Tobin’s Q Research Paper

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Tobin’s Q is the ratio of the stock market valuation of firms to their “replacement” costs. Economists going at least as far back as Thorstein Veblen have noted the possibility of a discrepancy between the stock market value of firms and their replacement costs. Veblen conceived of a historiography of “capital,” whereby capital took on different meanings in accordance with various historical periods. In reference to the competitive phase of nineteenth-century capitalism, Veblen understood that crisis resulted from a “readjustment of [capital] values” ([1892] 1998, p. 112). New technologies made existing capital installations obsolete so that the “nominal accepted valuation of the capital, on which its returns are computed, exceeds its actual value as indicated by its present earning capacity” ([1892] 1998, p. 112). Here, Veblen compares a measure of capital based on “putative” earning capacity to actual expenditures on plant and equipment. That is, he formulates a measure of Q, without actually naming the ratio. According to Veblen, misalignments of valuations produce a psychological “malady of affections” in the investing class, a psychological fact that produces industrial depression ([1904] 1978, p. 237). In the transition to the great monopolies established during the Great Merger Wave of 1897 to 1903, Veblen contended that high stock valuations relative to replacement costs (i.e., high Qs) were reflective of monopoly power and a “sabotaging of production.”

In stark contrast to Veblen’s contention that high Qs reflect a monopolistic restriction on output and investment, modern Q theory, as elaborated by William C. Brainard and James Tobin (1977), holds that high Qs are primary forces driving new investment ahead. Tobin and Brainard’s modern version of Q theory derives from John Maynard Keynes’s remarks in his General Theory of Employment, Interest, and Money ([1936] 1953). In this famous work, Keynes noted that stock market booms would encourage investment because new plant and equipment could be “floated off on the Stock exchange at an immediate profit” (p. 151). In the aggregate, a Q greater than one indicates that the stock value of firms exceeds their replacement costs and so there is an incentive for greater investment. Conversely, stock market slumps should drag Q below one, dampening the rate of building because entrepreneurs could buy similar enterprises on the stock market for less than it would cost to build them.

Implications Of Q Theory

As an investment theory, Q theory has two clear, potentially testable implications. First, stock market booms should encourage investment. Second, mergers and acquisitions should rise when the stock market slumps and should fall off during stock booms. The first implication—that investment should go up during stock booms—is a virtual truism in that stock booms generally occur during booms in the general economy. It is generally difficult, however, to measure the separate effects of causative variables when many causative variables move together. For example, high profits generally expand both stock valuations and investment, so it is difficult to isolate any separate effect of high stock valuations on investment. In early tests, Tobin found “a good relationship” of investment and Qs (1978, p. 425). Yet in more recent studies, models that have used Q as a variable to explain investment have fared no better and have often done worse than pared down models using variables other than Q (Chirinko 1993; McCarthy 2001). So it is uncertain whether Q theory operates on new investment as predicted.

The other implication—that mergers and acquisitions should move countercyclically to stock booms and busts— is clearly refuted by the evidence. In the stock boom years of the 1920s, the 1960s, the 1980s, and the 1990s, mergers and acquisitions expanded rapidly. And during stock market slumps, mergers and acquisitions declined, often spectacularly as in the Great Depression of the 1930s. Various explanations have been offered to explain these results. Some theorists have postulated that stock booms allow firms additional financing through stock issues or debt collateralized by stock, which together with merger promoters have encouraged more acquisitions (Du Boff and Herman 1989). Other theorists suggest that stock booms encourage a wider divergency in stock valuations of companies (Gort 1969; Shleifer and Vishny 2003), although such an explanation seems at variance with the fact that stock valuations decline much more severely over shorter periods of time than they expand during booms.

Marginal Q And Monopoly Power

In order to fully comprehend how Q operates on investment and mergers, theorists still need to derive credible estimates of what is termed marginal Q—the additional stock valuation consequent on additional capital installations. In regard to the building of new firms, the logic of Q theory makes sense if there is “free entry” into indus-tries—that is, new firms can be built and sold on the stock market. But when existing firms have monopoly power, the predictions of Q theory make sense only if marginal Q and Q move together. In contemplating new investment, existing firms would ask if additional capital spending would enhance the share price of the firm by more than the cost of the investment. Estimates of marginal Q have been made, but these estimates have either relied on assumptions of perfect competition in product markets (Hayashi 1982) or assumptions that conceive of capital as separate from technological change (Abel and Blanchard 1986). These assumptions are clearly unrealistic in an economy dominated by oligopolies, which install plant and equipment that often embody certain specific kinds of technology.

