The Neoclassical Theory of Investment

Dale W. Jorgenson contributed to the development and understanding on the neoclassical investment theory. In the following post I will try to outline and discuss the neoclassical investment theory in simply words. At its heart, Jorgenson’s investment model bases on the idea that there exists an optimal capital stock.  Economic actors, such as firms, invest and disinvest in order to reach the optimal capital stock.

One can separate investment into replacement and net-investment. While replacement investment serve the purpose to replace depreciated capital, net-investment define actually changes to the capital stock. Net-investment are essential for the long-term determination of the capital stock. The neoclassical investment theory assumes that firms invest if their current capital stock is smaller than the optimal capital stock. Vice versa, firms disinvest in case their current capital stock is sufficiently larger than the optimal capital stock.

The optimal capital stock can change for various reasons. Changes in demand can lead to changes in the optimal capital stock. An increase in demand implies that firms can increase the amount of goods they can sell and attain higher profits. However, in order to be able to produce more goods firms need to expand their production capabilities. Hence, firms need to invest in more capital. Furthermore, changes in financial costs can lead to changes in the optimal capital stock. For instance, a decrease in interest rates might lead to a decrease in financial costs. An investment project that has not be been profitable with higher financial costs might suddenly become profitable and hence increase the optimal capital stock. Nevertheless, the current capital stock of a firm may also change for reasons unrelated to the business cycle. For instance, delays in delivery may defer adjustments of the capital stock.

Besides the neoclassical investment theory, Tobin’s q-investment theory represents a popular alternative theory of investment. The q-theory of investment implicitly considers the marginal costs of adjusting the capital stock. Hence, in contrary to the neoclassical theory of investment, the q-theory of investment is not primarily based on the assumption of an optimal capital stock, but emphasizes the optimal adjustment path towards the new capital stock.

Suggest Readings:

Jorgenson, D. (1963), „Capital Theory and Investment Behaviour”, American Economic Review 53, 247–259.

Jorgenson, D. (1967). The theory of investment behavior. In Determinants of investment behavior, NBER, 129-175.

Jorgenson, D. (1971), „Econometric Studies of Investment Behavior: A Survey”, Journal of Economic Literature 9, 1111–1147.


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