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A Markup Interpretation of Optimal Rules for Irreversible Investment

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  • Avinash Dixit
  • Robert S. Pindyck
  • Sigbjorn Sodal

Abstract

We re-examine the basic investment problem of deciding when to incur a sunk cost to obtain a stochastically fluctuating benefit. The optimal investment rule satisfies a trade-off between a larger versus a later net benefit; we show that this trade-off is closely analogous to the standard trade-off for the pricing decision of a firm that faces a downward sloping demand curve. We reinterpret the optimal investment rule as a markup formula involving an elasticity that has exactly the same form as the formula for a firm's optimal markup of price over marginal cost. This is illustrated with several examples.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5971.

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Date of creation: Mar 1997
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Publication status: published as Dixit, Aumash, Robert S. Pindyck and Sighiorn Sodal. "A Markup Interpretation Of Optimal Investment Rules," Economic Journal, 1999, v109(455,Apr), 179-189.
Handle: RePEc:nbr:nberwo:5971

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Cited by:
  1. Gianluca Baio & Laura Magazzini & Antonio Nicita & Fabio Pammolli & Massimo Riccaboni, 2003. "Il Decreto DL 15/04/2002, n. 63 sul Contenimento della Spesa Farmaceutica," Working Papers 0-2003, Competitività Regole Mecati (CERM).
  2. Calderon, Cesar & Loayza, Norman & Serven, Luis, 2000. "External sustainability : a stock equilibrium perspective," Policy Research Working Paper Series 2281, The World Bank.
  3. Sodal, Sigbjorn, 1998. "A simplified exposition of smooth pasting," Economics Letters, Elsevier, vol. 58(2), pages 217-223, February.
  4. Arunish Chawla, 2008. "Multinational Firms, Monopolistic Competition and Foreign Investment Uncertainty," CEP Discussion Papers dp0866, Centre for Economic Performance, LSE.
  5. Jamet, Stephanie, 2004. "Irreversibility, uncertainty and growth," Journal of Economic Dynamics and Control, Elsevier, vol. 28(9), pages 1733-1756, July.
  6. Arunish Chawla, 2008. "Multinational firms, monopolistic competition and foreign investment uncertainty," LSE Research Online Documents on Economics 19592, London School of Economics and Political Science, LSE Library.

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