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When analyzing the role of the market in allocating resources, we can identify two types of investment principal, business and individual. For now, we do not analyze government as one type of investment principal.
In order to be investment principal, a business must have resources to invest and the right to make investment decisions on its own. The motive for businesses to invest is to pursue value appreciation or profitability. There may be motives other than profitability. One of the following two scenarios will apply. In the first scenario, the ultimate motive for businesses to invest is profitability, although they invest due to reasons other than profitability. This is an indirect way for businesses to pursue profitability to ensure that investments will increase total profits. In the second scenario, businesses have other goals besides profitability. Businesses make investments in order to reach those goals. The second scenario does exist, but accounts for a small portion of overall investments. We can ignore this scenario when we study business investments.
Similar to businesses, individuals must also have resources to invest and the right to make investment decisions on their own before they are qualified as investment principal. The motive of investments by individuals is also to pursue value appreciation in order to increase personal income. This does not exclude individuals from having other motives when they invest. These scenarios are insignificant and can be ignored when we analyze investments by individuals.
If both businesses and individuals have the same investment motive, i.e., pursuit of profit or higher income, they will need to estimate opportunity cost in every scenario, even when there is only one investment opportunity. Estimating opportunity cost is to select the direction of use and the combination of resources. Businesses and individuals will naturally select the direction of use and the combination of resources that are in their best interests before they decide on whether to invest, how to invest, and how much to invest.
If a business or individual decides to invest after estimating the opportunity cost of an investment, the investment activities are generally only influenced by price or by market competition. The general principles of investment behavior hereby referred to are applicable to the investment activities under the Walrasian equilibrium condition.
Investment activities consist of a series of transactions. As investment principal, businesses and individuals must have sufficient monetary capital to invest, with some utilized to purchase production materials and some to pay salaries and rents. If they do not have enough monetary capital on hand, they will need to borrow from the capital market and pay interest. Purchasing production materials, paying salaries and rents, raising capital, and paying interest are all transactions. Under the Walrasian equilibrium condition, total demand is always equal to total supply at any price level. No excess demand or supply exists in the economy, and every transaction is conducted at the equilibrium price. Hence, business or personal investors are always able to borrow sufficient capital, if needed, at the equilibrium interest rate determined by the demand and supply of the capital market. If they need to purchase production materials, they will be able to secure the needed quantity at the equilibrium price in the production materials market. If they need labor, they will be able to find sufficient labor to meet production needs at the equilibrium salary level set by the supply and demand of the labor market. In summary, all these meet the investors' needs, as well as their economic interests.
Likewise, business and personal investors do not have to worry about the sales of the products produced by their investments under the Walrasian equilibrium condition. As the market does not have excess demand and supply, every product they produce will be sold at an equilibrium price. These situations are also consistent with investors'economic interests.
Investment decisions in such economic environment are actually very simple. As investment principal, businesses and individuals simply follow the principles of market competition, which states that the market determines everything and investors do not have to worry about their investments. This is because market information is complete and information flows freely. As a result, investors have a full understanding of the current market as well as the market in the future. There are no unknown uncertainties. As long as investors have enough information, they can proceed with investments, allocating resources, organizing production and sales without concerning about uncertainties, or taking precautionary measures. It is not necessary to reserve excess cash to cope with business uncertainties or to purchase additional inventory. Completely following market arrangement will bring satisfactory results to investors. This is the general investment principle, even though it only exists theoretically under the Walrasian equilibrium condition.
As pointed out in Chap. 1 of this book, disequilibrium but not Walrasian equilibrium exists in real life. In the current socialist economy, the market is not fully developed, information is neither complete nor flowing freely, and price does not function to adjust demand and supply as it is supposed to. These are the striking characteristics of economic disequilibrium, giving rise to a new requirement for the study of investments made by businesses and individuals.
Under disequilibrium conditions, business and personal investors must consider the constraints on resource supplies before making an investment decision. They include constraints on required capital, required production materials, and labor. If resource supplies are limited, the execution of investment plans will meet obstacles. In addition, current resource supplies as well as the prospect of future supplies are equally important to investors. The production capacity built through an investment requires continuing supplies of resources, particularly raw materials, energy, maintenance parts, and transportation capacity. Therefore, even though current resource supplies seem to have no or limited constraints, investments may still encounter obstacles if future supplies of resources are expected to be constrained.
As investment principal, businesses and individuals must also consider demand constraints, or market constraints, which actually exist under disequilibrium conditions. Market constraints refer to shortage of demand for the products produced by the new production capacity from an investment. If market is limited, fulfilling an investment plan is also not straightforward. Similar to resource supply constraints, current and future markets are equally important to investors. If products from an investment can only sell now, but demand in the future is uncertain, an investor will have to consider the feasibility of the investment.
