Investment, Interest, and Capital

336 Pages·1970·6.347 MB·English

by  Jack Hirshleifer

INVESTMENT, INTEREST
AND CAPITAL
by J. Hirshleifer
"The closely related topics of invest
ment, interest, and capital are widely
considered to be among the most dif
ficult portions of economic theory. . ..
Often, however, what has baffled the
reader has been obscurity of expres
sion rather than expressions of ob
scurity . . .. It is the aim of this work
to set forth an analytical structure
... that will make capital theory a
meaningful whole."
from the Author's Preface
Investment, Interest and Capital dis
pells much of the mystery surrounding
capital theory. The central contention
is that capital theory is not a peculiar
branch of economic analysis following
its own novel rules, but is rather the
generalization of the standard theory
of economic choice into the domain of
time. When the fundamental concepts
of resources and commodities, prefer
ences and productive processes, and
private and social decisions are all
generalized so as to involve time in
an essential way, the result is not an
excrescence upon the body of eco
nomic theory but rather the natural
completion and extension of it.
The book covers the investment deci
sions of individuals and firms and
market intertemporal equilibrium-un
der both certainty and uncertainty,
(continued on bode flop)
INVESTMENT,
INTEREST,
AND CAPITAL

INVESTMENT,
INTEREST,
AND CAPITAL
J. Hirshleifer
Professor of Economics,
University of California, Les Angeles
PRENTICE-HALL, I NC.,
Englewood Cliffs, N.J.
:J; 1970 bv
PRENTICE-HALL, INC.
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PREFACE
The clusely related topics of investment, interest, and
capital are widely considered to be among the most difficult portions of
economic theory. In some degree, this view is correct, for in the broadest
interpretation these topics-which together constitute what we denote, for
brevity, "capital theory"-represent an extension of economic analysis into
the domain of time and consequently ofu ncertainty ( the future being intrinsically
uncertain). All of standard rc ertain, timeless) theory is thus incorporated
as a special simplified case. Often, however, what has baffled the student
has been obscurity of expression rather than expression of obscurity. As an
ill-assorted melange of ideas, without a unifying conception, any analytical
system would be difficult to understand. It is the aim of this work to set
forth an analytical structure (the main lines of which are by no means
original with the writer) that will make capital theory a meaningful whole.
The unifying conception has been alluded to already. Capital theory
is a generalization of economic theory into the domain of time; in the
analytical structure the fundamental economic concepts of resources and
commodities, preferences and productive processes, and private and social
decisions must all be generalized so as to involve time in an essential way.
That is, we will deal with dated commodities, with time-preferences, and so on.
The special terminology of capital theory is perhaps unfortunate in veiling
the essential identity of the underlying concepts with those of standard
price theory. Thus, to "invest" is to sacrifice goods of a current date for
goods of a later date; "interest" is an element in the price ratio ( exchange
rate) between present and future goods; "capital" is the presenfembodiment
v
vi Preface
of future-dated consumptive goods. \Vhen systematically constructed as a
theory of allocation of resources over time, the core of capital theory loses
most of its air of mystery ( which is not to say, of course, that many advanced
topics will not continue to present serious difficulties).
\Vhile capital theory is one of the more difficult branches of economics
from the theorists' point of view, it is also a branch of intense immediate
concern from the viewpoint of the practical man of affairs. Economists are
only rarely called upon to employ the theory of demand or of cost or of
production to assist a government or business administrator or a national
planner. But the questions of criteria for efficient investments and optimum
financial budgeting are of such urgent practical interest that a whole
literature-possessing only tenuous connection with "mainstream" economic
theory-has grown up in response. In fact, it would be more correct to say
that three whole subliteratures have grown up: the first in the area of
business economics ( the problem of "capital budgeting"), the second in the
