Political risk is widely present in developing but also in developed countries, and stems from a variety of sources. The objective of this paper is twofold. First, we develop a theoretical model to investigate the impact of political risk on irreversible investment. Second, we apply our model to an analysis of the risk of separation of the province of Quebec from the Canadian federation. We consider the investment decisions of a monopolistically competitive firm under uncertainty about demand and about the tax-adjusted price of investment goods. We develop a model of irreversible investment which incorporates learning and a regime switch with time-varying transition probabilities. If a given regime represents a riskier environment in terms of the state of demand or the state of investment price, then attaching a positive probability to a switch to that regime increases the marginal adjustment cost of investing, reduces the expected marginal value of capital, and reduces irreversible investment. We use annual sectoral data for the Quebec economy for the period 1983-1996 to match the behaviour of actual investment with simulated series from our model.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
2405.
Find related papers by JEL classification: D92 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Firm Choice and Growth, Investment, or Financing E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity O11 - Economic Development, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development O16 - Economic Development, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment
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