Author(s):
Michelle Baddeley and Geoff Harcourt
Date of publication: August 2021
Working paper number: 05
Abstract:
Sub-optimal levels of investment in fixed capital are a pressing problem for modern economics. Behavioural economics provides some potential explanations, but behavioural economic insights are not commonly incorporated into standard capital investment models which capture neither the diversity of investment appraisal techniques used in practice, nor the range of decision-making styles used by real-world businesses. In filling these gaps, this paper brings together insights from capital investment theory with insights from behavioural economics to develop a behavioural economic model of investment appraisal, allowing for boundedly-rational investment decision-making. This model is applied in a macroeconomic analysis to show how the misapplication of investment appraisal criteria, especially under conditions of endemic uncertainty, is associated with sub-optimal levels of macroeconomic investment - with negative macroeconomic implications in terms of production, employment, productivity, wages and cyclical volatility.