Besides the constraints on resource supply and demand under disequilibrium conditions, businesses and individuals also have to consider various uncertainties. To ensure that the investment can proceed normally as well as the production capacity built through an investment can operate properly, investors will have to take various precautionary actions, such as raising additional capital to meet overspending and keeping extra cash on hand. Investors may also purchase additional inventory to guard against the potential interruption to raw material supplies or shortage of raw materials, thus resulting in abnormal inventories of raw materials, energy, equipment, and maintenance parts and greater use of working capital. To prevent market shares from shrinking or to avoid heightened sales competition, investors may have to adopt unusual measures to protect or increase their market shares, which also requires additional working capital. These situations require higher inputs of capital than those without uncertainties.
In addition, in a disequilibrium economy, investors feel compelled to find necessary information themselves, since information is neither complete nor flowing freely in the market, which is one of the characteristics of disequilibrium. These efforts also require additional investments. Marginal benefits from the additional investments in pursuit of information will outweigh potential losses due to incomplete or delayed information, and hence investors are willing to commit these additional investments.
Let us set aside discussions on the gap between the price level under equilibrium conditions and that under disequilibrium conditions. Compared with equilibrium conditions, the need for businesses to stock up abnormal inventory and hold additional capital to protect and increase market share as well as obtain relevant information under disequilibrium conditions requires more capital investment to install the same amount of new production capacity. The price level needs to be considered as well. If funding capital is constrained and the capital market is not fully developed, the interest rate required will be higher than the equilibrium interest rate. If supplies of production materials are constrained and the production materials market is not fully developed, the price of production materials under these conditions will be higher than the equilibrium price. If investors adopt noncompetitive measures to protect their market shares, merchandise selling prices under these conditions will exceed the equilibrium price formed through normal market competition under equilibrium conditions. Higher interest rate and production material prices require higher capital investment. In this circumstance, the same production capacity under disequilibrium conditions requires higher capital investment than that under equilibrium conditions. Higher merchandise selling prices in turn justify higher capital investment. That is, after factoring in the higher selling prices in the future market, investors would consider additional investment not only indispensable but also rewarding. Thus, extra capital investment is justified.
The above analyses clearly demonstrate that disequilibrium conditions require businesses and individuals to invest more capital to build the same production capacity than equilibrium conditions do. In other words, the total investment to build the same production capacity under disequilibrium conditions will always exceed that under equilibrium conditions. This is the characteristic of business and personal investment behavior under disequilibrium conditions.
Committing additional investment requires not only additional cash but also additional supply of production materials. It is relatively easy to understand additional cash, as the initial form of additional investment is always monetary capital. Additional investment in the form of supply of production materials (i.e., raw materials, energy, equipment, and parts) is reflected in abnormal inventory. Besides, additional costs to protect or increase market share or to obtain information are also partially reflected in the cost of purchasing production materials.
Hence, business and personal investment under disequilibrium conditions, including additional investment, will surely lead to resource allocations that are rather different from those under equilibrium conditions. Under equilibrium conditions, the market plays its roles to ensure resources automatically flow to sectors and regions where they are most profitable, and the changes of supply and demand in the market as well as subsequent price changes will place various resources in appropriate areas. There may be some cases of local or structural idling or waste of resources during the transfer between various sectors, regions, and investment principals, which normally are unable to be avoided. However, generally speaking, as excess demand and excess supply are equal to zero, resources can be effectively combined and efficiently utilized. However, it is quite different under disequilibrium conditions.
For example, due to resource supply constraints, business and personal investors often commit additional capital investment in excess inventory to protect against supply shortages or interruption, or other uncertainties in the economy, which further widens the existing shortages of resource supply. As a result, the existing imbalance between supply and demand will deteriorate, causing resource misallocation. The phenomenon of stagflation in the socialist economy mentioned earlier is to a certain extent related to the excess inventory that most businesses and individuals build up as a precaution.
Another example can be seen from the impacts of businesses and individuals on the capital market due to their needs for additional investment. Economic disequilibrium indicates that the demand for capital in the capital market probably exceeds the supply of capital during that period. The need for additional investments intensifies capital shortages.
In terms of resource allocation, it is very difficult to allocate resources in a way that contributes to increasing utilization efficiency if there are constraints on supply in the economy. The form of resource combination will have to adjust to the situation of supply shortages. If this situation happens, a portion of resources will remain idle in the economy. If we want to utilize that portion of resources in case of resource supply shortages, we will likely sacrifice the efficiency of resource allocation. Both scenarios are reflective of resource misallocation.