Effects of changes in investment on productivity

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Microeconomic Decision‑Makers: Firms and Production – Effects of Changes in Investment on Productivity

Microeconomic Decision‑Makers: Firms and Production

Objective: Effects of Changes in Investment on Productivity

Investment by firms refers to the expenditure on capital goods (machinery, equipment, buildings) and on research & development (R&D) that increase the capacity to produce goods and services. Changes in the level of investment can shift a firm’s productivity in both the short run and the long run.

Key Concepts

  • Physical Capital Investment – spending on tangible assets that are used repeatedly in production.

  • Human Capital Investment – training, education and health improvements that enhance workers’ skills and efficiency.

  • Research & Development (R&D) Investment – expenditure aimed at creating new products or improving production techniques.

  • Productivity – the amount of output produced per unit of input. Common measures:

    • Labour productivity: \$ \displaystyle \frac{Y}{L} \$

    • Capital productivity: \$ \displaystyle \frac{Y}{K} \$

    • Total factor productivity (TFP): \$ \displaystyle \frac{Y}{K^{\alpha}L^{1-\alpha}} \$

How Investment Affects Productivity

  1. Increasing Physical Capital

    More or better machinery allows each worker to produce more output, raising labour productivity. The production function shifts upward:

    \$ Y = f(K, L) \$

    where an increase in \$K\$ (capital) raises \$Y\$ for a given \$L\$.

  2. Human Capital Development

    Training improves the efficiency of labour, effectively increasing the quality of \$L\$. This also shifts the production function upward.

  3. R&D and Technological Innovation

    R&D can lead to new production techniques that make existing capital and labour more productive, reflected as an increase in TFP.

  4. Scale Effects

    When investment enables a firm to expand output, economies of scale may reduce average costs, further enhancing productivity.

  5. Adjustment Periods

    In the short run, additional capital may be under‑utilised, so productivity gains are limited. Over time, as workers become familiar with new equipment and processes, productivity rises.

Illustrative Table

Type of InvestmentShort‑Run Effect on ProductivityLong‑Run Effect on Productivity
Additional MachineryModest increase; may be limited by existing labour skills.Significant increase as workers adapt and maintenance improves.
Worker TrainingImmediate improvement in labour efficiency.Sustained higher productivity; complements other capital.
R&D for New ProcessLittle impact until the new process is implemented.Potentially large jump in TFP and overall output.
Expansion of Factory SpaceMay not affect productivity until equipment is installed.Allows larger scale production; can reduce average costs.

Diagrammatic Representation

Suggested diagram: Upward shift of the production function (or PPF) after an increase in investment, showing higher output for the same level of labour.

Key Takeaways

  • Investment raises the stock of capital and can improve human capital, both of which enhance productivity.

  • The magnitude of the effect depends on the type of investment and the time horizon.

  • In the long run, sustained investment leads to higher total factor productivity, allowing firms to produce more at lower average costs.

  • Understanding the link between investment and productivity helps firms make informed decisions about where to allocate resources for maximum economic gain.