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Investment Function

Investment Function — Learn the meaning of investment, types (autonomous vs induced), determinants, and the relationship between investment and income. CBSE Class 12 Macroeconomics notes.

Notes

Investment Function

Class 12 Macro Economics — What is investment? What determines how much businesses invest?

Meaning of Investment

Investment
Investment refers to the expenditure incurred by firms on the purchase of capital goods (machinery, equipment, buildings) and changes in inventory (stock of unsold goods and raw materials) during an accounting year.

Physical Capital Only

In macroeconomics, Investment onlymeans purchase of physical capital goods — machines, factories, trucks, computers. Buying shares, mutual funds, or old houses is NOT investment in macro terms — that's just transfer of ownership (financial investment).

Key Point

Investment does NOT depend on current income. Businesses invest based on future profit expectations, not today's earnings. That's why Investment (I) is treated as autonomous in our simple model.
Induced vs Autonomous Investment
AspectInduced InvestmentAutonomous Investment
MotiveResponds to changes in incomeIndependent of income level
Income ElasticityHigh — rises when income risesZero — fixed regardless of income
Curve ShapeUpward sloping (positive slope)Horizontal line (parallel to X-axis)
SectorPrivate sector (profit-driven)Government (infra, public goods)

Induced Investment

Induced Investment
Investment that responds positively to changes in income and output. As national income rises, businesses invest more to expand production capacity.

Real-Life Example

When the Indian economy grows rapidly (say GDP growth of 8%), companies like Tata Motors build new factories, Flipkart opens more warehouses, and local bakeries buy bigger ovens. That's induced investment — driven by rising income and demand.

Induced Investment Curve

National Income →I →Ii
Income Level₹300 cr

At Y = ₹300 cr, Induced Investment I = ₹35 cr

Autonomous Investment

Autonomous Investment
Investment that does NOT change with changes in income. It is fixed — determined by factors like government policy, technology, or long-term expectations, not current national income.

Autonomous Investment Curve

IaNational Income →I →Y₁Y₂I₀No change in I

Examples of Autonomous Investment

Government spending on:
  • Building a new highway (NH-44 expansion — ₹10,000 cr)
  • Setting up IITs and AIIMS in new cities
  • Defence equipment purchases
  • Railway electrification projects
These happen regardless of whether this year's GDP is high or low.

Determinants of Investment: MEI and ROI

Marginal Efficiency of Investment (MEI)
The expected rate of return from an additional unit of investment. It compares the prospective yield (expected profit) with the supply price (cost) of the capital asset.

Two Main Factors Determining MEI:

Supply Price

The cost of buying the capital asset. A new CNC machine costs ₹15 lakh — that's its supply price.
Example: A new delivery van costs ₹8 lakh. That's the supply price.

Prospective Yield

The expected net profit from using the asset over its lifetime.
Example: The delivery van is expected to generate ₹2.4 lakh net profit per year.

Marginal Efficiency of Investment (MEI)

$$MEI = \frac{\text{Prospective Yield}}{\text{Supply Price}} \times 100$$
Rate of Interest (ROI)
The cost of borrowing funds to finance the investment. If you borrow at 12% interest, your investment must earn more than 12% to be profitable.

Investment Decision Tool

Supply Price (Cost of asset)₹50,000
Prospective Yield (Expected annual profit)₹8,000
Rate of Interest (ROI)12%

MEI

16%

ROI

12%

INVEST ✓ — MEI (16%) > ROI (12%)

Decision Rule

A firm will invest only if MEI > ROI. If the expected return (MEI) is higher than the cost of borrowing (ROI), the investment is profitable. If MEI < ROI, the firm will not invest — it would lose money.

Key Takeaways

Key Takeaways

  • Investment in macroeconomics means physical capital formation — machines, buildings, inventory. NOT financial assets like shares.
  • Induced investment responds to changes in income (upward sloping curve). Autonomous investment is fixed (horizontal curve).
  • MEI (Marginal Efficiency of Investment) = (Prospective Yield / Supply Price) × 100 — the expected rate of return.
  • A firm invests when MEI > ROI (rate of interest). When MEI < ROI, investment does not happen.
  • Government investment (infrastructure, defence, public goods) is typically autonomous — independent of current income.