Investment — Meaning, Types and Determinants

In economics, investment refers specifically to expenditure on NEW capital goods — machinery, factory buildings, tools, and additions to inventory stock — that add to an economy's productive capacity. This is a narrower, more technical meaning than the everyday use of "investment" to describe buying shares or financial assets, which merely transfers ownership of EXISTING assets between people and adds nothing to the economy's real productive capacity.

Investment is classified into two types based on WHAT drives it:

Autonomous investment is investment undertaken independently of the current level of income or output — driven instead by long-term factors such as population growth, technological change, or government infrastructure programmes (a new highway or public hospital, for instance, is built regardless of this year's national income level).

Induced investment is investment that varies DIRECTLY with the level of income or output — as output rises, firms need more machinery and capacity to produce the larger output, so induced investment rises with income (this is the basis of the acceleration principle, covered later in this chapter).

Two key factors determine the profitability, and hence the volume, of investment a firm is willing to undertake:

Marginal Efficiency of Capital (MEC) is the expected rate of return on an additional unit of capital investment — essentially, the rate of profit a firm expects to earn on one more machine or one more unit of new capital, considering its likely future revenue stream against its cost.

Rate of Interest is the cost of borrowing funds to finance the investment (or the opportunity cost of using the firm's own funds instead of lending them out). …