The investment decision is a marginal benefit-marginal cost decision

• The marginal benefit from investment is the expected rate of return (r)
• The marginal cost is the interest rate (i) that must be paid for borrowed funds; the two are the determinants of
• investment spending.
• An investment is made if the expected rate of return exceeds the interest rate (r > i). Investments are not made when interest rate exceeds the expected rate of return (r < i)

Expected rate of return:

• Businesses only make investments when they expect to recieve profits.
• r = (TR - cost of investment) / cost of investment.
• Firms are risk takers. therefore, can't guarantee profits.
• Firms have to think about expected rate of return must be greater than the real interest rate.

The real interest rate:
Business only invest when the rate of return is greater than the interest rate (r>i)

• Ex: Taking out a loan for a 1000 dollar machine. If the interest rate is 7%, you pay $70 dollars in interest (1000 x 0.07). If the rate of return is 10%, then you gain $100 from buying the machine (1000 x 0.1).
  • Your net profit is $30 ($100-$70)
    
  • Notice that the rate of return > interest rate, therefore the investment is worth it.

• Real interest rate = Nominal Interest Rate - Inflation
• Interest cost= interest rate x cost
  

Investment demand curve:

• This curve shows the amount of investment forthcoming at each real interest rate.
  • The level of investment depends on the expected rate of return and the real interest rate.
  • Marginal-benefit, marginal-cost rule is applied to determine which investment projects should be undertaken
  • there is an inverse relationship between the interest rate (price) and dollar quantity of investment demanded
  • We apply the rule of undertaking all investment up to the point where the expected rate of return, r, equals the interest rate, i.
  • Investment demand at one level includes prior investment having the level of expected rate of return and higher

Shifts of the investment demand curve
Generally, any factor that leads businesses collectively to expect greater rates of return on their investments increases investment demand

• Acquisition, maintenance and operating costs:
  • When these costs increase, expected rate of return from prospective investment decreases
    • causes the investment demand curve to shift to the left
  • When costs fall, expected rate of return from prospective investment increase
    • causes the investment demand curve to shift to the right
• Business taxes:
  • An increase in business taxes results in decreasing expected profitability of investments
    • causes the investment demand curve to shift to the left
  • A decrease in business taxes results in an increase of expected profitability of investments
    • causes the investment demand curve to shift to the right
• Technological change:
  • The development of new products, improvements in existing products, and the creation of new machinery can stimulate investment.
    
    • cause the investment demand curve to shift to the right.
      
• Stock of capital goods on hand:
  • When firms are overstocked with capital, there is no incentive to invest so investments decline and the curve shifts to the left
  • When firms are running low with capital goods, firms tend to increase investment, therefore, shifting the ID curve to the right
  • Inventory that isn't moving costs the firm money for every second it sits on the shelf, so it would obviously be ill-advised to invest without moving inventory.
• Expectations:
  • If businesses expect the future sales, future operating costs, and future profitability to be poor, they won't increase their investment.
    
    • cause the investment demand curve to shift to the left
  • If businesses expect profits in the future, then they will increase their investment.
    • cause the investment demand curve to shift to the right.
  • The expected rate of return on capital investment depends on the firm’s expectations of future sales, future operating costs, and future profitability of the product that the capital helps produce

Instability of Investment

• Durability
  • Since investments are durable, they can be reused.
  • During hard times, firms do not have to buy new capital
  • If firms anticipate a good future, they may buy a lot of new capital now
  • Depending on expectations for the future, a firm may choose to fix capital rather than purchase new units, thus spending less.
• Irregularity of innovation
  • When there is a new advancement in technology, this causes a surge in capital investment; however, innovation occurs at irregular times
• Variability of Profits
  • Future profitability is based on the firm's current profit but that in itself is variable
  • When a firm is expanding, it invests more whereas a firm with declining profits do the opposite
• Variability of Expectations
  • Businesses tend to react to future expectations but that is unpredictable and can change quickly
  • The stock market helps as one of the indicators of society's confidence in businesses so this influences the decisions made by firms. However, stocks themselves are unpredictable and fluctuates greatly.