Issues in the Development of the Neo-classical Theory of Investment Behavior

IN a recent paper Robert Eisner and M. I. Nadiri [8] have raised several issues that bear on the development of the neoclassical theory of investment behavior. Specifically, they attempt to present evidence on the following issues: (1) Is the elasticity of substitution different from unity? (2) Is the general Pascal form of the distributed lag function, relating investment to its underlying determinants, appropriate? (3) Is replacement proportional to capital stock? 1 These issues are of some significance and deserve further analysis, however, they cannot be resolved on the basis of evidence presented by Eisner and Nadiri. Our first purpose is to demonstrate that the model used by Eisner and Nadiri directly contradicts the model we originally presented [14, 18, 20]. If our model is valid, the EisnerNadiri model is false and vice-versa. Evidence predicated on the validity of either model is not relevant to the validity of the other. Our second purpose is to consider the Eisner-Nadiri model as a potential contribution to the neoclassical theory of investment behavior in its own right. Unfortunately, even a cursory examination of the internal logic of the EisnerNadiri model reveals a theoretical lapse; they combine increasing returns with competitive equilibrium. Aspects of our maintained hypothesis such as constant returns to scale can be imposed on the Eisner-Nadiri model, eliminating the internal contradiction in their theoretical analysis. Their results have been reexamined from this point of view by Charles Bischoff [3]. 2 He finds that the stochastic specification they have employed is not supported by their data. For a correctly specified model of the Eisner-Nadiri type, the conclusions that they have reached are reversed. Our examination of the Eisner-Nadiri model leaves open the questions they raise concerning the validity of various aspects of our maintained hypothesis. The specific issue discussed at length by Eisner and Nadiri, whether the elasticity of substitution is unity, is of interest in judging the validity of the maintained hypothesis underlying our model. In Eisner's extensive series of empirical studies of investment behavior the maintained hypothesis is that the elasticity of substitution is zero.8 Thus, evidence on the elasticity of substitution bears equally on the validity of our maintained hypothesis and on that of Eisner's "permanent income" theory of investment. Substantial evidence is available on the value to be assigned to the elasticity of substitution. This evidence has been generated by detailed empirical testing extending over nearly a decade. The available evidence for manufacturing industries of the United States in the aggregate or at the two-digit level, where our work has been concentrated, provides strong support for our maintained hypothesis that the elasticity of substitution is unity. This evidence directly contradicts the maintained hypothesis underlying Eisner's research on investment. Our overall conclusion is that important issues remain to be resolved in implementation of the neoclassical theory of investment behavior, but they are not the issues raised by Eisner and Nadiri. We conclude with a brief review of the most significant of these issues.