Investment Function

Investment function is the second component of the effective demand which is the determinant of the level of income, employment and output in the economy. According to Keynes, unless there is a change in the propensity to consume, employment and income can rise only with an increase in investment. In Keynesian economics, Investment means real investment which refers to the net addition to the existing stock of capital in the form of new machinery, new factory buildings, roads etc. This real investment increases the level of income, output and employment.
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 The real investment differs from financial investment, which relates to the purchase of existing stocks, shares, securities etc. This constitutes merely an exchange of money and does not affect the level of employment in an economy. According to Stonier and Hague, By investment we do not mean the purchase of existing paper securities, bonds, debentures or equities, but the purchase of new factories, machineries, and the like. An investment is termed real investment only when it leads to a increase in the demand for human and physical resources, resulting in an increase in their employment. Investment is a flow variable and its counterpart is stock 2 variable called capital.

Types of Investment: (1) Autonomous and Induced Investment: Autonomous investments are independent of income changes. It is not based on consideration of profit. Autonomous investments are made primarily by the government and thus, are not based on profit motive. Example: Autonomous investments are peculiar feature of a war or a planned economy, for example, expenditure on arms and equipment to strengthen the defense of India may be called autonomous investment as it is incurred irrespective of the level of income or profit. 3

 on the other hand, induced investment changes with a changes in income. Hence, it is income elastic and guided by profit motive. Thus, in a free enterprise capitalistic economy, investment is sensitive to changes in income or induced by profit motive. The shape of induced investment curve thus, upward sloping, indicating a rise in investment as a result of rise in income. Both autonomous and induced investment curve can be shown by the diagrams as:
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(a) Autonomous Investment

(b) Induced Investment

Investment Investment

I2

I1

I1

I2

Income Income

 The above figures shows that : (a) the autonomous investment curve I1I1 is parallel to the OX axis, which indicates investment does not increase as a result of increase in income. (b) The induced investment curve I2I2 slopes upward indicating an increase in investment in response to the increase in the income. Factors Determining Real Investment Marginal Efficiency of Capital (MEC): According to Keynes, Marginal Efficiency of Capital (MEC) in conjunction with the rate of interest, determines the real investment. But, for the moment, we shall concentrate on the MEC as related to real investment.
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 MEC: it refers to the expected profitability of a new capital asset. Or, it is the expected rate of return or the highest rate of return over cost from the employment of an additional capital asset. According to Stonier, the MEC is The marginal efficiency of a particular type of capital asset shows what an entrepreneur expects to earn from one more asset of that kind compared with what he has to pay to buy it. The investment opportunity will be carried on as long as the expected rate of profit exceeds the rate of interest. Moreover, it will be carried to the point at which the MEC is equal to the rate of interest. 7

 In reality the MEC is the ratio of two factors: (a) Prospective yield from the capital asset. (b) The supply price or replacement cost of the asset. Prospective Yield Prospective yield represents the flow of money income expected by a business firm from the sale of output produced by an income yielding asset over its life time. For Example: when a new factory is established, the investor expects to get back not only his original investment but also a series of annual income from sales of the output. It is however, difficult to estimate correctly the life of the capital assets. According to Harris, an estimate of what an investment will earn in five, ten or twenty years is based on guess work. Moreover, the expected return from the capital 8 asset are likely to vary from year to year.

 From these expected annual returns, we have to deduct the running expenses such as maintenance expenses, cost of raw materials and depreciation except interest charges. Accordingly, the entrepreneurs is left with net return (net of all costs) called the prospective yields. Suppose we know the life of the income yielding assets, we may refer to these annual returns as a series of annuities represented by Q1, Q2, Q3 ..Qn where Q stands for the annuity and the subscripts 1, 2, 3, n refers to the years in which the annuities flow. Thus, the prospective yield is distributed over the life of the new capital asset. Further, these annuities are future returns and vary from year to year.
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Supply Price or Replacement Costs: The supply price or the replacement cost of an entrepreneur is related to the price he has to pay to acquire a brand new capital asset. This cost of the asset is called supply price or replacement cost.

Hence, supply price refers to that price at which the new capital asset is acquired or the old one is replaced. It should be noted that the supply price of a capital asset is the cost producing a new asset of that kind and not the price of an existing asset.
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 The MEC can be easily calculated with these two concepts, namely, the prospective yield and the supply price of an asset. In particular, if we know the value of Qs and if we equally know what it will cost to produce such an asset which is a source of these yields, then the ration between the two is known as MEC. According to Keynes, Being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price. Hence, Supply price = Discount Prospective yield.11

How to Calculate MEC:

Suppose an investor feels that a given investment in new capital asset (say a machine) will cost him Rs. 10,000. Suppose this machine is expected to yield over its life time a net return of Rs. 500 per annum. To find out MEC of the new capital asset, we would simply calculate the ratio of the expected annual net return divided by Rs. 10,000, which results: 500/10,000 = .05 or 5%. Thus, the MEC is 5% i.e. the expected annual net return on the investment of Rs.10,000 is 5%. The formula for calculating Supply Price: Cr = (Q1/(1+r)) + (Q2/(1+r)2) +.+ (Qn/(1+r)n) Where, Cr stands for supply price or replacement cost of the new capital asset. Q1, Q2, Q3Qn denotes expected annual rate of return each year from the capital asset. r stands for rate of discount of MEC. 12

