Towards an Economic Theory of Replacement Investment

This paper develops an economic theory of replacement investment that can provide a basis for specifying an econometric model of investment behavior. The long-run and short-run effects of changes in the interest rate and in tax laws are examined. The paper also investigates several reasons why the common assumption of a technologically constant rate of replacement is incorrect even as an asymptotic limit. LARGE VARIATIONS in capital spending continue to motivate econometric studies of investment behavior. The past decade has seen the development of attempts to model net investment as the adjustment of the capital stock to a desirable level. Building on earlier work by Lutz [35], Haavelmo [21], and others, Jorgenson and his collaborators (e.g. [24, 28, 31, and 33]) have provided an operational model of net capital accumulation that relates desired capital to the cost of capital services. Although serious objections have been raised about the specification of the optimal capital stock (including [5, 9, 13, and 15]) and about the arbitrary nature of the adjustment dynamics [37], it is likely that some form of this general model will continue to provide a framework for future investment studies. In contrast to these developments of a theory of capital expansion, replacement investment continues to be analyzed in terms of a non-economic model of technical necessity. Jorgenson and others have adopted the simplifying assumption that replacement investment is a constant proportion of the capital stock.2 This assumption has been challenged and contrary evidence has been offered by Feldstein and Foot [14] and Eisner [10]. The purpose of the current paper is to examine several aspects of a theory of replacement investment. We hope not only to show that a model with a constant replacement rate is implausible and unsatisfactory but also to provide a basis for better empirical work in the future. The magnitude of replacement investment (the annual rate of replacement investment generally exceeds expansion investment) makes this issue a matter of substantial importance.