Monopoly power permits a divergence of marginal Q and Q. If marginal Q could be estimated accurately, then Q theory might well be able to better predict investment as well as mergers and acquisitions. If existing firms bumped up against new investment limits during stock booms (if marginal Q fell off), then this might explain why mergers and acquisitions expand during these same stock booms (Medlen 2003). Brainard and Tobin (1977) argued that marginal Q and Q moved together, but in the absence of any credible estimates of marginal Q, the question is still open.

Q theory has also been used to gauge monopoly power (Lindenberg and Ross 1981). Industries that have persistent monopoly power would presumably enjoy abnormally high profits over time. Given that industries with persistent monopoly power are protected against new entrants, such industries should exhibit high Qs. Conversely, in competitive markets, the Q ratio should approximate one; if “free entry” exists, then any abnormally high profitability would soon be eroded as new entrants came into the market.

In addition to theoretical problems, Q theory also contains unresolved measurement problems—particularly regarding the “replacement costs” of assets. With ongoing technological change, many assets would not be replaced at all. So the measurement of replacement costs might well be of questionable value. Some theorists also question whether the concept of replacement costs make sense in an information age in which capital often takes the form of knowledge, inclusive of the knowledge of in-house specialized workers (Bond and Cummins 2000). In addition, the very concept of marginal Q has been questioned on the basis that theorists have not yet fully understood the time path of new investment, a necessary precondition for any possible measurement of marginal Q (Caballero and Leahy 1996).


  1. Abel, Andrew B., and Oliver J. Blanchard. 1986. The Present Value of Profits and Cyclical Movements in Investment. Econometrica 54 (2): 249–273.
  2. Bond, Stephen R., and Jason G. Cummins. 2000. The Stock Market and Investment in the New Economy: Some Tangible Facts and Intangible Fictions. Brookings Papers on Economic Activity 2000, no. 1: 61–124.
  3. Brainard, William C., and James Tobin. 1977. Asset Markets and the Cost of Capital. In Economic Progress, Private Values, and Public Policy: Essays in Honor of William Fellner, eds. Bela Balassa and Richard Nelson, 235–262. Amsterdam: North-Holland.
  4. Caballero, Richard J., and John V. Leahy. 1996. Fixed Costs: The Demise of Marginal q. NBER Working Paper Series, no. 5508. National Bureau of Economic Research, Cambridge, MA.
  5. Chirinko, Robert S. 1993. Business Fixed Investment Spending: Modeling Strategies, Empirical Results, and Policy Implications. Journal of Economic Literature 31 (4): 1875–1911.
  6. Du Boff, Richard B., and Edward S. Herman. 1989. The Promotional-Financial Dynamic of Merger Movements: A Historical Perspective. Journal of Economic Issues 23 (1): 107–133.
  7. Gort, Michael. 1969. An Economic Disturbance Theory of Mergers. Quarterly Journal of Economics 83 (4): 624–642.
  8. Hayashi, Fumio. 1982. Tobin’s Marginal q and Average q : A Neoclassical Interpretation. Econometrica 50 (1): 213–224.
  9. Keynes, John Maynard. [1936] 1953. The General Theory of Employment, Interest, and Money. San Diego, CA: Harcourt, Brace, Jovanovich.
  10. Lindenberg, Eric B., and Stephen A. Ross. 1981. Tobin’s q Ratio and Industrial Organization. Journal of Business 54 (1): 1–32.
  11. McCarthy, Jonathan. 2001. Equipment Expenditures since 1995: The Boom and the Bust. Current Issues in Economics and Finance 7 (9). Federal Reserve Bank of New York, New York.
  12. Medlen, Craig. 2003. Veblen’s Q-Tobin’s Q. Journal of Economic Issues 37 (4): 967–986.
  13. Shleifer, Andrei, and Robert W. Vishny. 2003. Stock Market Driven Acquisitions. Journal of Financial Economics 70 (3): 295–311.
  14. Tobin, James. 1978. Monetary Policy and the Economy: The Transmission Mechanism. Southern Economic Journal 44 (3): 421–431.
  15. Veblen, Thorstein. [1892] 1998. The Overproduction Fallacy. In Essays in Our Changing Order. New Brunswick, NJ: Transaction Publishers. Originally published in Quarterly Journal of Economics 6, no. 4 (1892): 484–492.
  16. Veblen, Thorstein. [1904] 1978. The Theory of Business Enterprise. New Brunswick, NJ: Transaction Books.

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