Tobin’s Q Theory of Investment

Let us make in-depth study of the Tobin’s Q theory of investment.

Many economists believe that fluctuations in stock market do not reflect the true state of fundamentals of the firms and the economy.

Influenced by exogenous factors, even when the fundamentals of the firms or the economy are quite strong stock market prices fall sharply lowering the market value of the capital installed by the firms which discourage more investment by them.

Therefore, many consider stock market movements as poor economic indicators. In India we have seen in recent years that stock market is highly volatile and movements in it have been determined not by India’s own economic fundamentals but by factors originating abroad such as financial crisis of the US in 2008-09, Eurozone crisis occurring in 2010-2012, who wins the presidential election in the US etc.

Of course global happening such US financial crisis and Eurozone debt problem may affect India’s exports, but stock market movements in India have been out of all proportions to their effects on Indian firms and give wrong signals about the state of fundamentals of the Indian economy.

However, in the -world today we cannot ignore the link between the stock market and corporate firms and therefore the economy as a whole as much of investment is made by the corporate firms and this is affected by stock market prices. A noted American economist, James Tobin, put-forward a view that links fluctuations in stock market with fluctuations in investment.

It should be noted that the stock refers to the total market value of share capital of a corporate firm which is owned by its shareholders. The shareholders of a firm get return in the form of annual dividends as well as capital gains arising from the rise in prices of shares of a firm. The shares of a corporate firm are traded in the stock market. When the prices of shares of a firm rise, the value of the capital installed by the firm will increase.

This will induce the firm to add to its stock of capital installed and thus make more investment. The increase in the market value of capital of firms influences incentive to invest more by the firms. James Tobin in his q-theory of investment put forward the view that the firms base their investment decision on the estimate of the value the stock market places on the firms ‘assets or capital installed relative to the cost of replacing them.

It may be noted that share prices of firms tend to be high when firms offer good opportunities for profitable investment because profitable opportunities determine the future incomes of the shareholders of the firms.

Tobin writes its q-ratio as under:

q = Market Value of Firm’s Capital Stock/Replacement Cost of the Capital Stock

The market value of installed capital of firms is determined by the prices of their shares in the stock market while the replacement cost of the installed capital is the cost that will be incurred if the capital assets of the firms have to be produced and procured if they were produced in the current period.

Tobin argued that investments by the firms depend on whether q is greater or less than one. When q-ratio is greater than one, it implies that the stock market places a higher value on firm’s installed capital than its replacement cost. This provides incentive to the firms to add to its installed capital stock. That is, the firm will make more investment.

On the other hand, if q-ratio of a firm is less than one, this implies that the stock market values its stock of capital assets less than its replacement cost. This will discourage managers of a firm to replace its capital assets as they wear out. Thus, according to Tobin, it is q-ratio of a firm as to whether its value is greater or less than one that determines investment by a firm.

Tobin’s g-theory of investment has been shown to be closely related to neoclassical theory of investment. It is noteworthy that Tobin’s q depends on both current and future economic profits earned from installed capital. According to neoclassical theory of investment, if marginal product of capital (MP_k) is greater than the cost of capital, the firm will be making profits on their installed capital.

These profits will induce others to own shares of the firm. As a result, the market value of the stock of installed capital by the firm will rise. This means higher value of g-ratio of the firm which will provide incentive to the firm to invest more by producing or buying more capital assets.

Likewise, if the marginal product of capital (MP_K) is less than the cost of installed capital of the firms, the firms will be having losses on their stock of capital assets. This will reduce the market value of its installed capital and thus lowering the value of q.

Merits of Tobin’s q-ratio as a measure of inducement to invest, as mentioned above, is that it reflects both the current and future profitability of capital assets of the firm. For example, if government in its annual budget reduces the corporate income tax beginning next year, this will result in larger expected profits after tax for the firms.

These larger expected profits will raise the value of the existing capital of the firm and therefore induce the firms to install more capital, that is, make more investment Mankiw therefore writes, “Tobin s q-theory of investment emphasises that investment decisions depend not only on current policies but also on policies expected to prevail in the near future”