Unit 3 Aggregate demand and the multiplier model
3.11 Why is investment volatile?
Households tend to smooth their consumption spending when they can, but there is no similar motivation for a firm to smooth investment spending. Firms increase their stock of machinery and equipment and build new premises whenever they identify an opportunity to make profits. But, unlike eating and most other consumption expenditures, investment can be postponed. There are several reasons why this is likely to produce clusters of investment projects at some times and few at other times.
New technology
When an innovation like the spinning jenny in the Industrial Revolution or spreadsheet programmes in the information and communications technology (ICT) revolution is introduced, firms using the new technology can produce output at lower cost or produce higher-quality output. They expand their share of the market. Firms that fail to follow may be forced out of business because they are unable to make a profit using the old technology. But new technology means that firms must install new machines. As firms do this, there is an investment boom. This will be amplified if the firms producing the machinery and equipment need to expand their own production facilities to meet the extra demand expected.
In this case, investment by one firm pushes other firms to invest: if they don’t, they may lose market share or even be unable to cover their costs and eventually have to leave the industry. But investment by one firm can also pull other firms to invest by helping to increase their market and potential profits.
The high-tech investment boom in the US can be identified in the aggregate data. From the mid-1990s, new ICT was introduced into the US economy on a large scale. Figure 3.20 shows the sustained growth of investment in new technologies—around 10% or higher—through the second half of the 1990s. Nothing similar is visible in the data since then.
Figure 3.20 Investment in new technologies and the dot-com bubble (1991–2022).
US Bureau of Economic Analysis. 2023. Fixed Assets Accounts Tables. FRED. 2023. NASDAQ Composite Index. Note: the series are in current US dollars. NASDAQ value is the yearly average of the close price value of the NASDAQ. Investment in new technologies is the investment in information processing equipment, computers and peripheral equipment, communication equipment, communication structure, and investments for software, semiconductors, and other electronic components and computers.
Figure 3.20 also shows the behaviour of the NASDAQ index. The NASDAQ is the US stock exchange where shares (or stocks) in high-tech companies are bought and sold. The index is an average of the prices at which these shares are traded.
The index rose strongly from the mid-1990s to an all-time peak in 1999 as stock market investors’ confidence in the profitability of new tech firms grew. Investment in IT equipment (the red line) grew rapidly as a result of this confidence, but dropped sharply following the collapse in confidence that caused the fall of the stock market index. This suggests that overinvestment in machinery and equipment had occurred: investment did not begin growing again until 2003. Robert Shiller, the economist, argued that the NASDAQ index was driven high by what he called ‘irrational exuberance’. Beliefs in the future of high-tech led not only to share prices rising to levels that were unsustainable, but also to excessive investment in machinery and equipment in the high-tech sector.
Robert Shiller explains in a VoxEU podcast how ‘animal spirits’ contribute to the volatility of investment and to both overinvestment and a stock market bubble.
Units 5 and 6 will show why, on the basis of ‘present value’ we might expect investment and stock prices to rise and fall together.
Credit constraints
In Section 3.10, we highlighted the role of credit constraints for consumption behaviour. Credit constraints also affect firms, and are another reason for the clustering of investment projects and the volatility of aggregate investment. In a buoyant economy, profits are high and firms can use these profits to finance investment projects. They will also typically find it easier to borrow and to issue new shares. Access to finance from sources outside the firm is also easier: in the US high-tech boom, for example, the expansion of the NASDAQ exchange reflected the appetite of investors to provide finance by buying shares in firms in the emerging ICT industries. In Unit 6, we examine this mechanism in more detail.
A coordination problem: Vicious and virtuous circles
- capacity utilization
- A firm, industry, or entire economy is at full capacity utilization if it is producing as much as the stock of its capital goods and current knowledge will allow. If is is producing less, it is ‘below full capacity utilization’ or ‘at a low capacity utilization rate’.
To understand how one firm’s investment can induce another firm to invest, think of a local economy consisting of just two firms. Firm A’s machinery and equipment are not fully used, so although the firm can produce more if it hires more employees, there is not enough demand to sell the products it would produce. This is a situation of low capacity utilization. For the owners of Firm A to undertake new investment, they need to anticipate growing demand for their output.
Firm B has the same problem. Because of low capacity utilization, profits are low for both. Incomes in the local economy remain low, and so does demand. Therefore, when we think about both firms together, we have a vicious circle (Figure 3.21).
Figure 3.21 Low expected demand for the firm’s products creates a vicious circle.
If the owners of both A and B decide to invest in new capacity and hire at the same time, they would employ more workers, who would spend more, increasing the demand for the products of both firms. The profits of both would rise, and we have a virtuous circle (Figure 3.22):
Figure 3.22 High expected demand for the firm’s products creates a virtuous circle.
These two circles highlight the role of expectations of future demand. The incentive to invest depends on expected demand, which in turn depends on the behaviour of other actors in the economy. The firms in the vicious circle have a coordination problem. If both invested together, everyone would be better off.
Question 3.14 Choose the correct answer(s)
Figures 3.21 and 3.22 show that total investment spending can be volatile because the interaction of individual firms’ decisions can lead to vicious (low-profit) or virtuous (high-profit) circles. Which of the following might encourage all firms in the economy to behave in such a way that they all increase their investment spending together?
