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AS Macroeconomics / International Economy

Capital Investment and Spending

Investment is spending by UK firms on capital goods such as new factories, plant or buildings, machinery & vehicles. It is an important component of demand, but as we shall see, it also has an impact on the supply-side of the economy.

Definition of Capital Investment

• Capital investment is defined as spending on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future.
• A broader definition of investment would encompass spending on improving the human capital of the workforce - for example extra investment in training and education to improve the skills and competences of workers.
• Most economists agree that investment is vital to promoting long-run economic growth through improvements in productivity and a country’s productive capacity.

Gross and Net Investment

Gross investment spending includes an estimate for capital depreciation since some investment is needed to replace technologically obsolete plant and machinery. Providing that net investment is positive, businesses are expanding their capital stock giving them a higher productive capacity and therefore meet a higher level of demand in the future.

The Economic Importance of Capital Investment

Firms often invest in new capital goods to exploit internal economies of scale. This, together with technological advances that are often built into new machinery, is vital to improving the UK's competitiveness and to causing an outward shift in the country’s production possibility frontier.

The amount of capital equipment available for each worker to use and whether this capital is up to date has a bearing on the productivity of the labour force. The quality of business training also matters to make the most of investment in new capital and technology

In the short run, devoting more a country’s scarce resources to the production of investment goods (a process known as capital accumulation) might require a reduction in today’s output of consumer goods and services (lower consumption would be accompanied by a rise in saving). The re-allocation of resources towards capital goods would be shown by a movement from point A to B on the production possibility frontier.

But if the extra investment is successful and leads to an increase in a country’s productive capacity then the PPF can shift out and open up the potential for an increased output of consumption goods to meet people’s needs and wants. This is shown by a movement from point B on the PPF to point C which lies on the new PPF after the effects of an increase in investment.

Investment affects AD as well as Aggregate Supply (AS)

It should be remembered that investment is also a component of AD. Businesses involved in developing, manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit from increased orders for new plant and machinery. 

A rise in capital investment will therefore have important effects on both the demand and supply-side of the economy – including a positive multiplier effect on national income.

• Demand side effects: Increase spending on capital goods – affects industries that manufacture the technology / hardware / construction sector
• Supply side effects: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in LRAS (trend growth)

It is not just the level of capital investment which is important but also the quality of the increase in the capital stock. A high level of investment on its own may not be sufficient to create an increase in LRAS – workers need to be trained to work the new machinery and there may be time lags between new capital spending and the knock-on effects on output and productivity in particular. Also, if there is insufficient demand in a market, a high level of capital investment may lead to excess capacity emerging in industries – putting downward pressure on prices and profits

One way to remember the importance of investment is to consider the 3 Cs - capacity, costs and competitiveness. Higher investment should allow British businesses to lower their production costs per unit, increase their supply capacity and become more competitive in overseas markets.

Key Factors Determining Capital Investment Spending

Several factors influence how much businesses are prepared to commit to investment projects:

• Real interest rates: Interest rates affect the cost of borrowing money to finance investment. If the rate of interest increases, the cost of funding investment increases, reducing the expected rate of return on capital projects. A second factor is that higher interest rates raise the opportunity cost of using profits to finance investment – i.e. a business might decide that the cost of financing new capital is too high and that it could earn a higher rate of return by simply investing the cash. Low interest rates are not always good news for business investment. Recently economists have become concerned that low interest rates has reduced the cost of capital for businesses to such an extent that some low quality capital investment projects have been given the go ahead and much of this investment has proved to be disappointing.
• The rate of growth of demand: Investment tends to be stronger when consumer demand is rising, giving businesses an extra incentive to invest to expand their capacity to meet this demand. Higher expected sales also increase potential profits – in other words, the price mechanism should allocate extra funds and factor inputs towards investment goods into those markets where consumer demand is rising.
• Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of corporation tax (or increases investment tax-allowances) there is a greater incentive to invest. Britain has relatively low rates of company taxation compared to other countries inside the EU. This is a factor that helps to explain why Britain has been a favoured venue for inward investment from overseas during the last decade.

• Technological change and degree of market competition: In markets where technological change is rapid, companies may have to commit themselves to higher levels of investment to keep pace with the shifting frontier of technology and remain competitive. In markets where there is a premium on a business keeping costs down but at the same time, achieving year on year gains in efficiency and quality of service, there is also an incentive to keep capital investment spending high.
• Business confidence: Business confidence can be vital in determining whether to go ahead with an investment project. When confidence is strong then planned investment will rise. The Confederation of British Industry (www.cbi.org.uk) publishes a quarterly survey of confidence that gives economists an insight into likely trends in investment from manufacturing industry – although it must be remembered that over 70% of total GDP now comes from the service sector.  In recent years, capital spending by service businesses has grown strongly – but manufacturing investment has weakened.

Business investment and the economic cycle

Investment depends critically on the health of the economy. When GDP growth is strong and inflation is under control, then business investment invariably picks up. There is often a time lag involved – it takes time for businesses to reach capacity constraints and give the go ahead for new projects. And the completion of new investment schemes inevitably is subject to the risk of delay.