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How to Take Investment Decision in Production

As everyone knows that the production of goods and services requires various factors of production i.e. land, labor, capital, and entrepreneurship, etc. All these factors render productive services in the production process combinedly and with their joint effort a final product shapes out. Hence, the entrepreneurs need to know about the productive efficiency of factors for making investment decisions so that to what extent the factors are to be invested on and utilized for an expected profit. Therefore, it requires measuring the efficiency of capital and investment on other factors of production. Here, our main focus is to explain the methods of measuring the efficiency of capital and investment. There are different ways to measure the efficiency of capital and investment in production. Before we proceed to the study of various methods of measuring the efficiency and taking an investment decision in production, let us first analyze the meaning and types of capital and investment.

1- Meaning of Capital and Investment

Capital is something man-made assets which are further used to produce some other goods and service. For instance, the chisel is a capital for a carpenter and a screw-driver for an electrician. Similarly, real assets, factories, plants, equipment, and financial assets, etc. are all capital for an entrepreneur. In other words, capita refers to previously produced inputs that can be further used to produce some other goods and services. The amount of capital accumulated over a period of time in an economy is a stock of capital.

Generally, investment is spending money on acquiring real and financial assets that yield returns over time. However, in economics investment means purchasing or building real assets like plants, equipment, etc. that are further used to produce other goods and services. In other words, investment refers to an addition to the stock of real assets to make a profit.

2- Types of Investment

There are various types of investment which are mentioned as follows.

2.1- Gross and Net Investment
The total amount of expenditure made on capital assets in a certain time period, usually one year, is called gross investment. In fact, gross investment is the sum of net investment and depreciation whereas net investment is the outcome of gross investment minus depreciation and obsolescence charge.

2.2- Business Fixed, Residential, and Inventory Investment
Business fixed investment refers to the investment in machines, tools, and equipment that entrepreneurs purchase for the use of further production of goods and services. Residential investment refers to the expenditure that is made on construction or purchasing new houses or residential apartments for the purpose of a dwelling or renting out to others. Likewise, the investment that is made on holding inventories of finished and semi-finished goods is known as inventory investment.

2.3- Planned, Unplanned, and Actual Investment
The investment that is made intensionally to achieve a predetermined goal is referred to as a planned investment whereas the investment that must be made due to some unexpected changes in economic and other factors is called unplanned investment. On the other hand, the sum of planned and unplanned investments is called an actual investment.

2.4- Induced and Autonomous investment
Induced investment is the investment that is dependant on the level of income and it is made with a motive of earning profit. When firms expect a potential profit or future economic conditions are favorable, induced investment goes up and vice versa. With an increase in disposable income, a consumption demand of a community also rises, and to meet the demand, there is an increasing pressure to produce and supply more goods. This requires more investment and hence, it generates more profit. So, induced investment is profit-motivated, and income elastic. It is highly influenced by income than that of the rate of interest and wage-rate.

The nature of the induced investment has been explained with a help of the following diagram.

In the above diagram, II is the investment curve that shows induced investment at various levels of income. At the OY income level, induced investment is equal to AY, and with the increase in income level from OY to OY1, the induced investment also has gone up from AY to BY1. In case of a fall in income from OY1 to OY, the induced income level also will fall to BY1 to AY. Thus, it is clear from the above diagram that induced investment is income elastic.

Autonomous investment is independent of the level of income and it is income inelastic. It is influenced by external factors like innovations, inventions, population growth, labor force, social and legal institutions, war, revolutions, change in weather, etc. but not affected by a change in aggregate demand. Such an investment itself changes the demand. The investment whether it is made by the government or private sectors in building dams, roads, canals, schools, hospitals, etc. is known as autonomous investment.

The autonomous investment has been explained with an aid of the following diagram.
In the above diagram, II represents an autonomous investment. The autonomous investment curve is horizontal to X-axis and it implies that autonomous investment is constant and not influenced by a change in income level.

3- Determinants of Investment

Taking a decision for, whether to invest in new capital assets or not, depends on the marginal efficiency of capital and rate of interest. Therefore, the major determinants for taking the investment decision are marginal efficiency of capital and rate of interest. These two determinants have been explained as follows.

3.1- Marginal Efficiency of Capital (MEC)
Marginal efficiency of capital refers to the productivity or expected rate of returns of an additional unit of capital. MEC commonly shows the possible return from the additional capital investment. Whether it is profitable to invest in new capital assets or not, is the first focusing point of an entrepreneur before taking an investment decision. Therefore, the entrepreneur must compare the prospective yield or MEC he gets from his investment, and the rate of interest for the loan taken to invest on capital assets.

