Revision: Business investment | tutor2u Economics

This revision note covers capital investment spending in the economy. Investment is spending by businesses and the government on capital goods such as new factories, machinery & vehicles. Much new investment embodies advances in technology. Investment (I) is an important component of AD, but as we shall see, it also has an impact on the supply-side and is a key factor driving the competitiveness of a country in a globalising world.

Different Types of Investment

1. Capital investment is spending on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future.
2. A broader definition of investment includes spending on improving the human capital of the workforce through training and education to improve the skills and competences of workers.
3. Infrastructure is spending on new sewers, wind farms, telecommunications networks, motorways and ports – this can be done by the private and the public sector.
4. Most economists agree that investment is vital to promoting long-run growth through improvements in productivity and capacity, shown by an outward shift in the production possibility frontier.

Gross and Net Investment

Gross investment spending is the total amount that the economy spends on new capital. But this figure includes an estimate for the value capital depreciation since some investment is needed each year just to replace technologically obsolete or worn out plant and machinery. If gross investment is higher than depreciation, then net investment will be positive and this means that businesses will have a higher productive capacity and can meet a higher level of AD in the future.

Investment and economic growth

In most theories of economic growth and competitiveness, investment has an important role to play. In this section we look at some of the major advantages from the accumulation of a bigger stock of capital.

Businesses often invest in new capital goods to exploit economies of large scale production. This, together with technological advances is vital to improving the UK’s competitiveness and to causing a shift in the country’s production possibility frontier.

Investment and Aggregate Demand

Investment is a component of AD i.e. (C+I+G+X-M). 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 spending will therefore have important effects on both the demand and supply-side – including a positive multiplier effect on national income.

(i) Demand side effects: Increase spending on capital goods – affects industries that manufacture the technology / hardware / construction sector

(ii) 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)

Quality of investment

A high level of investment on its own may not be sufficient to create an increase in LRAS since 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, a growing capital stock may lead to excess capacity putting downward pressure on prices and profits

Investment and jobs

There are some investment projects that cost people their jobs – this is particularly true when a business is looking to achieve greater efficiency and cost savings perhaps by replacing labour with capital inputs. That said most new investment creates fresh demand for workers, both in producing, designing and installing new plant and equipment and in working with it. And if the investment is successful in creating extra demand, so the demand for labour will expand.

A full set of AS macro revision notes is available here and our AS economics revision presentations can be found here

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