Graduate Macro Theory II: Notes on Investment

Tobin reasoned that firms should accumulate more capital when Q > 1 and should draw down their capital stock when Q < 1. That is, net investment in physical capital should depend on where Q is in relation to one. How would one measure Q in the data? Typically this is done by using the value of the stock market in the numerator and data on corporate net worth in the denominator – here net worth is defined as the replacement cost of capital goods. For example, suppose that a company is in the business of bulldozing. It owns a bunch of bulldozers. Suppose that it owns 100 bulldozers, which cost 100 each to replace. This means its replacement cost is 10, 000. Suppose it has 1000 outstanding shares of stock, valued at 15 per share. The market value of the firm is thus 15, 000 and the replacement cost is 10, 000, so Tobin’s Q is 1.5. Since bulldozers are worth more in the firm than outside the firm (the market evidently values each unit of capital inside the firm at 1.5 times its market value), the firm should evidently buy more bulldozers. One might be able to immediately point out an issue with this logic. Economic decisions should be made at the margin – the firm should buy another bulldozer if the marginal value of the bulldozer