“Investment theory is unsatisfactory because too little attention is paid to business expectations and unless you do this it is hard to explain what happened to investment rates in many Western economies since 2008.” Discuss.
In this essay I will describe the key aspects behind the basic neoclassical model of investment and explain how it can be considered a satisfactory model, sufficient in explaining the changes in the investment rates since 2008 of Western economies. I will then develop the discussion further to include other elements of investment theory, such as cost adjustments and investment irreversibility, showing that it would indeed be difficult to explain the investment rates. The basic neoclassical investment models all rely on the maximisation of all future cash flows with an infinite horizon, in terms of present value. It is therefore a dynamic intertemporal belief based on the available information and may be updated in each period. We assume cash flow arises from revenue which is a function of output and is subject to the associated costs of employing input factors, simply; labour & capital. Where the firm or individual is a price taker in a highly competitive market, they will only demand the level of labour that will not reduce their net-present-value. Demand for labour will always be set to a level where the revenue generated by an additional worker is not more than the wage they are being paid. The level of capital demanded by the firm will also be subject to the marginal-revenue-product-of capital equalling the costs of employing an additional unit of capital. These include the rental price of the unit, the depreciation incurred over the time period employed and any change in real purchase price of the capital, essentially the user-cost. With this theory I can now more easily discuss the original statement. Investment decisions are made on the firm’s expectation of future cash flow, a function of consumer demand. However, future...
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