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.
INTRODUCTION - CAPITAL, INVESTMENT AND NEW
TECHNOLOGY
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.
The Equilibrium Interest Rate
i1
i0
D
0
k0
k1
Quantity of capital
The Equilibrium Interest Rate
 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 K0
the equilibrium interest rate is i0.
 When the capital stock grows to K1 in the long
run, the equilibrium interest rate falls to i1.
Changes in Technology and the Capital Stock
i1
i0
i2
D1
D0
0
k0
k1
Quantity of capital
Changes in Technology and the Capital Stock
 The original demand curve D0 and capital stock
K0 produce an interest rate of i0.
 Technological improvements shift the desired
capital stock curve to D1.
 With a constant stock of capital, the interest rate
would rise to i1.
Changes in Technology and the Capital Stock
 However, the capital stock increases to K1,
which, other things being equal, would lower the
interest rate to i2.
 In the example shown, these two effects exactly
offset each other and the interest rate remains
unchanged at i0 where K1 and D1 intersect.
Value
Height
Rent and height profiles
Agricultural land
value
Agricultural land
value
0
Distance from city centre
Rent and height profiles
• 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.