Capital Investing

Executive Summary

* The theory of capital budgeting was rapidly integrated into the Panglossian story of economic efficiency

* According to this theory firms produce goods and services at the lowest possible cost while maximizing profits.

* This theory about the capital investing decision was publicized it as a way of boosting the macro performance of the economy by linking macro-level investment spending with "efficient" decentralized micro-level decisions of individual firms.

* Competition between technologies usually becomes competition between bandwagons, and adoption markets display both a corresponding instability and a high degree of unpredictability.

* One of the most straight-forward case histories is the early VCR market.

* . The VCR market started out with two competing formats selling at about the same price: VHS and Beta.

* If the claim that Beta was technically superior is true, then the market's choice did not represent the best economic outcome.

According to Tom Mouck, Ph.D, the market economist is analogous to Dr. Pangloss in Voltaire's novel Candide. Thus, during the 1960s, with the development of the capital assets pricing model (CAPM), the efficient markets hypothesis (EMH), and modern portfolio theory (MPT), the theory of capital budgeting was rapidly integrated into the Panglossian story of economic efficiency. According to this theory, individuals save and invest in accordance with their preference for current versus future consumption and make investment decisions that maximize return in accordance with their own psychological aversion to risk; and firms produce goods and services at the lowest possible cost while maximizing profits (i.e., the return to investors). With respect to new capital investments, a firm will accept new investments that have an expected rate of return in excess of the firm's cost of capital. Thus, in equilibrium the firm's marginal rate of return would be equal to the cost of capital. This theory about the capital investing decision was widely heralded as "scientific". The U.K., in the 1960s, even publicized it as a way of boosting the macro performance of the economy by linking macro-level investment spending with "efficient" decentralized micro-level decisions of individual firms.

With respect to Panglossian capital budgeting applied to investing in new technologies, Brian Arthur's theory of increasing returns challenges the notion that the most efficient new technology will prevail in a free market. With respect to the practical applications of capital budgeting, Brian Arthur's theory implies that future cash flows associated with high tech investments may not be susceptible to meaningful estimation.

"Real world" competition, of course, is rarely as passive as suggested in this basic model. The possibility of "winner-take-all" in a technological competition creates powerful incentives