ABSTRACT
When John Maynard Keynes developed macroeconomic theory to explain why unemployment could exist in an equilibrium, one of his conditions for that equilibriumwas that planned aggregate investmentmust equal planned aggregate savings. The central role investment played in theGeneral Theory led to the study of investment becoming a topic largely confined to macroeconomics. This has changed in more recent years, but even today it is rare to find a chapter on capital investment in micro-oriented industrial organization texts, even though other investment decisions, like advertising, R&D, and mergers are featured there. This neglect of investment is unfortunate for two reasons. First, because plant and equipment purchases, advertising, R&D, and mergers are all forms of investment, whatever theory explains one should in principle explain the others. Understanding the determinants of plant and equipment purchases may help in understanding purchases of plant and equipment embodied in ongoing firms (mergers), and the purchase of the intangible assets created by advertising and R&D. Second, knowledge of the determinants and effects of all forms of investment can help sort out the various hypotheses about managerial motivation and discretion discussed in the previous two chapters. In this chapter, therefore, we take up some of the hypotheses that have been
put forward to explain plant and equipment purchases, the empirical support for these hypotheses, and empirical evidence on the returns on investment. Because a potentially important determinant of investment is the firm’s cost of capital, we shall also explore its determinants as put forward in modern finance theory. We shall also take up the dividends payment decision of the firm, because of its close relationship to investment. We begin, however, with the determinants of capital equipment purchases.
