Download Investment and Institutions Stephen Nickell April 2006

Investment and Institutions
Stephen Nickell
April 2006
Presentation to be given at a
conference to celebrate the 500th
anniversary of the University of Urbino
on 12 May, 2006 in Urbino.
Basic Investment Theory

K t , t  = real net earnings stream of a firm, K(t) is capital stock.

C(I(t),t) = instantaneous cost of purchasing a stream of new capital goods,
including adjustment costs and purchase price. Assume C11  0 (convexity).
 One unit of capital purchased at t costs C1(I(t),t).
 This unit generates a stream of revenue.
e   t  K K  , 
from   t to  , assuming the unit of capital decays at rate  .  K is the
impact on earnings of a unit increase in capital.
 To maximise profits, the marginal cost of purchasing a unit of capital equals
the present value of the net revenue generated, ie.

C1 I t , t    e  r   t  K K  ,  d
t
 RHS not observed – Hayashi 1982 showed under some strict assumptions it
may be replaced by Average Q. Unfortunately assumptions don’t hold and
Ave.Q is endogenous.
 So investigate  K 

K t , t  .
K
 Consider firm with a constant returns production function AF(K,N),A = level
of productivity, N = employment.
 Firm faces a demand curve P  where P is the real price of output.
 Assuming no employment adjustment costs, at each point in time, for given K,
the firm will choose P,N, to solve
max (PAF(K,N)-WN)
P,N
s.t. AF(K,N) = P 
where W is the real wage.
 The FOC is
MAFN(K,N)=W
where M=P/Mark-up.
Mark-up = mark up of price on marginal cost  1  1 


1
 Since F is constant returns, FN can be written as FN(K/N,1) and solving the
FOC shows K/N= FN1 W / MA at each point in time.

So  may be defined as
  PAF K , N   WN  C I , P I 
where PI is the real price of capital goods.

So  K  MAFK K / N ,1 where K / N  FN1 W / MA
This implies
 K  MAf W / MA, f '  0

As a consequence, investment at t is determined by

C1 I t , P t   Et  e  r   t  M  A  f W   / M  A d
I
t
where Et is expectation formed at time t and recall C11>0.
• This simple framework has the following
implications.
• Factors which raise the mark-up of price
on marginal cost will tend to lower
investment (by lowering M).
• Factors which raise productivity will tend to
raise investment.
• Factors which raise wages will tend to
lower investment.
 How do employment adjustment costs fit into this story?

 K can now be written


 K  f W / MA   KN N *  N ,  KN  0 ,
where N* is the equilibrium employment level.
 So if employment is tending to expand, it will typically be below its
equilibrium level and, as a consequence, investment will tend to be lower.
The opposite will be the case if employment in the firm is tending to contract.
Institutions and investment
• Via wages. Unions, by capturing quasi-rents or
otherwise, will tend to raise wages and hence reduce
investment. Unions are often more effective in the
presence of strong EPL but are much weakened if the
firm faces a high level of product market competition.
• Via productivity. Total factor productivity tends to be
lower if there is a low level of competition in the product
market or a high level of product market regulation
including high barriers to entry. Mediators may include
R and D or innovation.
• Via mark-ups. Again low levels of competition or high
levels of regulation and barriers to entry tend to raise
mark-ups.
Institutions and Investment. Evidence.
• Unions are typically associated with lower investment.
Addison and Hirsch (1989), Journal of Labor Economics 7(1).
Nickell and Denny (1992), Economic Journal, 102, 874-887.
Aidt and Tzannatos (2002), Unions and Collective Bargaining.
Economic Effects in a Global Environment (World Bank).
• There is some evidence that EPL is associated with lower
investment.
Calcagnini and Saltari (2005).
• High levels of product market regulation and low
levels of competition tend to lower productivity,
Nickell (1996), JPE 104(4).
Aghion and Griffith (2005), Competition and
Growth (MIT Press).
• High levels of product market regulation and low
levels of competition are associated with high
mark-ups.
Griffith and Harrison (2004), The Link between
Product Market Reform and Macro-economic
Performance (European Commission).
• Via both these mechanisms, high levels of
product market regulation and low levels
of competition tend to lower investment.
Alesina, Ardagna, Nicoletti and
Schiantarelli (2005), Journal of the
European Economic Association, June,
1-35.
Griffith and Harrison (2004), as above.
• There is also evidence that high levels of
R and D both within a company and within
a companies suppliers raise investment.
• Evidence connecting product market
regulation and competition with R and D is
mixed.
• The most recent and sophisticated
research – Griffith, Harrison and Simpson
(2005), Institute for Fiscal Studies –
suggests that competition raises R and D,
and innovation and hence investment.