To an economist, investment is adding to the stock of physical capital, in the form of buildings and plant, machinery, and equipment for use in the production of other goods and services. It can also involve adding to the stock of human capital. The purchase of financial assets and existing physical assets, including land, is not investment to economists.
Investment is not an investment
Economists use the word ‘investment’ differently from the general public. To the public, an individual’s investment is the purchase of any asset with a view to gaining a return on it, whether the asset is a bank deposit, a share in a company, a house to rent out or land to farm. But to an economist, investment must increase the whole economy’s capacity to produce.
Changes in the stock of physical assets increase the productive capacity of an economy. In contrast, buying and selling existing assets, be they shares, second-hand machinery or land, does not add to the productive capital. It only involves a change of owner.
Economists exclude from the definition of investment assets acquired for consumption, such as a refrigerator bought for a house. But if a refrigerator was bought to allow a shop to sell more cold drinks, then it is an investment. When a house is built or enlarged it is investment, but if an existing house merely changes hands it is not. Economists call investment ‘capital formation’.
Types of investment
Investment can be broadly separated into increases in the following kinds of assets:
- residential buildings
- non-residential buildings
- plant, machinery and equipment (PME)
- transport equipment
- infrastructure, such as roads, dams, sewerage works, ports and airports
- land improvements like fencing, clearing bush and drainage (as opposed to land itself)
- intangible assets like software, and development of intellectual property such as patents and plant variety rights.
Why is investment important?
Investment is important to an economy for two reasons.
- Investment increases the stock of productive capital available. This increases the potential output that can be achieved.
- Investment is usually required to introduce changes in technology that allow new outputs, or more of an existing output to be produced with fewer inputs. The volume and quality of investment is an important determinant of the rate of economic growth of an economy.
Low prices and rising production costs led farmers to increase livestock slaughter rates in the 1960s. This led to a rapid growth in meat output, but at the cost of future growth, because numbers of breeding stock were reduced.
Disinvestment, which is often called depreciation, can occur because an asset becomes worn out and its productive capacity diminishes, or because the technology it embodies has been superseded by new technology and become obsolete. When tractors were introduced onto New Zealand farms, draught horses became less valuable. An asset may also suffer economic depreciation because there is no longer a demand for the goods that it is designed to produce. For example a machine that made top hats depreciated in value when such hats went out of fashion.
At times New Zealand’s capital stock has actually decreased. In the depression in the early 1930s, and again in the recession of the early 1990s, the amount of investment or capital formation was less than the amount of disinvestment. As a result the value of total fixed capital stock decreased.
Earthquakes, fires and floods that destroy productive assets also lead to a drop in capital stock, at least temporarily. Investment activity to rebuild the capital lost will boost gross domestic product (GDP) but will not improve the overall productive capacity of the economy.