Use Tobin’s q theory and the neoclassical theory of investment to expl

Use Tobin’s q theory and the neoclassical theory of investment to explain how optimistic scenarios of the “information age” would cause overinvestment in computer-related capital goods, and how that overinvestment would cause a sudden reversal.

What will be an ideal response?

ANSWER

A high expected marginal product of capital causes a high demand for “information age” capital goods. Both producers and buyers of capital goods are rewarded with rising stock market valuations, which inspires increased investment. Though productivity improves — the marginal product of capital curve shifts up — the rapid increase in the capital stock is subject to diminishing returns — the marginal product of capital declines due to the rightward movement along the curve. Increasing supply and technological progress among the capital-producing firms prevents an increase in the real price of capital, so the user cost remains low and the capital stock continues to rise. When diminishing returns to capital meets “exuberance” driven stock prices, the latter begin to fall, which softens the demand for capital goods. The market valuation of firms in the tech sector drops dramatically, because they have both excess capital and depressed demand.