Economics - Note for students

1. Neoclassical theory of investment

2. • Neoclassical theory of investment behaviour is based on the neoclassical theory of optimal capital
accumulation which is determined by relative prices of factors of production.
• It is also called the fixed investment theory.
• Fixed business investment refers to the purchase of machines, construction of new factories,
warehouses, office buildings etc. by businessmen.
• The neoclassical theory explains that at a particular time how much capital stock a firm desires to
achieve. Further, according to this theory, rate of investment is determined by the speed with
which firms adjust their capital stocks towards the desired level.
• Labour – It is determined by the price of the factor and the contributions they make to the
production and revenue of the firms.

3. • According to this neoclassical theory, investment, that is, addition to the stock of capital in an economy is
determined by marginal product of capital (MPK) and user cost of capital which is also called real rental
cost of capital.
• Marginal product of capital (MPK) measures the addition to the production by using an additional unit of
capital, labour and technology remaining constant.
The marginal product of capital (MPK) is the amount of
extra output the firm gets from an extra unit of capital,
holding the amount of labor constant
If production output Y = F (K, L) then

4. Due to the operation of the law of diminishing returns, marginal product of capital declines as more units of
capital are used for production, the other factors being held constant. but it essentially stands for the rental for
capital a firm owns or gets it on rent basis and measures the opportunity cost of the funds spent on production
or purchase of a capital equipment.
The firms try to maximise profits or maximise the present value. Therefore, as long as the value of marginal
product of capital (which are in fact marginal receipts or benefits it gets from the use of capital in production)
exceeds the rental or user cost capital, it will be profitable for the firm to add to its stock of capital.