What is Investment Function?
A strategy or concept of economics that helps in identifying the connection between shifts in the investment patterns of people and other variable factors affecting investment in an economy is known as Investment Function.
The expenditure incurred to create new capital assets is known as Investment. These capital assets include buildings, machinery, raw material, equipment, etc. The expenditure on these assets results in an increase in the economy’s productive capacity. The investment expenditure can be classified under the heads:
- Induced Investment
- Autonomous Investment
1. Induced Investment
The investment which depends upon the profit expectations and has a direct influence of income level on it is known as Induced Investment. Induced Investment is income elastic. It means that the induced investment increases when income increases and vice-versa.
The above graph shows that the induced investment curve II has an upward slope from left to right. It indicates that as the income increases from OY to OY1, the investment also increases from OM to OM1.
2. Autonomous Investment
The investment on which the change in income level does not have any effect and is induced only by profit motive is known as Autonomous Investment. Autonomous Investment is income inelastic. It means that if there is a change in income (increase/decrease), the autonomous investment will remain the same. In general, autonomous investments are made by the Government in infrastructural activities. However, a country’s level of autonomous investment depends upon its social, economic, and political conditions. Therefore, the investment can change when there is a change in technology, or there is a discovery of new resources, etc.
The above graph shows that the amount of investment remains the same, i.e., OI, no matter whether the income level in the economy is OY or OY1.
Difference between Induced Investment and Autonomous Investment
|
Basis |
Induced Investment |
Autonomous Investment |
|---|---|---|
| Meaning | It is the investment that depends upon the profit expectations and has a direct influence on income level on it. | It is the investment on which the change in income level does not have any effect and is induced only by profit motive. |
| Motive | The motive behind induced investment is profit. It means that it depends on profit expectations. | The motive behind autonomous investment is social welfare. |
| Income Elasticity | Induced Investment is income elastic. It means that the induced investment increases when income increases and vice-versa. | Autonomous Investment is income inelastic. It means that if there is a change in income (increase/decrease), the autonomous investment will remain the same. |
| Investment Curve | As induced investment is income elastic, its curve slopes upwards. | As autonomous investment is income inelastic, its curve is parallel to X-axis. |
| Sector | In general, induced investment is done by the private sector. | In general, autonomous investment is done by the government sector. |
| Relation with National Income | Induced Investment is positively related to national income. | Autonomous Investment is unrelated to national income. |
Determinants of Investment
As per Keynes, the decision to invest in a new project or private investment depends upon two factors; i.e., Marginal Efficiency of Investment and Rate of Interest.
1. Marginal Efficiency of Investment (MEI):
MEI is the expected rate of return from an additional investment. The following two factors are required to determine MEI:
- Supply Price: It is the production cost of a new asset of that kind. Simply put, the supply price is the price at which one can supply or replace the new capital asset. For example, if old equipment is replaced by equipment of ₹20,000, then ₹20,000 is the supply price.
- Prospective Yield: It is the net return or net of all costs, which is expected from the capital asset over its lifetime. For example, if the equipment of ₹20,000 in the previous example is expected to yield receipts of ₹2,500 and the running expenses will be ₹500, then the prospective yield will be ₹2,500 – ₹500 = ₹2,000.
The Marginal Efficiency of Investment (MEI) of the given equipment will be:
2. Rate of Interest (ROI):
It is the cost of borrowing money for financing investment. There is an inverse relationship between ROI and the volume of investment. If the Rate of Interest is high, then the investment spending will be less and if the Rate of Interest is low, then the investment spending will be more.
Comparison between MEI and ROI
To know about the profitability of an investment, a comparison between MEI and ROI is done. If the Marginal Efficiency of Investment is more than the Rate of Interest, then the investment is profitable, and if the Marginal Efficiency of Investment is less than the Rate of Interest, then the investment is not profitable. For example, if a businessman has to pay 10% rate of interest on the loan and the MEI or expected rate of profit is 15%, then the businessman will surely invest and will continue to make the investment till the Marginal Efficiency of Investment becomes equal to Rate of Interest.