Question

Consider Tobin’s Q theory of investment. What are the determinants of investment? Does the empirical evidence agree with this theory? Does the neoclassical model of investment fit the evidence better than Tobin’s Q theory?

Answer 1

Answer-The Tobin's Q ratio is a quotient popularized by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Tobin's Q ratio equals the market value of a company divided by its assets' replacement cost. Thus, equilibrium is when market value equals replacement cost."

Q Ratio Formula

Tobin's Q=Total Market Value of Firm\Total Asset Value of

The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets.

What determines the rate of investment?

Tobin argued that investments by the firms depend on whether q is greater or less than one. When q-ratio is greater than one, it implies that the stock market places a higher value on firm’s installed capital than its replacement cost. This provides incentive to the firms to add to its installed capital stock. That is, the firm will make more investment.

On the other hand, if q-ratio of a firm is less than one, this implies that the stock market values its stock of capital assets less than its replacement cost. This will discourage managers of a firm to replace its capital assets as they wear out. Thus, according to Tobin, it is q-ratio of a firm as to whether its value is greater or less than one that determines investment by a firm.

Empirical evidences-

Tobin's Q is still used in practice, but others have since found, using data of the US economy from the 1920s to the 1990s, that so-called "fundamentals" predict investment results much better than the Q ratio. These include the rate of profit – either for a company or the average rate of profit for a nation's economy.

Others, like Doug Henwood in his book Wall Street: How It Works and For Whom, find that the Q ratio fails to accurately predict investment outcomes over an important time period. The data for Tobin's original (1977) paper covered the years 1960 to 1974, a period for which Q seemed to explain investment pretty well. But looking at other time periods, the Q fails to predict over- or undervalued markets or firms. While the Q and the investment seemed to move together for the first half of the 1970s, the Q collapsed during the bearish stock markets of the late 1970s, even as investment in assets rose.

Thus, many empirical evidences did not agree with the theory.

Neo-classical theory and Tobin's q theory-

Neoclassical: Firms maximize present discounted value of profits subject to constraints of a production function and an adjustment cost related to capital investment (firm can control investment, the capital flow, but the capital stock is predetermined).

Tobin’s q theory: The rate of investment is a function of (marginal) q, the ratio of the market value of additional investment goods to their replacement cost (here again, some adjustment cost is implicit, or else firm would inc/dec capital stock immediately, to set q=1).

Empirical evidences-

Neoclassical theory only predicts a relationship between the desired stock of capital and the interest rate. No reason to expect a smooth relationship between investments and the interest rate. Hayashi investigates the relation between average and modified q. Finds that modified q is much more stable over time (post-war US data). Hayashi demonstrates that Tobin’s q-theory is embedded within the neoclassical framework for the investment decisions of firms. I He also highlights that what really matters is modified q; taking account of investment tax credits and the tax treatment of deprecionation.