Investment

What It Means

In economics the term investment refers to purchases that contribute to the overall performance of an economy. This form of investment occurs in all sectors of society and usually involves the participation of individuals, businesses, and governments. When the overall level of investment is high, an economy generally expands, creating greater prosperity for a wider range of the population. When investment is low, the economy generally falters. As such, fluctuations in investment are the primary drivers of the business cycle—the repeated pattern of growth and slowdown that exists in all market economies.

In most cases investment refers to money spent on durable goods. Durable goods are generally defined as products that are designed to be used repeatedly over a relatively long period of time; according to most economists, a product is considered a durable good if it lasts three years or more. For most people durable goods refer to such material items as television sets, cars, and homes; by purchasing these goods, individuals contribute to the prosperity of the businesses that manufacture the goods, thereby bolstering the economy. Companies typically invest in such durable goods as manufacturing equipment and machinery, while governments invest in infrastructure such as roads, bridges, and dams. The products purchased through this form of investment are often referred to as tangible, or material, assets. Investment can also refer to spending on intangible, or nonmaterial, assets. Intangible assets can include education, skilled labor, or research.

People invest for a variety of reasons. Individuals can invest money in homes in order to improve their quality of life, or they can invest in higher education in order to increase their chances of finding a high-paying job. In both these cases, investment contributes to the overall health of the economy, both through the purchase of durable goods and the potential improvement of the workforce. This type of investment is also known as residential investment. A business will invest in new technologies in order to increase the efficiency of its production process. Government investments in infrastructure contribute to the economy by making it less costly for companies to transport goods. In a sense, all of these various forms of investment work together within an economy, generating economic opportunity, low-priced goods and services, and greater wealth.

When Did It Begin

In certain respects investment has existed since the earliest human civilizations, as ancient societies devoted a portion of their resources to producing and selling goods, building roads and fortifications, and generally contributing to the economic health of the community. Investment in the modern sense, however, did not play a significant role in the economy until the Protestant Reformation of the sixteenth century. According to German sociologist Max Weber (1864-1920), the people who held power in ancient Greece and Rome derived their wealth from land ownership and slave labor. These elite viewed commercial transactions, and working in general, as undignified; at the same time, they feared that large-scale investment would only create a broader base of wealth among the general population, thereby eroding their own power. With the Reformation, however, a new attitude toward commercial activity arose, one based on ideals of hard work (which Weber called the Protestant work ethic), individualism, and economic growth. In order to meet these goals, new business strategies, including investment, began to gain wider acceptance. Weber argued that the emergence of investment as a means of spurring economic expansion represented one of the key factors in the birth of modern capitalism.

The industrial revolutions of the late eighteenth and early nineteenth centuries witnessed an explosion of investment in both England and the United States, as new technologies accelerated the speed at which goods could be produced. Increased production levels resulted in significantly higher earnings, which led to increased financial investment in commercial activities. Indeed, the entire history of American economic expansion is rooted in the principle of investing in cheaper, more efficient ways of manufacturing goods and services.

More Detailed Information

When businesses consider how to invest their money, they focus on the potential benefits that might result from their investment. Since the goal of all profit-based companies is to earn money, business investments are made with the aim of increasing, or at least maintaining, profit levels. Companies achieve these goals by investing in new machinery, hiring more workers, and funding other expenditures designed to increase their capacity to create more products.

Businesses generally employ two means of funding their investments. In many cases a company will use profits from its existing operations, either to reinvest in its core business (for example, manufacturing tires) or to invest in the creation of a new form of business (such as introducing a line of windshield wipers). A company will also borrow money (a business loan or a line of credit) in order to invest in the expansion of its core operations. Ideally the money earned from the increase in production capacity will be greater than the money invested, thereby earning the company a profit. For example, say a tire manufacturer earns a profit of $200,000 in a given year. The company may want to invest that money in building a second factory, with the ultimate aim of doubling its manufacturing capabilities. If the cost of building a new factory is $1 million, then the company may use its profits for some of the expenditures (buying new equipment or hiring new workers) while taking out a loan to pay the remaining expenses. Once the second factory becomes operational, it will begin to generate income. For the first year or two, the earnings from the second factory might not offset the costs involved with getting it started, and the company may use all its earnings from that period to pay off its debt. By the third year, however, the company may have paid down its debt considerably and begun earning substantially higher profits than it did before building the second factory.

Government investment also plays an important role in the economic prosperity of private businesses. Government construction projects require the hiring of private businesses, thereby stimulating economic activity. When government invests money in infrastructure, a nation’s commercial activities also tend to run more smoothly: good roads and bridges help save transportation time while also reducing wear-and-tear on shipping vehicles, and power stations provide massive amounts of energy to companies throughout the country, enabling them to operate at a high capacity. When government investment in infrastructure declines, as it did during the 1980s, private industry will usually feel the effects.

How money is invested from year to year generally reflects broader trends in politics, the economy, and technology. During periods of increased economic expansion, people invest in commercial activities at a much higher rate, which in turns fuels continued growth. Eventually, however, the economy will inevitably slow down, and investment rates will fall. In this sense investment is regarded by economists to be a cyclical phenomenon.

Recent Trends

Because of the inherently volatile nature of economic activity, investment typically fluctuates over time. A comparison of investment trends in the United States during the 1990s and the early 2000s offers a valuable illustration of how patterns of investing can vary widely. Between 1995 and 2000, business investment in the U.S. rose at a rate of 10 percent per year. In the second half of 2000, however, this trend reversed itself dramatically, as investment dropped nearly 12 percent. Economists attribute this decline to the infamous “dot-com” bust, during which hundreds of computer and information technology firms declared bankruptcy. As a result of this decline in investment, by March 2001 the country had entered into a recession (a period of economic contraction).