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Expected Profitability of Capital under Uncertainty – a Microeconomic Perspective

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  • Pedro Rui Mazeda Gil

    ()
    (Faculdade de Economia, Universidade do Porto)

Abstract

Hartman (1972) and Abel (1983) showed that when firms are competitive and there is flexibility of labour relative to capital, marginal profitability of capital is a convex function of the stochastic variable (e.g., price); by Jensen’s inequality, this means that uncertainty increases the expected profitability of capital, which increases the incentive to invest. We argue that, besides factor substitutability, the relevant assumption for the convexity property to hold is the implicit assumption about the choice variable in the representative firm’s maximisation problem: the assumption of perfect competition implies that the choice variable is output and that price is exogenous. However, in the case of a firm facing a downward-sloping demand curve, both output and output price emerge as the possible choice variable. We show that, when price is the choice variable, marginal profitability of capital is a concave function of the stochastic variable; hence, by Jensen’s inequality, an increase in uncertainty decreases the expected profitability of capital. We also show that keeping the assumption of factor substitutability but changing the share of labour in the production function has an important impact on the degree of concavity/convexity of the capital profit function.

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Bibliographic Info

Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 157.

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Length: 18 pages.
Date of creation: Sep 2004
Date of revision:
Handle: RePEc:por:fepwps:157

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Keywords: Expected Profitability; Uncertainty; Jensen’s Inequality.;

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  1. Leahy, John V & Whited, Toni M, 1996. "The Effect of Uncertainty on Investment: Some Stylized Facts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(1), pages 64-83, February.
  2. Andrew B. Abel & Janice B. Eberly, . "The Effects of Irreversibility and Uncertainty on Capital Accumulation," Rodney L. White Center for Financial Research Working Papers 21-95, Wharton School Rodney L. White Center for Financial Research.
  3. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-85, December.
  4. 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.
  5. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  6. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  7. Andrew B. Abel & Janice C. Eberly, . "A Unified Model of Investment Under Uncertainty," Rodney L. White Center for Financial Research Working Papers 14-93, Wharton School Rodney L. White Center for Financial Research.
  8. Pindyck, Robert S, 1993. "A Note on Competitive Investment under Uncertainty," American Economic Review, American Economic Association, vol. 83(1), pages 273-77, March.
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