Capital Allocation Under a Financial Constraint: The Classical Investment Function

In the modern literature on investment, a distinction is normally made between neo‐Classical and Keynesian theories of investment. An earlier original approach can, however, be located in the works of Smith, Ricardo, and Marx. In this Classical tradition, investment is subject to a capital constraint, and capitalists allocate their capital according to the relative profitability of the various industries. We show that this behaviour is rational in a model in which capitalists optimize over an infinite horizon and form rational expectations: inter‐industry mobility can be expressed as an adjustment behaviour such that investments, ΔKi are proportional to profitability differentials: ΔKi = Ai (r¯i−r¯)