Question

According to the neoclassical theory of investment how do firms determine their optimal amount of investment spending?

Answer 1

Dale Jorgenson gave the neoclassical theory of investment.

A typical production firm, operating in a competitive model, looks at the neo-classical marginalist rule of profit maximisation. The main element in the neo-classical theory of investment is the rental price of capital.

The firm compares the cost and benefit of capital while deciding to invest. Acoording to the theory, there is an optimal amount of capital stock that a firm has. It decides this amount of capital by looking at replacement cost and production cost. Replacement cost is the depreciation of assets.

The firm in order to compensate for depreciation invests certain amount of capital in order to ensure optimal production.

Likewise, the other element of investment is concerned with the demand for production. If demand for the product increases, the firm increases investment, and if the demand falls down, the firm reduces its investment.

The most important factor in investment is rental price of capital. The firm may invest certain amount of money if the rental price of capital is low enough to ensure profitability of the project.

Thus, a firm looks at above mentioned three objectives while deciding to invest according to the neo-classical theory of investment.