Investment Theory
The literature on investment is dominated by two theories: the neoclassical theory
and the q theory. The neoclassical investment theory is based on the firm’s
maximisation of the discounted flow of profits [Jorgenson (1963)]. In the presence of a
constant elasticity of production function, and absent adjustment costs and a
possible substitution between capital and other variable inputs, the desired stock of
capital is determined by output and the user cost of capital.
An alternative to the neoclassical investment theory is the q approach The q model
relates investment to the q variable, the ratio of the market value of firms to the replacement cost of their assets [Tobin (1969)]. The model assumes that financial market data contain valuable information about changing incentives to invest. Thus, an increase in the prospective returns of firms or a decrease in the market discount rate raise the q ratio and thereby increase investment. Two major drawbacks of the classical version of the q theory are: first, the optimal amount of current investment depends only on the current value of average q, which is not confirmed in empirical analysis. Second, in contrast to the neoclassical theory, the role of the production function is not clearly specified in the original exposition.
Rate of Investment
Subsequent to the development of the q theory, Abel and Yoshikawa showed that it
can be integrated into the neoclassical theory of choice by considering marginal valuations of capital and the optimal rate of investment to be the rate for which q-1 is equal to the marginal cost of installation [Abel (1980) and Yoshikawa (1980)]. Later Hayashi modified the q theory by introduction of marginal q (associated with investment in the new capital) and distinguished it from average q (associated with the existing capital) [Hayashi (1982)]. He showed that sometimes both qs can be very different and the marginal rather than the average q is the central determinant of investment.
The q theory of investment has some theoretical advantages over the Jorgenson
neoclassical model. The q theory is robust to the Lucas critique. In fact, the q theory is
forward-looking rather than being based on current and past economic developments because the market valuation of firms used to compute q variable contains business expectations in the future and thereby information about changing incentives of the firms to invest. The next advantage of q theory is that it allows output to be endogenously determined and variable. The neoclassical theory, in contrast, assumes that output is given exogenously, which is inconsistent with perfect competition.
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