Profit, Output and Liquidity in the Theory of Fixed Investment

Abstract

ALTHOUGH MANY investment theories and econometric forms exist in the literature, there are essentially two great camps in this area; on the one hand, profits as a key explanatory variable and, on the other hand, some form of an output variable compete as determinants of the level of new investment in plant and equipment. These alternative approaches have existed side by side in the same literature. But they exist side by side in the same literature which contains the neo-classical theory of the firm. We raise the inevitable question: Does the neo-classical theory of the firm generate different theories of investment behavior, i.e., can profitand output-investment theories sprout from the same theoretical foundation? This Medusa-type problem is compounded when we examine the econometric studies of fixed investment. For here various investigators have developed their own intuitively meaningful estimating forms, usually based in one or the other great camps of investment theory. Thus, there are two points of focus which merge in the present paper: (1) we wish to examine the conditions under which profitand output-investment demand theories are engendered by the neo-classical theory of the firm; and (2) we shall spell out some of the conditions which underlie certain estimating forms that have appeared in the recent econometric literature. From this it may be possible to infer which conditions would generate an empirically superior profitsinvestment form and which conditions would make reliance upon the outputinvestment form preferable. It is clear that we are not primarily offering a theory of investment, but are trying to spell out the theoretical foundations of existing econometric estimating forms. In order to accomplish these aims, our analysis assumes the existence of a firm in a government-free market (no taxes) which attempts to minimize a cost function and/or maximize a profits function (revenue minus costs) subject to a production restraint (inter alia).1 The entre-