Investment
Leads and Laggards

Investment, as measured by gross domestic fixed capital formation lies at the heart of macroeconomic behaviour both on the demand- side as well as on the supply-side. Attempts to provide econometric accounts of UK business investment over time have been rather unsuccessful. In particular the so-called neo-classical model of investment in which investment varies inversely with the cost of capital has not on the whole enjoyed empirical support in the UK. In contrast the neo-classical model has fared better in the US. More generally, it has been difficult to observe adverse effects of interest rates on UK investment activity.

In our paper we propose a different theoretical framework for investigating the determinants of UK investment. Our framework reflects the fact that Britain is a small open economy and that investment activity is subjected to multinational as well as domestic influences. In this context the pre-tax cost of capital is unlikely to be very different in Britain than in other industralised countries. Secondly, it reflect the fact that the UK is not necessarily a technological leader. In contrast the neo-classical model assumes that the economy is on the cutting- edge of new technology and that if factor prices were the same in Britain and the US their production technologies would be broadly similar.

We therefore set-up a model in which Britain is assumed to be a technological laggard while the US is assumed to be a technological leader. This implies that the US lies on the technological frontier while the UK operates inside it. We suggest that the technological gap may be decomposed into four main elements which characterize the international diffusion process:

1. There may be information lags which prevent the rapid diffusion of new technology. By knowledge we refer here to practical knowledge about a new technology rather than vague awareness of it. In this context we explore whether inward and outward direct investment act as conduits through which potential knowledge of new technologies diffuses. However, in our empirical work we are unable to measure any such effects.

2. The successful absorption of new technologies may be inhibited by barriers to change e.g. by the restrictive practices of trade unions. There are two possibilities here; either a technology is permanently impeded or the barriers are worn down by attrition. Using the union mark-up as a measure of trade union power we find that union power impedes technology transfer but not on a permanent basis.
3. Even in the absence of information lags and absorbtion barriers it may be inappropriate for the UK to operate the same technology as say the US. If labour is relatively expensive in the US the appropriate technology in the UK will be relatively labour intensive. Thus part of the technological gap between the UK and the US might reflect differences in factor prices. Indeed, we find that as UK wages rise relative to US wages the UK economy tends to become more capital intensive vis a vis the US.

4. Finally, there are adjustment costs that might account for technological gaps. We explore several possible diffusion models and carry out non-nested tests on their statistical significance.

We measure the technological gap by the difference between the capital-leader ratios in the US and the UK. This definition begs many questions, not least of which includes comparisons in the measurement of the capital stock in different countries. Nevertheless, as an exploratory exercise our econometric findings broadly support the approach that we propose. These suggest that investment in the UK (and perhaps other laggard economies too) can be understood within the framework of technology and its international diffusion.