Investment and Economic Activity

Investment, Consumption, and Saving

Earlier we used the production possibilities curve to illustrate how choices are made about investment, consumption, and saving. Because such choices are crucial to understanding how investment affects living standards, it will be useful to reexamine them here.

Figure 14.4 "The Choice between Consumption and Investment" shows a production possibilities curve for an economy that can produce two kinds of goods: consumption goods and investment goods. An economy operating at point A on PPC₁ is using its factors of production fully and efficiently. It is producing C_A units of consumption goods and I_A units of investment each period. Suppose that depreciation equals I_A, so that the quantity of investment each period is just sufficient to replace depreciated capital; net investment equals zero. If there is no change in the labor force, in natural resources, or in technology, the production possibilities curve will remain fixed at PPC₁.

Figure 14.4 The Choice between Consumption and Investment

A society with production possibilities curve PPC₁ could choose to produce at point A, producing C_A consumption goods and investment of I_A. If depreciation equals I_A, then net investment is zero, and the production possibilities curve will not shift, assuming no other determinants of the curve change. By cutting its production of consumption goods and increasing investment to I_B, however, the society can, over time, shift its production possibilities curve out to PPC₂, making it possible to enjoy greater production of consumption goods in the future.

Now suppose decision makers in this economy decide to sacrifice the production of some consumption goods in favor of greater investment. The economy moves to point B on PPC₁. Production of consumption goods falls to C_B, and investment rises to I_B. Assuming depreciation remains I_A, net investment is now positive. As the nation's capital stock increases, the production possibilities curve shifts outward to PPC₂. Once that shift occurs, it will be possible to select a point such as D on the new production possibilities curve. At this point, consumption equals C_D, and investment equals I_D. By sacrificing consumption early on, the society is able to increase both its consumption and investment in the future. That early reduction in consumption requires an increase in saving.

We see that a movement along the production possibilities curve in the direction of the production of more investment goods and fewer consumption goods allows the production of more of both types of goods in the future.