Before comparing MEC and rate of interest, the entrepreneur must know the MEC of the prospective capital assets. However, to find out MEC requires calculations. There are various methods of calculating MEC that will be mentioned in this content later.

When the MEC of the prospective capital asset is once calculated, then the market rate of interest is compared with the MEC, and a decision for the investment can be taken as mentioned here.

1- if MEC is greater than the rate of interest, a decision to invest in capital assets is profitable. In such a case, the project is acceptable.

2- If MEC is equal to the rate of interest, it is not profitable to invest in capital assets, yet it is acceptable on a non-profit basis.

3- If MEC is less than the rate of interest, it is completely rejectable to invest in capital assets because it will incur losses.

3.2- Rate of Interest
The rate of interest is the cost of investment in new capital assets. if the market rate of interest is high then the fund for investment is costly and on the other hand, if the rate is low, it is cheaper to invest the fund in capital assets. There is an inverse relationship between the rate of interest and profitability. The higher the rate of interest the lower will be the profitability and vice-versa. So, taking a decision to invest in new assets or projects is influenced by the rate of interest and it is also known as a determinant of investment.

4- Concept of MEC (with a method of calculation)

MEC is the highest rate of return expected from an additional unit of capital over its cost. In other words, it is the ratio of the annual prospective return (Y) of additional capital assets to its supply price or cost (C). For example, if the annual prospective yield (Y) is equal to $ 200 from the capital assets having cost (C) $ 2000, the MEC will be 200/2000 =0.1 or 10%. Thus, MEC is the percentage of profit expected from a given investment on a capital asset.

J. M. Keynes has defined MEC in his word as 'I define marginal efficiency of capital as equal to the rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price.'

The above definition implies that MEC is the rate of discount which equates the present value of returns expected from the asset during its lifetime in the future, to its cost price. 

According to the definition, the present value of returns expected from the asset during its lifetime in the future, to its cost price can be calculated by applying the following method.

`C=\frac{R_1}{(1+r)}+\frac{R_2}{(1+r)^2}+\frac{R_2}{(1+r)^3}+.....\frac{R_n}{(1+r)^n}......(i)`

Where,
C = Supply price or cost price,
r =  Rate of discount,
R1, R2, R3, and Rn = prospective yield in the 1st, 2nd, 3rd, and nth year,

In the above expression, the term R1/(1 + r) is the present value of the capital asset which depends on the rate of discount or interest on which it is discounted.

For example, suppose the cost of a capital asset is $100 and its expected returns in a year is $110. Now let's calculate the rate of returns that equates to its supply price or cost price with its present value.

Given  C = 100
            R1 = 110
`C=\frac{R_1}{(1+r)}`
Plotting the value in the equation (i) we get;
`100=\frac{110}{(1+r)}`
Or,`100+100r=110`
Or,`100r=110-100`
Or,`100r=10`
`\r=\frac{10}{100}`
`\r=0.1`
`\r=10%` it is the expected rate of returns.

The present value is expressed as; R1/(1 + r) ......(ii)
Plotting the rate of discount in equation (ii) we get,
110/(1 + 0.1)
or, 110/1.1
or, 1100/11
0r, 100

The rate of discount or expected rate of return equal to 10% has equated the present value of the capital asset to its cost price. It will be profitable to invest in that capital asset only if the market rate of interest is lower than the expected rate of returns or 10% as calculated in the above example.

As mentioned above, a decision to invest in a capital asset is undertaken only if the expected rate of returns is greater than the market rate of interest. However, as a result of the operation of law of diminishing return of capital, MEC goes on declining with an increase in capital stock. Therefore, a firm in an economy is in equilibrium (or have an optimum capital stock) on account of investment at the point where MEC and the rate of interest are equal. 

The equilibrium situation of a firm on account of investment has been illustrated in the following diagram.
In the above diagram, the downward sloping MEC curve has shown that MEC falls with an increase in capital stock and vice-versa. It happens, due to the operation of law of dimishing returns in productivity of capital. In the diagram, it is seen that at capital stock equal to OK, MEC is equal to AK and with the increase in capital stock from OK to OK1, MEC also falls from AK to BK1. To have the optimum capital stock (equilibrium point), MEC must equal to the rate of interest. Suppose Or is the market rate of interest but AK is equal to MEC at OK capital stock. So, it is obvious that MEC is higher than the ongoing rate of interest and the investment on the capital assets of the firms increases. It continues to increase in investment in the capital assets till it reaches the capital stock OK1 and fall in MEC to BK1 or the market rate of interest as equal to Or. This is how the rate of interest and MEC are equal and the firms attain equilibrium or optimum capital stock.











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