Tobin’s q-Investment Theory

In the 60s and 70s, economists including Nicholas Kaldor and James Tobin came up with an alternative investment theory: the q-investment theory, sometimes also referred to as Tobin’s q-investment theory. At its core, Tobin’s q theory of investment relates fluctuations in investment to changes in the stock market. Although the theory gained popularity only in the 70s, first elements of the theory can already be found in works of John Maynard Keynes. In his General theory of employment, interest and money, Keynes mentioned already that investment might be linked to the stock market.

In contrast to the neoclassical investment theory, that explains investment in the context of an optimal capital stock, q-investment theory explains fluctuations in investment with changes in the stock market. That is, the q-investment theory explains investment using the difference between the stock market valuation of firms real assets and the replacement costs of these assets. According to Tobin’s q-investment theory, firms base their investment decisions on q, where q represents the ratio between the market value of all physical capital and its replacement costs.

q=\frac{\text{Equity Market Value + Liabilities Market Value}}{\text{Equity Book Value + Liabilities Book Value}}

In the case that q is above one (q>1), the stock market values the firm more than the market value of its real assets. In this case a firm can increase its value by acquiring additional capital. Thus, firms will investment and increase their capital stock. In the opposite case, when q is smaller than one (q<1), the market value of the firm is less than the replacement costs of the firms assets. It this case a firm does not replace depreciated capital, because the market values the additional investment less its costs. Hence, the capital stock will decrease.

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.

 

Suggested Reading:

Brainard, W. und J. Tobin (1968), „Pitfalls in Financial Model-Building”, American Economic Review 58 (2), 99–122.

Keynes, J. M. (2016). General theory of employment, interest and money. Atlantic Publishers & Dist.

Tobin, J. (1969), „A General Equilibrium Approach to Monetary Theory”, Journal of Money, Credit and Banking 1, 15–29.

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One Response to Tobin’s q-Investment Theory

  1. Pingback: The Neoclassical Theory of Investment | Economic Theory Blog

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