Economics • Economic BasicsHard
What does the 'Tobin's q' theory of investment suggest?
A. Investment is determined by the ratio of the market value of installed capital to its replacement cost.✓ Correct Answer
B. Investment depends exclusively on the current real interest rate set by the central bank.
C. Firms invest based on internal cash flows rather than external borrowing costs.
D. Capital accumulation occurs until the marginal productivity of labor equals the real wage.
💡 Solution & Explanation
Tobin's q theory posits that corporate investment is driven by the ratio of the firm's market value in the financial markets to the replacement cost of its physical capital stock. When this ratio exceeds unity, firms find it profitable to invest in new capital because the market values the investment higher than its production cost. James Tobin received the Nobel Prize in Economics largely for developing this framework.
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