Revision note – Investment and MEC

Investment is spending on capital goods by firms and government, which will allow increased production of consumer goods and services in future time periods. Be careful not to confuse the economists’ definition of investment with another interpretation – that investment involves putting funds into financial assets such as stocks and shares. Marginal Efficiency of Capital Theory – As investment increases, the return on the last unit of capital employed will be less and less as a result the Law if Diminishing Returns (i.e. The MEC falls). 

The theory states that it is profitable to invest so long as the MEC (the % return) is greater than the rate of interest (the cost of funds needed to finance the investment). The OPTIMUM level of Investment is where:

% MEC = the rate of interest

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

Gross and Net Investment

An important distinction to make is between gross and net capital investment spending

Net investment is positive when gross investment is higher than depreciation or capital consumption. Then there will be an increase in the nation’s stock of capital.

  • Fixed Investment – is spending on new capital machinery and plant, construction, housing, vehicles, etc.
  • Working Capital – is spending on stocks/inventories of finished goods and raw materials. The accumulation of stocks by firms, whether voluntary or involuntary, is counted as investment.

Gross Domestic Fixed Capital Formation (GDFCF) – is expenditure on fixed assets (buildings, vehicles and plant) either for replacing or adding to the stock of fixed assets.

Gross Domestic Investment Spending + Stockbuilding = Total Gross Investment

Other factors that affect investment demand

1. Expectations – the key to understanding investment decisions
The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.

2. Returns to an investment project

The expected returns from capital investment are determined by the demand for and the price of the output of goods or services generated by an investment and also by the costs of production. A rise in demand for the output that capital is purchased to supply will increase the potential revenue streams that a business can expect from a new project. Similarly, a change in the costs of purchasing the capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also affect the expected rate of return.

3. The importance of business expectations and uncertainty

Expectations of demand, prices and costs over the lifetime of the investment are key determinants of expected returns. There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes.

The rate of return from an investment is also influenced by the rate at which an investment project is assumed to depreciate over time.

The cost and availability of internal and external finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable.

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

  • If profit levels rise, firms will have more money to spend on investment and will have a greater incentive to do so.
  • Advances in technology may encourage firms to replace less productive capital equipment.
  • The government may also encourage investment by cutting corporation tax on firms’ profits and by giving investment subsidies.

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