There is no greater gap between economic theory and econometric practice than that which characterizes the literature on business investment in fixed capital. According to the neoclassical theory of capital, as expounded for example by Irving Fisher, a production plan for the firm is chosen so as to maximize utility over time. Under certain well-known conditions this leads to maximization of the net worth of the enterprise as the criterion for optimal capital accumulation. Capital is accumulated to provide capital services, which are inputs to the productive process. For convenience the relationship between inputs, including the input of capital services, and output is summarized in a production function. Although this theory has been known for at least fifty years, it is currently undergoing a great revival in interest. The theory appears to be gaining increasing currency and more widespread understanding.

By contrast, the econometric literature on business investment consists of ad hoc descriptive generalizations such as the" capacity principle," the" profit principle," and the like. Given sufficient imprecision, one can rationalize any generalization of this type by an appeal to" theory." However, even with the aid of much ambiguity, it is impossible to reconcile the theory of the econometric literature on investment with the neoclassical theory of optimal capital accumulation. The central feature of the neoclassical theory is the response of the demand for capital to changes in relative factor prices or the ratio of factor prices to the price of output. This feature is entirely absent from the econometric literature on investment. It is difficult to reconcile the steady advance in the acceptance of the neoclassical theory of capital with the steady march of the econo-metric literature in a direction which appears to be diametrically op-posite. It is true that there have been attempts to validate the theory. Both profits and capacity theorists have tried a rate of interest here or a price of investment goods there. By and large these efforts have been unsuccessful; the naive positivist can only conclude, so much the worse for the theory. I believe that a case can be made that previous attempts to" test" the neoclassical theory of capital have fallen so far