Capital, Investment and New Technology Chapter 12

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Capital, Investment and New TechnologyChapter 12

• LIPSEY CHRYSTAL
• ECONOMICS 12e

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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

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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.

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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.

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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.

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INTRODUCTION - CAPITAL, INVESTMENT AND NEW
TECHNOLOGY

• 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.

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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.

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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 capitals future
  stream of marginal revenue products.

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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.

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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.

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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.

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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.

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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.

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The Equilibrium Interest Rate
Interest rate per year
i1
i0
D
0
k1
k0
Quantity of capital
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The Equilibrium Interest Rate

• In the short run the interest rate equates the
  demand for capital with its fixed supply.
• The economys 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.

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Changes in Technology and the Capital Stock
Interest rate per year
i1
i0
i2
D1
D0
0
k1
k0
Quantity of capital
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Changes in Technology and the Capital Stock

• 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.

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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.

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Rent and height profiles
Value
Height
Large city
Building height Land Values
Small city
Building height Land Values
Agricultural land value
Agricultural land value
0
Distance from city centre
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Rent and height profiles

• 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.

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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.