- A major technological breakthrough is likely to encourage more investment in the automobile industry and in battery manufacture. Some firms may also recognize it as having implications for their industry, even though they do not produce electric cars. However, this single breakthrough is unlikely to encourage firms in all sectors to increase investment.
- The disruption to production in the war-affected region and to international trade caused by such a war is likely to have created uncertainty for firms about expected future demand and the prices of inputs to production. The end of the war would reduce uncertainty and boost confidence among firms in the economy, leading to higher investment.
- Encouragement from the government is unlikely to have much effect. Investments are risky and firms are unlikely to invest just because governments ask them to do so. However, such encouragement might have some effect if combined with government action, such as spending on infrastructure.
- An increase in government spending will encourage all firms to expect a higher demand for their products, which would have a beneficial effect on investment plans across the economy.
Extension 3.11 An investment coordination game
In this extension, we use game theory to analyse the problem of the vicious circle in investment—and how to get out of it. To understand the model you will need to know about game theory, Nash equilibrium, and coordination games, introduced in Unit 4 of the microeconomics volume. If not, you can either skip the extension, or read Sections 4.2, 4.3, and 4.13 before beginning work on it.
We will model the problem of the vicious and virtuous circles of investment as a game between two firms, A and B. As in every game, we specify the following:
- The actors: The two firms.
- The actions that they can take: Invest, or do not invest.
- The information they have: They decide simultaneously, so they do not know what the other has done.
- The pay-off: The profits resulting from each of the four pairs of actions that they could possibly take.
The four possible outcomes of the interaction and the pay-offs are given in Figure E3.3.
This figure shows what happens when the virtuous (both invest) and vicious (neither invest) circles occur. Note first what happens if one of the firms invests, but the other does not. If Firm A invests and B does not (the upper-right cell in the figure), then A pays to install new equipment and premises, but because the other firm did not invest, there is no demand for the products that the new capacity could produce; so A makes a loss. But had B known that A would invest, then B would have made higher profits by investing as well (getting 100 rather than only 80). On the other hand, had B known that A was not going to invest, then it would have done better to also not invest.
Figure E3.3 Investment decisions as a coordination game.
In this game, the two firms will do better if they both do the same thing, and the best outcome is when both firms invest. This is another reason that investment tends to fluctuate a lot. If owners of firms think that other firms will not invest, then they will not invest, confirming the pessimism of the other owners. This is why the vicious circle is self-reinforcing. The virtuous circle is self-reinforcing for the same reason. Optimism about what other firms will do leads to investment, which sustains the optimism.
- Nash equilibrium
- An outcome is termed a Nash equilibrium if none of those involved, by individually choosing a different action, could bring about an outcome that they would prefer. In game theory, a Nash equilibrium is a set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else. See also: game theory.
There are two Nash equilibria in this game (upper left and lower right). To find the Nash equilibria use the ‘dot’ and ‘circle’ method (The Economy 2.0: Microeconomics, Section 4.3), beginning with A’s best responses to B’s choices. If B invests, A’s best response is also to invest so a dot goes into the upper-left cell. If B does not invest, A chooses also not to invest so we place a dot in the bottom right-hand cell. Firm A does not have a dominant strategy. Now, we consider B’s best responses. If A invests, B’s best response is to invest and if A does not invest, B chooses not to invest. The circles showing B’s best responses coincide with the dots: B also does not have a dominant strategy. Where the dots and circles coincide, there are Nash equilibria.
- Pareto efficient, Pareto efficiency
- An allocation is Pareto efficient if there is no feasible alternative allocation in which at least one person would be better off, and nobody worse off.
- coordination game
- A game in which there are two Nash equilibria, one of which may be Pareto superior to the other. Also known as: assurance game.
The Nash equilibrium (lower right) in which both firms have low capacity utilization and low hiring and investment is not Pareto efficient, because there is a change in which both make higher profits, namely if both firms decide to invest. This is a coordination game like the ones described in The Economy 2.0: Microeconomics Section 4.13, such as driving on the right or left side of the road, and the crop specialization game.
The name is very apt here because to make the move from the vicious to the virtuous circle, the firms have to coordinate in some way (both agree to invest) or develop optimistic beliefs about what the other will do. This kind of optimism is often called business confidence, and it has a major role in the fluctuations in the economy as a whole. As we will discuss in Unit 5, under some circumstances, government policy can also help shift an economy from the Pareto-inefficient outcome to the Pareto-efficient outcome.
Question E3.2 Choose the correct answer(s)
Consider a local economy comprising just two firms, Firm A and Firm B. Currently, both firms have low capacity utilization. The following table shows the profits (or losses if negative) when the firms invest or do not invest:
Based on this information, which of the following statements is correct?
- When Firm B invests, the best response strategy is for Firm A to invest. Similarly, when Firm B does not invest, the best response strategy is for Firm A not to invest. Therefore, there is no dominant strategy.
- Both firms not investing is also a Nash equilibrium.
- Firm A investing and Firm B not investing is Pareto inefficient, but it is not a Nash equilibrium.
- The Pareto-efficient Nash equilibrium is when both firms invest, and to achieve this outcome, both have to believe that the other firm will invest. If either thought the other would not invest, then they would also not invest.
