Capital, Investment and New TechnologyChapter 12

LIPSEY & CHRYSTAL

ECONOMICS 12e

Learning Outcomes

• Physical capital differs from other variable inputs in that it is sometimes ‘lumpy’ and is generally durable.

• In order to evaluate capital investments, firms need to calculate whether it adds net value to the firm

Learning Outcomes

• The present value of any future income stream is what it would be worth paying today to obtain that future income stream.

• An investment adds net value to a firm if the present value of the income stream generated exceeds the present value of the extra costs incurred.

Learning Outcomes

• Firms will invest up to the point where the present value of the project ceases to be positive.

• This is conceptually equivalent to the principle that a profit-maximizing firm will set marginal cost equal to marginal revenue.

Learning Outcomes

• All investments are risky to some degree, as their value relies on future income steams and the future is uncertain.

• The recent revolution in information and communication technology (ICT) has important implications for the way firms work and for the economy in general.

Capital as input• Because capital goods are durable, it is necessary

to distinguish between the stock of capital goods and the flow of services provided by them, and thus between their purchase price and their rental price.

• The linkage between them relies on the ability to assign a present value to future returns.

• The present value of a future payment will be lower when the payment is more distant and the interest rate is higher.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

• Firms will hire capital goods up to the point where the rental price of capital in each period equals its marginal revenue product in that period.

• The rental price is the amount that is paid to obtain the flow of services that a capital good provides for a given period.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

• The purchase price is the amount that is paid to acquire ownership of the capital, and in equilibrium it is equal to the present value of the future net income stream generated by the capital.

• This is the present value of capital’s future stream of marginal revenue products.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

• An individual firm will invest in capital goods as long as the present value of the stream of future net incomes that are provided by another unit of capital exceeds its purchase price.

• For a single firm and for the economy as a whole, the size of the total capital stock demanded varies negatively with the rate of interest.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

The investment decision • A central element of an investment appraisal is the

choice of discount rate. Firms should discount future cash flows at a rate that reflects the cost of funds to them and the riskiness of the project involved.

• Present value calculations should allow for inflation appropriately.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

The investment decision • Sunk costs should not influence future investment

decisions.• The option value of an investment that has not yet

been made may justify delaying the investment.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

New Technology• The revolution in information and communication

technologies (ICT) has roots that go back to the nineteenth century, but it accelerated in the latter part of the twentieth century when a new general purpose built technology, the electronic computer and a few related technologies, began to transform much of the economic, social, and political structure of society.

• The revolution has been associated with many new products, new production processes, and new forms of organization.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

• Nonetheless, resources still move in response to price signals and profit motives, and recessions and inflations have not been banished for ever.

• Two of the special features of ICT industries are increasing returns and network externalities. These generate a winner-take-all competition between firms.

INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

D

k1k0

i1

i0

The Equilibrium Interest RateIn

tere

st r

ate

[% p

er y

ear ]

Quantity of capital

0

· In the short run the interest rate equates the demand for capital with its fixed supply.

· The economy’s desired capital stock is negatively related to the interest rate, as shown by the curve D.

· In the short run, when the stock of capital is K0 the equilibrium interest rate is i0.

· When the capital stock grows to K1 in the long run, the equilibrium interest rate falls to i1.

The Equilibrium Interest Rate

k1k0

i1

i0

Changes in Technology and the Capital Stock

Inte

rest

rat

e [%

per

yea

r ]

Quantity of capital

0

i2

D1

D0

· The original demand curve D0 and capital stock K0 produce an interest rate of i0.

· Technological improvements shift the desired capital stock curve to D1.

· With a constant stock of capital, the interest rate would rise to i1.

Changes in Technology and the Capital Stock

· However, the capital stock increases to K1, which, other things being equal, would lower the interest rate to i2.

· In the example shown, these two effects exactly offset each other and the interest rate remains unchanged at i0 where K1 and D1 intersect.

Changes in Technology and the Capital Stock

Rent and height profiles

Distance from city centre0

Hei

ght

Val

ue

Small city

Buildin

g height

+ Land V

alues

Large city

Building height

+ Land Values

Agricultural landvalue

Agricultural landvalue

• Both land rents and building heights tend to be highest at the city centre.

• The figure shows two typical rent gradients for cities of two different sizes.

• Rents are highest at the city centre and fall towards the periphery.

Rent and height profiles

• At the boundary between the city and the countryside, the rent that urban uses can pay just equals the rent that can be paid for the same land in agricultural uses.

• Building heights will show a similar profile, being highest at the centre and tending to fall as one moves towards the periphery.

Rent and height profiles