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Long-run Investment under Uncertain Demand

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  • Luca Di Corato

    (Department of Economics, Swedish University of Agricultural Sciences, Sweden)

  • Michele Moretto

    (Department of Economics, University of Padova, Fondazione Eni Enrico Mattei and Centro Studi Levi-Cases, Italy)

  • Sergio Vergalli

    (Department of Economics, University of Brescia, and Fondazione Eni Enrico Mattei, Italy)

Abstract

In the literature investigating the impact of uncertainty on short-run and long-run investment, most authors have used a log linear profit function. This functional form has been generally considered a reasonable approximation for more general ones and has the advantage of providing closed form solutions for both short-run investment rule and long-run rate of capital accumulation. In this paper, we consider a firm facing a linear demand function with additive shocks and present a technique for the analytical approximation of the long-run average rate of capital accumulation for the case of an inverted U-shape profit function. We then compare the long-run rates of capital accumulation calculated under both assumptions within a plausible range of parameter values. We notice significant differences and conclude that the choice of a log linear functional form has a non-trivial impact on the magnitude of the long run rate of capital accumulation.

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Bibliographic Info

Paper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2013.65.

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Date of creation: Jun 2013
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Handle: RePEc:fem:femwpa:2013.65

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Keywords: Investment; Demand Uncertainty; Irreversibility;

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  1. Baldursson, Fridrik M., 1998. "Irreversible investment under uncertainty in oligopoly," Journal of Economic Dynamics and Control, Elsevier, vol. 22(4), pages 627-644, April.
  2. Hartman, Richard & Hendrickson, Michael, 2002. "Optimal partially reversible investment," Journal of Economic Dynamics and Control, Elsevier, vol. 26(3), pages 483-508, March.
  3. Bentolila, Samuel & Bertola, Giuseppe, 1990. "Firing Costs and Labour Demand: How Bad Is Eurosclerosis?," Review of Economic Studies, Wiley Blackwell, vol. 57(3), pages 381-402, July.
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  5. Steven R. Grenadier, 2002. "Option Exercise Games: An Application to the Equilibrium Investment Strategies of Firms," Review of Financial Studies, Society for Financial Studies, vol. 15(3), pages 691-721.
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  8. Avinash Dixit, 1992. "Irreversible Investment with Uncertainty and Scale Economies," STICERD - Theoretical Economics Paper Series /1992/240, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  9. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
  10. Giuseppe Bertola & Ricardo J. Caballero, 1991. "Irreversibility and Aggregate Investment," NBER Working Papers 3865, National Bureau of Economic Research, Inc.
  11. Sudipto Sarkar, 2009. "A real-option rationale for investing in excess capacity," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 30(2), pages 119-133.
  12. Dangl, Thomas, 1999. "Investment and capacity choice under uncertain demand," European Journal of Operational Research, Elsevier, vol. 117(3), pages 415-428, September.
  13. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
  14. Abel, Andrew B. & Eberly, Janice C., 1997. "An exact solution for the investment and value of a firm facing uncertainty, adjustment costs, and irreversibility," Journal of Economic Dynamics and Control, Elsevier, vol. 21(4-5), pages 831-852, May.
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