Factors Affecting Investment

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Factors Affecting Investment

Some of the factors that influence the profitability of investment and thus influence its volume are as follows:

Change in the level of National Income or GDP

Profitability of investment depends upon how much returns it is likely to yield to the entrepreneur over the life time of the capital asset. If the level of national income keeps on increasing, it is likely to result in a continuous rising demand for customer goods in the market. Since consumption is a function of income, at higher levels of GDP, people are likely to spend more on consumer goods. The higher consumption expenditure would mean higher demand for goods and more revenue to the producers. To meet the increasing demand for consumer goods and make larger profits by increasing their production, the entrepreneurs would naturally go in for purchase of new capital equipment and thus increase the investment to rise. On the other hand, a fall in GDP and a consequent reduction in the demand for consumer good would reduce the demand for capital goods and thus, affect the level of investment in an adverse manner.

Innovation and Technical Progress

Innovations and technical progress have an important influence on the growth rate of investment in an economy. Innovations refer to the development of new products, new resources, discovery of new markets and the application of new methods in the production process. Technical progress means the use of new and more efficient production techniques or use of new methods in production of goods. Both innovations and technical progress move hand-in-hand and open up more profitable opportunities for the entrepreneurs. This leads to a much greater demand for capital goods and increase the volume of investment.

Population Growth

Increase in the rate of population growth during the early period of economic development in the contemporary developed countries, has been generally accompanied by massive increase in the volume of investment. Rapid expansion in the size of population offers more markets for the goods. During the period of rapid growth of population, The entrepreneur, in expectation of a higher demand and greater profitability, would naturally like to make expansion in their plant and equipment and thus, undertake more f new investments. The economics history of the modern advanced nation’s shows that the period of rapid population growth have also been the periods of massive outbursts in investment activity.

Future Expectations

Expectations of future play key role in determining the volume of investment during a given time period. The capital goods are of a durable character. They have a long life and thus yield income year after year. All the investment made in such goods cannot be recovered immediately; it accrues only in the shape of annual returns over the life time of the capital goods. Therefore, while calculating his profits from investment, the entrepreneur has to make an estimate of future returns.

Rates of Taxation and Government Policy

Tax rates have an important impact on investment. As we know, the private entrepreneur’s decisions to invest are based on the expected profitability of capital. Tax forms a deduction from the income of the entrepreneurs and thus high rates of taxation reduce the amount received by the entrepreneurs, thereby reducing the expected profitability of investment. Higher rates of taxation, thus act as deterrent to investment, whereas low tax rates, or tax exemption, will provide an incentive for investment. Similarly, if the government gives increased subsidies to the new entrepreneurs and provide them other benefits, this might act as incentives for the new investment.

The policy of the government regarding public expenditure also influences the volume of investment. If the government spends more money on the weaker sections of society this public expenditure adds to the real income of the people and leads to an increase in the demand for goods and services, which in turn favorably affects the profitability of capital and thus offers an incentive for investment.

The Rate of Interest

The market rate of interest is an important factor influencing the level of investment. Having worked out the marginal efficiency of capital, the entrepreneurs would compare it with the market rate of interest, because while the MEC denotes the returns to capital the rate of interest is its cost-cost of borrowing funds for investment. Only when the MEC is more than the rate of interest, the entrepreneurs would like to undertake new investment. Thus, if the marginal efficiency of capital is given, reduction in the market rate of interest would encourage investment, while any risen in it would discourage new investment.

Money Supply

Change in the supply of money in an economy affect the volume of investment through the rate of interest. The rate of interest is determined by the demand for money and the supply of money. If the demand for money is given as constant, an increase in the supply of money will reduce the market rate of interest. Similarly, if the supply of money is reduced, then with the given demand for money, it will raise the market rate of interest.


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