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Irreversible investment with regime shifts

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  • Guo, Xin
  • Miao, Jianjun
  • Morellec, Erwan

Abstract

Under the real options approach to investment under uncertainty, agents formulate optimal policies under the assumption that firms’ growth prospects do not vary over time. This paper proposes and solves a model of investment decisions in which the growth rate and volatility of the decision variable shift between different states at random times. A value-maximizing investment policy is derived such that in each regime the firm’s investment policy is optimal and recognizes the possiblity of a regime shift. Under this policy, investment is intermittent and increases with marginal q. Moreover, the rate of investment typically is very small but exhibits some spurts of growth. Implications for marginal q and the user cost of capital are also examined.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 122 (2005)
Issue (Month): 1 (May)
Pages: 37-59

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Handle: RePEc:eee:jetheo:v:122:y:2005:i:1:p:37-59

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Web page: http://www.elsevier.com/locate/inca/622869

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  1. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  2. Harchaoui, T. & Lasserre, P., 1995. "Testing the Option Vakue Theory of Irreversible Investment," G.R.E.Q.A.M. 95b04, Universite Aix-Marseille III.
  3. Giuseppe Bertola & Ricardo J. Caballero, 1991. "Irreversibility and Aggregate Investment," NBER Working Papers 3865, National Bureau of Economic Research, Inc.
  4. Robert S. Chirinko, 1992. "Business Fixed Investment Spending: A Critical survey of Modeling Strategies, Empirical Results, and Policy Implications," Working Papers 9213, Harris School of Public Policy Studies, University of Chicago.
  5. Eberly, Janice C. & Van Mieghem, Jan A., 1997. "Multi-factor Dynamic Investment under Uncertainty," Journal of Economic Theory, Elsevier, vol. 75(2), pages 345-387, August.
  6. Andrew B. Abel & Janice C. Eberly, 1995. "Optimal Investment with Costly Reversibility," NBER Working Papers 5091, National Bureau of Economic Research, Inc.
  7. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, vol. 50(1), pages 213-24, January.
  8. Andrew B. Abel & Janice C. Eberly, 1993. "A Unified Model of Investment Under Uncertainty," NBER Working Papers 4296, National Bureau of Economic Research, Inc.
  9. Andrew B. Abel & Janice B. Eberly, . "The Effects of Irreversibility and Uncertainty on Capital Accumulation," Rodney L. White Center for Financial Research Working Papers 21-95, Wharton School Rodney L. White Center for Financial Research.
  10. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  11. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  12. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-85, December.
  13. Morellec, Erwan, 2001. "Asset liquidity, capital structure, and secured debt," Journal of Financial Economics, Elsevier, vol. 61(2), pages 173-206, August.
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