sphere of government expenditure decisions, especially but not exclusively
in relation to public resource investments ("cost-benefit analysis"), and the
third in the crucial but ill-understood topic of national development
("growth strategies"). A secondary purpose of this book will be to indicate
the bearing of capital theory-more specifically, of the economic theory of
intertemporal resource allocation-upon some special problems in each of
these fields.
This book is addressed to "the student," in the broad root sense of that
honorable term. It is hoped that as a relatively brief and comprehensible, yet
systematic, treatment of capital theory, it may earn a place on the general
economist's bookshelf. The book may be useful to students (in the narrower
sense) in graduate price-theory courses, where the weakness of the standard
texts in the area of capital theory demands some supplementation; the
earlier chapters may also be helpful to undergraduates. Finally, the book
attempts to be of value for professionals in the crucial bridging roles between
pure theory and practical affairs: business and government economists,
systems analysts, and development planners.
The organization of the book is made reasonably clear by the Table of
Contents, but a few remarks may be helpful here. The introductory chapter
is a review and summary of price theory (i.e., of economic theory abstracted
from the dimension of time); its essential role is to illustrate the logical
structure of economic theories of choice. The main text following is in two
parts. The first considers choice over time, but in the absence of risk and
uncertainty. This restriction permits a relatively elementary theoretical
development, and does not preclude the consideration of a number of topics
possessing great theoretical and empirical interest. Part I is to a considerable
degree within the accepted corpus of economic analysis, so that the discussion
is largely expository. In Part II, where uncertainty is specifically incorporated
Preface vii
into the analysis, a Y.Jmewhat higher level rJf analytical difficulty is unavoid
ably ,:ncountered. Still, the central id,:as are seen to be rather natural
generalizati<ms of thrY.Se already develrJped, while the extension of the domain
of the analysis permit, attack rm a number rJf problems that cannot be
rC!!-Olved under th<: artifi<:ial a5sumptirJn of certainty. The approach
throughout atternpu trJ unify th<: analysis rJf private and social intertemporal
allocation r,f resources, under both certainty and uncertainty, with the
general ecrmomir: theory r,f choice.
\Vhile the sequ<:ni::e of subj,:ct5 covered follows a single consistent plan,
the metlwd ()f argument is <:dectic. "Literary" reasoning, geometrical
demrJrLstratirm, and analytical and algr:braic proofs are all employed-as
called for by thr: naturr: rJf the t0pic, by the psychological need for variety
in exposition, and by the author's desire to provide examples of all major
type!! of econrJmic argument. Furthermore, emphasis will be placed at
timeii upon the parallels betwr:en different methrJds of argument applied to
the 5ame proposition or eumomir: theorem.
This study has been sr, <:mbarrassingly long in preparation that a
complete li,t rJf acknowledgrnr:nts has become infeasible. I must, however,
expreiis my thanks t<J th1; organizations and institution.s that have provided
me with fellowship ~upport and/rJr dr:rical assistance at various stages:
Guggenheim Foundatirm, Center for Advanced Study in the Behavioral
Sciences, Ford foundation 1Fac,1lty Research Fellowship), :,.;-ational Science
Foundation I Senior PrJstdr,ctoral F ellrJwship;, Center for Operations
Rev..arch and Ecrmr,metrics at the l:n iversity of Louv ain, and of course my
home imtitution, Gniversity of California, Los Angeles. The series of
dedicated typist~ over the years I can only thank collectively. I should
like to acknowledge the suggestions and corrections offered by a number of
my students, including Barbara Gardner, Julie Da Vanzo, Robert M. Gay,
Michael McDowell, Patricia Richard,, and Edward Gallick. Portions of
the manuscript were read and criticized by colleagues at l:CLA and else
where, including Armen Alchian, Axel Leijonhufvud, Harold Demsetz,
Steven :,.;-. S. Cheung, Jan Mossin, and Gordon Pye. Thanks are especially
due to Profeiisor of Finance Frederick Amling of the l: niversity of Rhode
Island and Professor Stewart C. Myers of M.LT., who read the manuscript
and offered valuable criticism and r:omments.
University of California, Lor Angele, J. HIRSHLEIFER