Investment and the Purpose of Production

The most important principle of macroeconomics is that the purpose of production is consumption. (This is followed closely by the principal of scarcity--there are not enough resources to produce all the goods and services that people can use to achieve their goals.)

Where does this leave investment? By investment, I mean the production of new capital goods. (Not the purchase of financial assets like stocks or bonds.) If the purpose of production is consumption, why use scarce resources to produce capital goods instead of using the resources to produce consumer goods and services? The reason is simple and is consistent with the most important principle of macroeconomics. Capital goods are resources. Resources are used to produce capital goods in order to the use them in combination with other resources to produce consumer goods and services in the future.


With a market economic system, firms specialize in producing particular types of capital goods and consumer goods and services. Their direct motivation for producing these goods is to sell them for a profit.


For the most part, firms that produce capital goods sell them to other firms who buy them. Since firms won't produce what they cannot sell, in a market system, investment, in the sense of the production of new capital goods, requires investment expenditure, generally by firms, on capital goods.


Investment expenditure, or purchases of new capital goods by firms, is motivated by either by depreciation, the replacement of existing capital goods that are wearing out, or else by an effort to expand productive capacity. In either case, the motivation to obtain the capital goods is to produce goods and services in larger quantities than would otherwise be possible. Of course, the reason to produce these goods and services is to sell them at a profit.

For the most part, the logic of the market order is perfectly aligned with the most important principle of macroeconomics. Firms that produce consumer goods or services purchase capital goods to be able to maintain or expand the production of consumer goods and services. Firms producing capital goods to be used by firms producing consumer goods may be directly producing them to make a profit, but the firms buying them do so to produce consumer goods and services, which they plan to sell to households for a profit.


But what of firms producing capital goods to sell to other firms also producing capital goods? The principle remains the same. Resources might be devoted to producing capital goods, which can help produce other capital goods, which can help produce still other capital goods. However, in the end, the purpose of the joint activity of all these firms should be the production of consumer goods and services in the future.


In a market system, firms produce goods in order to sell them. Considering current production decisions, what is relevant is expectations that households will purchase consumer goods and services. For firms producing consumer goods and services, expected consumer expenditure in the near future is important.

Firms producing intermediate goods--materials, parts, and the like--used to produce consumer goods, and firms producing capital goods used to produce consumer goods depend on expectations of purchases by firms producing the consumer goods, which are also motivated by expected consumer spending in the future.


And finally, firms producing capital goods that are used to produce other capital goods, and firms producing intermediate goods used by those firms, depend on expectations of consumer expenditure in the more distant future. For the market system to produce those goods, there must be some expectation that there will be consumer expenditure sufficient to purchase perhaps unknown consumer goods and services in the future.


Consider a shift in production away from consumer good and services towards capital goods. What needs to happen to expectations? There needs to be a decrease in expected consumer expenditure in near future, and an increase in expected consumer expenditure in the more distant future. The opposite should hold as well. An expectation of reduced consumer expenditure in the more distant future should be matched an increase in expected consumer expenditure in the near future.


Now, suppose that there is a decrease in expected consumer expenditure both in the near and the more distant future. Firms produce fewer consumer goods now, because they expect to sell fewer consumer goods and services in the near future. Firms producing intermediate goods and capital goods used by firms producing consumer goods will produce less, because they will expect firms producing consumer goods and services to purchase less. And finally, firms producing capital goods and intermediate goods used to produce capital goods will produce less, expecting lower sales in the more distant future.


Of course, the second most important principle of macroeconomics is scarcity. There are not enough resources to produce all the consumer goods and services that people can use (now and in the future.) Reducing expected future consumption in the near and more distant future to match productive capacity is desirable. The reason to restrict the production of consumer goods and services in the near future is to free up resources to expand the production of capital goods and so, increase the ability to produce consumer goods and services in the more distant future. And the opposite is true as well. The reason to restrict the production of capital goods and so the potential to produce consumer goods and services in the future is to free up resources to produce consumer goods and services in the near future.


But suppose expected future spending on consumer goods, in both the near and more distant future falls, so that firms in both consumer and capital goods industries are producing at levels below their capacity. With such a recession (or depression,) in output, a recovery would generally require an increase in expected consumer expenditure, either in the near future, the more distant future, or both.

Presumably, the key to generating appropriate expectations of consumer expenditures in the near future is for firms to experience increased sales of consumer goods and services in the present--consumer expenditures now. In a market economic system, where households can spend what they like, expected consumer expenditure in the more distant future is more problematic.


On the other hand, the production of capital goods provides at least two avenues which generate future demands for consumer goods. The extra output generated by the capital goods results in a matching income that can be used to purchase consumer goods. And the added net worth of those who own the added capital goods should provide an incentive to purchase added consumer goods rather than save. Of course, future increases in income and net worth is no guarantee of future consumer expenditures. Househoulds could save in the future.

Perhaps the best way to generate the needed expectations of future consumption in the more distant future is to expand consumption expenditure in the present. While a simple projection of the present into the near future is plausible, the impact on the more distant future involves a lesson about the operation of economic institutions. What happens when expectations about consumer expenditure in the near future and distant future are too low to fully utilize the productive capacity of the economy? If consumer expenditure rises now, in such a situation, and this is understood to be a feature of economy, then firms in capital goods industries can anticipate that they will be able to sell their products to firms that will expect to be able to sell their products perhaps directly to other firms, but in the end, to households purchasing consumer goods and services in the more distant future.

Fortunately, there is a market process that results in increased consumption. If saving is greater than investment, then the interest rate should fall. The lower interest rate reduces the quantity of saving supplied, which is an increase in consumer expenditure.

For example, suppose there is an increase in the supply of saving, so spending on consumer goods and services fall. This is compounded by a perverse change in expectations so that the demand for investment decreases and worse, becomes perfectly inelastic with respect to the interest rate. At the current interest rate, saving is greater than investment. The interest rate needs to fall enough so that the quantity of saving supplied falls to match the new level of investment demand. The initial decrease in consumption is not only reversed, but expands so that it rises enough to offset the decrease in investment expenditures.

If firms expect this process to operate, then these sorts of perverse expectations are less likely to develop. In the more distant future, the interest rate will be at whatever level is necessary to generate enough consumer spending to purchase the consumer goods and services that the capital goods can produce. Given this expectation, an increase in the supply of saving will have a much more favorable consequence. The interest rate falls, and while there is a decrease in the quantity of saving supplied, dampening the decrease in spending on consumer goods and services, there is also an increase in the quantity of investment demanded. Households spend less on consumer goods and services, but firms spend more on capital goods, confident that the additional income and added net worth implied by those additional capital goods will result in the needed consumer expenditure to purchase the added output.


Suppose, instead, that this market process is blocked, for example, by a central bank that creates (or corrects) monetary disequilibrium as needed to keep an interest rate on target. Interest rates are kept from falling because "the problem" is too little saving. Perhaps interest rates are already low by historic standards. Lower consumption results in lower expected consumption in the near future, and reduced production, income, and employment of resources. If this problem is expected to continue, lower expected consumption in the more distant future can result in reduced investment demand in the present, exacerbating the problem. The notion that interest rates are already low enough, and that the current high levels of saving are desirable, and that it is necessary to just wait for investment to pick up would be wrongheaded and counterproductive.


It is then that it is important to remember that the purpose of production is consumption. Investment can be useful and productive, but only it is directed to future consumption. If firms cannot see how additional capital goods can be used to produce consumer goods and services that can be sold at a profit in the future, then the resources should be used to produce consumer goods and services in the near future. And the way to motivate firms to produce those consumer goods and services is an expansion in spending on consumer goods and services now.