Under investment problem refers to the phenomenon that the actual level of investment in an economy is lower than the optimal level. This problem is quite common and can have detrimental effects on economic growth if left unresolved. The under investment problem usually stems from market failures and distortions that lead to inefficient capital allocation. Some major causes include information asymmetry, agency problems, market power of firms, policy uncertainty, and weak legal systems. To tackle under investment, policymakers need to carefully diagnose the specific reasons and implement reforms to remove barriers to investment, strengthen corporate governance, enhance financial sector development, improve business environment, and provide better legal protections. With sound policies and institutions, capital can be channeled to its most productive uses, fostering innovation and raising long-term growth potential. However, simply encouraging more investment without addressing underlying distortions may lead to waste and overcapacity. The key is striking the right balance between quantity and quality of investment.
Information asymmetry hinders efficient investment
One major source of under investment is information asymmetry between borrowers and lenders. Entrepreneurs typically have much better information about project risks and returns than outside investors. This leads to adverse selection – lenders are unable to distinguish between good and bad borrowers, so they charge high interest rates, which in turn dissuades good borrowers from seeking external financing. Financial intermediaries like banks help reduce information gaps through due diligence and relationship lending. However, small firms often lack sufficient track record or collateral. Developing credit bureaus, strengthening accounting standards, and legal protections for investors can improve transparency and enable more productive investment.
Agency problems between managers and shareholders cause underinvestment
Agency problems refer to the conflicts of interest between managers and shareholders. Managers may engage in empire building and perk consumption that benefit themselves at the expense of shareholders. They may reject positive NPV projects if returns are realized beyond their tenure. Equity-based compensation helps align incentives by tying managerial pay to shareholder value. Monitoring by large shareholders and the threat of takeovers also constrain managerial excess. However, good corporate governance requires balancing incentives and supervision to avoid undue pressure for short-term gains over long-term investments.
Market power distorts investment efficiency
Firms with market dominance face less competitive pressure to invest in new productive capacity. They can restrict output, charge high prices and earn excessive profits without fear of losing market share. Weak antitrust policies fail to restrain anti-competitive conduct, allowing incumbent firms to exploit their market power. Procompetitive reforms to reduce entry barriers, limit concentration, and prevent collusion help new innovative firms grow. Competitive neutrality policies also restrict state owned enterprises from crowding out private investment.
Uncertainty over policies increases investment risks
Erratic government policies that frequently shift raise uncertainty over investment returns, increasing hurdle rates and discouraging capital spending. For instance, unpredictable changes in tax codes, tariffs, regulations make it hard for businesses to plan long-term investments. Policy consistency, transparency and commitment to rules-based regimes help provide a stable business environment. Institutional quality and rule of law also matter. Weak legal systems with poor contract enforcement exacerbate uncertainty.
In summary, under investment stem from distortions like information gaps, corporate governance issues, lack of competition, and policy uncertainty. Carefully designed reforms to foster financial development, strengthen market discipline, reduce barriers to entry, and ensure policy credibility are crucial to enable capital flows to highest return uses and accelerate growth.