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.
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