Capital, Investment and New Technology Chapter 12 LIPSEY & CHRYSTAL ECONOMICS 12e

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

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.

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.

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.

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. 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. 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 capital’s future stream of marginal revenue products. 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. 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. 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. 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. 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. INTRODUCTION - CAPITAL, INVESTMENT AND NEW TECHNOLOGY

D k1k1 k0k0 i1i1 i0i0 The Equilibrium Interest Rate Interest rate [% per year] Quantity of capital 0

 In the short run the interest rate equates the demand for capital with its fixed supply.  The economy’s 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 K 0 the equilibrium interest rate is i 0.  When the capital stock grows to K 1 in the long run, the equilibrium interest rate falls to i 1. The Equilibrium Interest Rate

k1k1 k0k0 i1i1 i0i0 Changes in Technology and the Capital Stock Interest rate [% per year] Quantity of capital 0 i2i2 D1D1 D0D0

 The original demand curve D 0 and capital stock K 0 produce an interest rate of i 0.  Technological improvements shift the desired capital stock curve to D 1.  With a constant stock of capital, the interest rate would rise to i 1. Changes in Technology and the Capital Stock

 However, the capital stock increases to K 1, which, other things being equal, would lower the interest rate to i 2.  In the example shown, these two effects exactly offset each other and the interest rate remains unchanged at i 0 where K 1 and D 1 intersect. Changes in Technology and the Capital Stock

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

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. 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. Rent and height profiles