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Investment and Hysteresis

It seems that firms behave contrary to the standard economic theory of investment. We observe that firms do not invest as soon a price rises above long-run average cost; instead firms wait until price rises substantially above long-run average cost. On the downside, firms stay in business for lengthy periods while absorbing operating losses, and price can fall substantially below average variable cost without inducing disinvestment or exit. Recent developments in the theory of investment under uncertainty offer an interesting new explanation. The new approach builds on an interesting analogy between real investments and options in financial markets: In the timing of investment, waiting has positive value because time brings more information about the future prospects of a project. This new approach suggests that textbook pictures of the dynamics of a competitive industry need to be substantially redrawn. More generally, it says that a great deal of inertia is optimal when dynamic decisions are being made in an uncertain environment.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.6.1.107
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Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 6 (1992)
Issue (Month): 1 (Winter)
Pages: 107-132

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Handle: RePEc:aea:jecper:v:6:y:1992:i:1:p:107-32
Note: DOI: 10.1257/jep.6.1.107
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  1. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
  2. Pindyck, Robert, 1989. "Irreversibility, uncertainty, and investment," Policy Research Working Paper Series 294, The World Bank.
  3. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  4. Dixit, Avinash K, 1989. "Hysteresis, Import Penetration, and Exchange Rate Pass-Through," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 205-28, May.
  5. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  6. Dixit, Avinash, 1991. "Irreversible Investment with Price Ceilings," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 541-57, June.
  7. Mankiw, N Gregory, 1985. "Small Menu Costs and Large Business Cycles: A Macroeconomic Model," The Quarterly Journal of Economics, MIT Press, vol. 100(2), pages 529-38, May.
  8. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
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