 To take concrete example, let us suppose that the prospective annual yields from the use of the new capital asset whose life is 3 years only are as follows: 1st year 2nd year 3rd year Rs. 1,050 Rs. 3,525 Rs. 9,261 Suppose the supply price of the asset is Rs. 12,200. Further the rate of discount of 5% will equate the yields of the capital asset with its supply price Rs. 12,200. This can be calculated as: Rs. 12,200 = (1,050/1+.05)+(3,528/(1+.05)2)+9,262/(1+.05)3) = (1,050/1.05)+(3,528/(1.1025))+9,262/(1.1576)) =1,000+3,200+8,000 =12,200 Hence, this unique rate of discount (5%) is called the marginal efficiency of capital. 13

How to Calculate Present Value: The usual procedure for determining the present value of some expected income stream is to discount it at the current rate of interest. Example: suppose there is an asset which yields an income of Rs. 3000 per year of three years (Rs. 9,000 over its total life time), Suppose the current rate of interest is 5% per year, then the total present value of the asset will be: Vp = R1/(1+i) + R2/(1+i)2 ++Rn/(1+i)n where, Vp is the present value, R1, R2,Rn is the expected income stream and i is the current rate of interest. 14

 Hence, the present value at 5% rate of interest will be: Vp = (3000/1.05) + (3000/(1.05)2) + (3000/(1.05)3) = (3000/1.05) + (3000/(1.10)) + (3000/(1.15)) = 2,857 + 2,721 + 2,597 = Rs.8,175 Thus, we find that the present value of the asset is Rs.8,175, an amount less than sum of the absolute amount to be received in three years. This shows that the more remote the data in the future at which the income is expected, has a lower present value But, if we lend a sum of Rs.2,857 for one year, Rs.2,721 for two years and Rs.2,597 for three years at 5% rate of interest, the sum will give Rs.3,000. 15

Investment Demand Schedule:

We have seen that MEC is determined by relating the aggregate net return of an asset to its supply-price. In this case, it is possible to construct a schedule of MEC or Investment Demand Schedule of all types of capital assets. It shows a functional relationship between the MEC and the amount of investment. The schedule shows that if there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased partly because the prospective yield will fall as the supply of that type of capital is increased. Moreover, the relationship shows that as investment in a particular capital asset increases, the marginal efficiency decreases. The marginal efficiency of all types of capital asset which may be made during a given period of time represent the Investment demand schedule or the MEC schedule. 16

The investment demand schedule is illustrated as follows:

Investment (Rs. Crores) MEC (%)

200
400 600

10
9 8

800
1,000 1,200

7
6 5
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 The above schedule shows that MEC declines as the volume of investment increases in a given type of capital asset during any period of time. Keynes states that: if there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased. This shows there is an inverse relationship between the MEC and investment, which states that the rate of MEC decreases as the investment increases. Thus, the MEC curve will be downward sloping from left to right, which is shown as:
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Y MEC

P
Q MEC Curve O X V W Investment

The figure shows the MEC curve which slopes downward from left to right like an ordinary demand curve. The curve shows that as investment rises from OV to OW, MEC falls from OP to OQ.
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Factors Affecting Investment:

There are large number of short-run and long-run factors which influence the investment. These are:

Short-run Factors:
1. Nature of Demand, Price and Cost: if the cost are expected to rise or prices are likely to fall and the demand for particular product is prone to decline in future, average business mans expectation regarding the rate of return from any given investment will also decline affecting the investment adversely.

On the other hand, investment will get fillip, if the entrepreneur expects a fall in cost, or rise in prices, increase in demand or combination of these.
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2.Change in propensity to Consume: A change in propensity to consume changes investment and vice versa. 3. Change in Income: Sudden changes in income caused by windfall profits or losses influence the investment. It will stimulated by a rise in income and damped by fall in income. 4. Current rate of Return on Investment: it influence future expectation. The entrepreneur expect the current state of affairs will continue in future as well. Therefore, higher the current rate of return, higher is the marginal efficiency of capital.
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5. The State of Business Confidence: the alternative waves of optimism and pessimism also affect the Investment. Optimism boost Investment While pessimism lowers it. Periods of optimism and pessimism are often refer to the results, as one would expects them to be based on political, psychological and social factors. Long-Run Factors: 1. Rate of Growth of Population: the growth of population favorably affects investment, because the basic needs of a fast growing population require a greater amount of capital investment in the fields of Municipal and public utilities services, residential buildings and consumer goods industries specially those producing necessaries of life.
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2. Developing New Territories: It encourages heavy investment in housing, transport, sanitation etc. therefore, the Investment is favorably affected. 3.Technological Progress: Improvements in techniques of production stimulate investment. Specially, when it is of labor-saving type or capital intensive, it lowers the cost of production, calls for huge investment activity. Example: the manufacturing of steel, cars, rubber, glass, textile, electrical goods etc. has resulted in greater technological progress and the expansion of market resulting in increased investment. 4. Development of Infrastructure: investment in transport, power, and other SOC has a favorable affect on Investment. 23