External and Internal Adjustment Costs and the Theory of Aggregate and Firm Investment

Abstract

The function of investment, developed by Clower (1954), Witte (1963), Foley and Sidrauski (1970, 1971) and Purvis (1973), views the investment function as the supply function of capital goods producers. In the function the for the stock of capital on the part of asset-holders, together with the size of the existing stock, determines the price of a unit of capital. This price, together with the supply function of capital goods producers, determines the rate of capital accumulation. The investment function that emerges from this theory is the aggregate supply function of capital goods producers. In contrast, the cost developed by Eisner and Strotz (1963), Gould (1968), Lucas (1967), Treadway (1969) and Uzawa (1969), views the investment function as the function for capital accumulation of the users of capital. In this theory, increasing marginal costs of investment (internal to the firm) limit the rate at which the firm wishes to accumulate capital. These adjustment costs give rise to a function for capital accumulation which is distinct from the for the stock of capital. In the present paper it will be argued that there is no e3sential conflict between the function and the cost of the investment function. Each contributes an important element to a complete theory of the investment function; neither is complete in itself. This paper emphasizes that the investment function is both a supply function and a function and that the form and properties of the investment function are influenced by both external and internal adjustment costs. The investment function is viewed as the supply function of new financial claims which are issued by firms as the financial counterpart of physical investment. The investment function is also viewed as the function for physical resources to be used in the production of new capital. The price of existing units of capital, as reflected in the market values of firms, plays the critical role of the demand price for an increment of capital; however, this price is not equated to the price of capital goods. The difference is taken up by the firm's internal, marginal adjustment cost. The price of capital goods is the supply price of capital goods producers. This supply price reflects adjustment costs that are external to any particular capitalusing firm, but are internal to the economy as a whole. Ultimately, therefore, the aggregate investment function reflects both the internal adjustment costs of the cost and the external adjustment costs of the function theory. The plan of discussion is as follows. Section I lays out a model of productive technology which incorporates both internal and external adjustment costs. Section II analyses the behaviour of the economy under the