Is the Firm-Level Relationship between Uncertainty and Irreversible Investment Non- Linear?

Abel and Eberly (1994, 1999) suggest that the relationship between uncertainty and investment is non-linear and can be represented by an inverted U- curve: at low levels of uncertainty, investment and uncertainty show a positive relationship whereas at high levels of uncertainty the relationship is a negative one. We empirically test this hypothesis using panel data on 459 US manufacturing industries (4-digit level) for the period 1958 to 1996 for different sources of uncertainty: (i) output price, (ii) productivity, and (iii) factor costs. Our results tend to support Abel and Eberly's hypothesis and are robust with respect to different specifications of the investment model. Furthermore, this non-monotonic (inverted "U shaped") relationship was significant for almost all the various sources of uncertainty that were tested and for varying degrees of irreversibility. We further distinguish between the components of uncertainty: industry-wide and firm-specific. This distinction demonstrates that the investment-uncertainty relationship remains nonlinear and significant only in certain cases: when uncertainty is firm specific and arises from output prices or productivity, or when uncertainty is aggregate and arises from factor costs.