Investment Behavior and the Production Function

Abstract

In the economic theory of investment behavior the form of the optimal production and investment policy depends critically on the form of technology. The purpose of this paper is to select an appropriate description of technology on the basis of empirical evidence for United States manufacturing industries. The evidence is consistent with a production function characterized by elasticity of substitution equal to unity and constant returns to scale. For this description of technology the optimal policy determines an optimal rate of growth of capital and associated capital/output and labor/output ratios for any set of prices of output, labor input, and capital input. The desired level of capital is a perpetually moving target to which actual capital never converges. The corresponding model of investment policy has been employed extensively in econometric studies of investment behavior. Characterization of the form of optimal investment policy makes it possible to resolve the considerable controversy over the interpretation of econometric models of investment.