Unit 2 Macro: Factors Driving Business Investment

Profit-seeking businesses will go ahead with an investment if they believe that it will - over its projected lifetime - yield a real rate of return greater than if the money had been invested in the next best alternative way. Opportunity cost is a useful idea to use here. Private sector businesses usually focus on these objectives when investing in new capital inputs:

• Improving productivity to drive down unit costs and achieving economies of scale

• Expanding capacity to meet rising demand and to supply to new markets (e.g. exports)

• Increasing capacity in advance of an increase in market demand (i.e. the accelerator)

• Replacing obsolete capital equipment and buildings

For public sector investment such as new roads, schools and prisons, priorities may be different. Public sector capital projects are still subject to tests about their expected rates of return and the cost-benefit analysis will include estimates of the social costs and benefits of the investment rather than a narrow focus on private costs and benefits.

Returns to an investment project are affected by demand for and the price of the output generated by an investment and by the costs of production

1. A rise in demand will increase the revenues a business can expect from a new project

2. A change in the costs of buying capital, the costs of training workers to use new capital and in maintaining the capital stock will also impact on the expected rate of return

3. The expected return from an investment is influenced by the rate at which a new capital project depreciates over time and changes in corporation tax on profits

Expectations – the importance of animal spirits

• One of the important lessons of Keynesian economics is the role played by business ‘animal spirits’ in determining how much money firms are willing to commit to capital spending.

• There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and real incomes.

In the chart above we follow the expected export order books for industrial businesses. See how in the final months of 2008 and into 2009 there was a steep rise in the % of businesses reporting export orders below normal and this stayed high throughout 2009. Businesses that sell their products overseas were clearly seeing a fall in new export sales because many other advanced economies were going into recession.

Sentiment in the survey improved during 2009 and one key reason for this was twenty per cent depreciation in the value of the pound against other major currencies which made UK exporters more price competitive. By 2010 there were hopes of a strong export-led recovery in the British economy.

However recent data shows a new fall in export optimism among industrial businesses – bring this kind of updated information into your exam answers. Export order books are falling and this time the main cause appears to be the crisis in the Euro Zone countries into which more than 40% of UK exports flow. Is this a sign of a second “double-dip” recession in 2011 and 2012?

Our second confidence chart (see above) provides some background evidence on business sentiment and the percentage of firms reporting that they are working below full capacity.

• Ordinarily around half of industrial firms say that they are producing below their full capacity output although this varies at different stages of the cycle.

• This figure climbed from 55% in the middle of 2008 to a high of 76% in the second quarter of 2009 – clear evidence that falling demand had led to a reduction in production leaving many businesses with spare productive resources.

• This is often enough to postpone planned investment because there is little need to invest to boost capacity when demand is low.

• The bottom pane on the chart shows general business optimism or pessimism and sentiment about exports. The data shows the percentage balance of replies, for example, if 65% of businesses are pessimistic and 35% are optimistic then the net balance is -30% (some of course might be neutral!).

• The key point is that business confidence did worsen a lot. Exporters were less worried about the situation but many domestic firms feared the effects of a deep recession.