What Determines

Private Investment Spending?

What determines private business investment spending? As with consumer expenditure, the answer is gradually being clarified through both theoretical and empirical work. Begin again with a simplified model. Later we shall look at some of the modern empirical evidence.

Fundamentally, expected profits determine how much a business will spend on investment in any given year. When a businessman thinks he can invest in a new machine and get back over the life of the machine what it costs, plus running expenses, plus interest on the money invested, plus some extra return (profit), he will probably make the investment. He will invest when the expected rate of return on his invested capital exceeds the going rate of interest (cost of capital) he must pay for funds to make the investment.

The Marginal Efficiency of Investment

Economists call the expected rate of return on investment the “marginal efficiency of investment” (m.e.i.). Suppose, for example, a businessman is thinking of buying a new milling machine for his plant. He knows the machine will cost $10,000 and his engineers estimate that it will increase the annual output of the plant by about $2,000, with unchanged costs for labor and materials. To maintain the machine, however, will cost about $500 a year. (To make the example easy, assume the machine lasts indefinitely.) Thus, the expected annual net return on the $10,000 investment in the machine will be $1,500. The marginal efficiency of investment would thus be 15 per cent (that is, $15 return annually on every $100 invested). If he could borrow money at, say, 5 per cent to buy the machine, it looks like a good investment.

‘What factors determine the marginal efficiency of investment in typical cases? Some of the major ones are:

Expected Product Demand. The dominant consideration is the expected demand for the firm’s product. Note that it is expected net return on investment that matters. Thus, whenever a businessman expects the demand for his product to rise, this anticipation increases the expected rate of return he can get by investing in new plant and equipment that will increase his output or improve the quality of his product. The fact that expectations govern the marginal efficiency of investment makes it subject to wide fluctuations, depending on how things look to the businessman.

FIG. 7-3 Private investment spending fluctuates sharply.
It is now higher than ever before, but gross investment is
roughly the same percentage of g.n.p. as in other pros-
perous periods.

If the world looks black, down goes the marginal efficiency of investment. Note here the tie back to consumer spending. One of the big forces in fluencing the expected return on new investment is consumer spending—more broadly, the total demand for business’ products.

Technology and Innovation. Research and development push the marginal efficiency of investment up. If a new machine promises to lower costs or improve product quality, this promise will be reflected in a larger expected net return on the investment. Some investment is justified just to replace old machinery with duplicate equipment, but technological advance is the foundation of most present-day investment in plant and equipment.

Taxes. With modern corporation income tax rates, businessmen are primarily concerned with the expected rate of return on investment after taxes. In 1967, all corporations except the smallest paid income taxes of about 50 per cent on their profits. (If we take this factor into account, the milling-machine investment above loses a lot of its glamour.) An increase in corporation tax rates, other things equal, will lower the marginal efficiency of investment; a decrease will raise it.

Ceneral Outlook. A businessman can never estimate precisely all the factors involved over the life of a major investment. Will demand for the final product really be what he expects? Will tax rates stay the same? W/ill the government step in and regulate his business? Will a new machine come along that will make this one obsolete? ‘With all this uncertainty, the general outlook of the businessman often plays a big role in his final decision on whether or not to invest.

Interest Rates—

“The Cost of Money”

The other side of the picture is the interest rate—the cost of the money needed to make the investment under consideration. If the businessman has to borrow the funds needed, we can get a direct figure for the cost of money—maybe it’s 5 per cent. But even if he has the money already, possibly in retained earnings from previous profits, he must still figure “implicit” interest on the funds used, since when he ties them up here he will be foregoing interest he could earn by investing them elsewhere. Then the proper interest rate to charge is harder to estimate, but he must settle on some figure for his calculation. We’ll look at the details presently.