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New Activities, the Welfare Cost of Uncertainty and Investment Policies

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  • Joshua Aizenman

Abstract

This paper studies the effect of policy uncertainty on the formation of new activities in Romer's (1994) type of an economy, where productivity of labor increases with the number of capital goods. Adding a new capital good requires a capital specific set-up cost, invested prior to using the capital good. Agents are disappointment averse, putting greater utility weight on downside risk [as modeled by Gul (1991)]. Policy uncertainty is induced by the Disappointment aversion implies that investment, labor and capitalists' income drop at a rate proportional to the standard deviation of the tax rate. Hence, policy uncertainty induces first-order adverse effects, whereas policy uncertainty leads to second-order effects when consumers maximize the conventional expected utility. The adverse effects of policy uncertainty can be partially overcome by a proper investment policy. The paper interprets the tax concessions granted to multinationals as a commitment device that helps overcoming the adverse implications of policy uncertainty.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5825.

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Date of creation: Nov 1996
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Publication status: published as International Journal of Finance & Economics, Vol. 3, no. 2 (April 1998): 97-110
Handle: RePEc:nbr:nberwo:5825

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  1. 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.
  2. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
  3. Pindyck, Robert S. & Solimano, Andrés., 1993. "Economic instability and aggregate investment," Working papers 3552-93., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  4. Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
  5. Ethier, Wilfred J, 1982. "National and International Returns to Scale in the Modern Theory of International Trade," American Economic Review, American Economic Association, vol. 72(3), pages 389-405, June.
  6. Ramey, Garey & Ramey, Valerie A, 1995. "Cross-Country Evidence on the Link between Volatility and Growth," American Economic Review, American Economic Association, vol. 85(5), pages 1138-51, December.
  7. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  8. Joshua Aizenman & Nancy Marion, 1991. "Policy Uncertainty, Persistence and Growth," NBER Working Papers 3848, National Bureau of Economic Research, Inc.
  9. Rivera-Batiz, Luis A & Romer, Paul M, 1991. "Economic Integration and Endogenous Growth," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 531-55, May.
  10. Alesina, Alberto, et al, 1996. " Political Instability and Economic Growth," Journal of Economic Growth, Springer, vol. 1(2), pages 189-211, June.
  11. Uzi Segal & Avia Spivak, 1988. "First Order Versus Second Order Risk Aversion," UCLA Economics Working Papers 540, UCLA Department of Economics.
  12. Anne O. Krueger, 1974. "Foreign Trade Regimes and Economic Development: Turkey," NBER Books, National Bureau of Economic Research, Inc, number krue74-1, May.
  13. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  14. Blomstrom, Magnus & Persson, Hakan, 1983. "Foreign investment and spillover efficiency in an underdeveloped economy: Evidence from the Mexican manufacturing industry," World Development, Elsevier, vol. 11(6), pages 493-501, June.
  15. Roubini, Nouriel & Swagel, Phillip & Ozler, Sule & Alesina, Alberto, 1996. "Political Instability and Economic Growth," Scholarly Articles 4553024, Harvard University Department of Economics.
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Cited by:
  1. Paolo Panteghini, 2000. "On Corporate Tax Asymmetries and Neutrality," CESifo Working Paper Series 276, CESifo Group Munich.
  2. Heikkinen, Tiina & Pietola, Kyosti, 2006. "Investment and the Dynamic Cost of Income Uncertainty: the Case of Diminishing Expectations in Agriculture," Discussion Papers 11868, MTT Agrifood Research Finland.
  3. Klimenko, Mikhail M., 2004. "Industrial targeting, experimentation and long-run specialization," Journal of Development Economics, Elsevier, vol. 73(1), pages 75-105, February.

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