs, the MEC will be high which 
will encourage investment in this and related industries. For example, the 
invention of television must have encourage the electronics industry to invest in this capital asset and use them to produce television set, if they had expected 
profits to be higher than costs. Thus lower maintenance and operating cost in the 
case of new product are important in increasing the inducement to invest.

(8) Growth of population. A rapidly growing population means a growing market 
for all types of goods in the economy. To meet the demand of an increasing 
population in all brackets, investment will increase in all type of consumer goods 
industries. On the other hand, a declining population results in a shrinking 
market for goods thereby lowering the inducement to invest.

(9) State policy. The economic policies of the government have an important 
influence on the inducement in the country. If the state levies heavy progressive 
taxes on corporations, the inducement to invest is low, and vice versa. Heavy 
indirect taxation tends to raise the price of commodities and adversely affect 
their demand thereby lowering the inducement to invest, and vice versa. If the 
state follow the policy of nationalization of industries, the private enterprise 
would be discourage to invest. On the other hand, if the state encourages private 
enterprise by providing credit, power and other facilities, inducement to invest 
will be high

(10) Political climate. Political condition also affect the o invest. If there is 
political instability in the country, the inducement to invest may be affected 
adversely. In the struggle for power, the rival parties may create unrest through 
hostile trade union activities thus creating uncertainty in business. On the other 
hand a stable government creates confidence in the business community to invest 
is raised. Similarly the danger of a revolution or war with sum other country has an adverse effect on the inducement to invest, whereas peace and prosperity 
tends to raise it.

Other determinants of investment include the following;

i) Level of national income 
ii) Business climate
iii) Technological progress
iv) Government policies on wages and salaries and taxation

Self Assessment Exercise
i. Explain various determinant of investment expenditure.

THEORETICAL DETERMINANTS OF INVESTMENT

The decision to invest in a new capital asset depends on whether the expected 
rate of return on the new investment is equal or greater or less than the rate of 
interest to be paid on funds needed to purchase this asset. It is only when the 
expected rate of return is higher than the interest rate that investment will be 
made in acquiring new capital assets.
In reality, there are three factors that are taken into consideration n while making 
any investment decision. They are the cost of the capital asset, the expected rate 
of return from it during his lifetime, and the market rate of interest, Keynes sums 
up this factor in his concept of the marginal efficiency of capital (MEC).
Marginal Efficiency of Capital.(MEC) - The marginal efficiency of capital is 
the highest rate expected from an additional unit of a capital asset over its cost. 
In the word of Kurihara, ―it is the ratio between the prospective yields (y) is the 
aggregate net return from an asset during its life-time, while the supply price (p) 
is the cost of producing this asset. If the supply price of a capital asset is 
N20,000 and its annual yield is N2,000, the marginal efficient of this asset is
. Thus the marginal efficiency of capital is the percentage 
of the profit expected from a given investment on a capital asset.
Keynes relates the prospective yield of a capital asset to its supply price and 
defines the MEC as ―equal as equal to the rate of discount which would make the 
percentage value of the series of annuities given by the return expected from the 
capital asset during its life just equal to its supply price.‖ 1 this can be express as:
sp =
Where sp is the supply price or the cost of the capital asset, R1, R2.…. Rn are 
the prospective yield or the series of expected annual return from the capital asset 
exactly equal to the present value of the expected yield from it.
The Marginal Efficiency of Investment ( MEI)
The MEI is the rate of return expected from a given investment on a capital asset 
after covering all its cost, expect the rate of interest. Like the MEC, it the rate 
which equates the supply price of a capital asset to its prospective yield. The on 
an asset will be made depending upon the interest rate involve in getting funds 
from the market. If the rate of interest is high, investment is at a low level. A low 
rate of interest leads to an increase in investment. Thus the MEI relates the 
investment to the rate of interest. The MEI schedule shows the amount of 
investment demanded at various rate of interest. That is why, it is also called 
investment demand schedule or curve which has a negative slope
To what extent the falls in the interest rate will increase investment depends 
upon the elasticity of the investment demand curve of the MEI curve. The less 
elastic is the MEI curve, the lower is the increase in investment as a result of fall 
in the rate and the Marginal efficiency of investment. The horizontal axis 
measures the amount of investment; the MEI and MEI‘ are investment demand 
curves. The MEI curve in panel (A) is less elastic so investment increase by I’I‖ 
which is less than the increase in investment I1I2 show in panel (B) were the 
MEI curve is elastic. Thus given the shape and position of the MEI curve, a fall 
in the interest rate will increase the volume of investment.

On the other hand, given the rate of interest, the higher the MEI, the larger shall 
be the volume of investment. The higher marginal efficiency of investments 
implies that the MEI curve shift to the right. When the existing capital assets 
wear out, they are replaced by new ones and level of investment increases.
Self Assessment Exercise
i. Explain the difference between MEC and MEI.

CONCLUSION

This unit looked at concept of investment expenditure and its determining 
factors, it also explain functional relationship between investment and income 
level, which is elastic in nature. This functional relationship is express both 
algebraically (function) and graphically (curve). We also, explain the concept of 
average and marginal propensity to invest.

SUMMARY

This unit explore the major types of investment expenditure and equally 
examined the determinants of investment both psychological and theoretical. The 
study unit also expresses relationship between saving and investment.

MARKED ASSIGNMENT

i. Explain what is meant by investment in Keynesian context.
ii. List and explain components of investment expenditure function
iii. Given that I = 20 + 2/3Y decompose this investment function and 
illustrate each component.
iv. Differentiate between Average and Marginal propensity to invest 
with numerical examples.

REFERENCES

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Jhingan M.L, (2010); International Economics, Vrinda Publications (P) Ltd. 
Delhi, India
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