The effect of mean reversion on entry and exit decisions under uncertainty
Many economic variables of interest exhibit a tendency to revert to predictable long-run levels. However, mean reverting processes are rarely used in investment models in the literature. In most models, geometric Brownian motion processes are used for tractability. In this paper, a firm's entry and exit decisions when the output equilibrium price follows an exogenous mean reverting process are examined, and then compared to the decisions of the firm under the usually employed assumption of lognormally distributed output price, presented in Dixit (1989a). By extending previous work by Sarkar (2003) to account for costly reversibility, we show that mean reversion has a significant effect, not only on firm-specific entry and exit decisions, but also on the balance of entering and exiting firms in an industry/market. Thus it would be erroneous to use the more tractable geometric Brownian motion process as an approximation for a mean-reverting process in models and investigations of aggregate industry investment.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, vol. 39(5), pages 659-681, September.
- Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
- Nagae, Takeshi & Akamatsu, Takashi, 2008. "A generalized complementarity approach to solving real option problems," Journal of Economic Dynamics and Control, Elsevier, vol. 32(6), pages 1754-1779, June.
- Andrew B. Abel & Janice C. Eberly, 1996. "Optimal Investment with Costly Reversibility," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 581-593.
- Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
- Majd, Saman & Pindyck, Robert S., 1987.
"Time to build, option value, and investment decisions,"
Journal of Financial Economics,
Elsevier, vol. 18(1), pages 7-27, March.
- Saman Majd & Robert S. Pindyck, 1985. "Time to Build, Option Value, and Investment Decisions," NBER Working Papers 1654, National Bureau of Economic Research, Inc.
- Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-985, December.
- Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Robert S. Pindyck, 1986. "Irreversible Investment, Capacity Choice, and the Value of the Firm," NBER Working Papers 1980, National Bureau of Economic Research, Inc.
- Avinash Dixit, 1989. "Hysteresis, Import Penetration, and Exchange Rate Pass-Through," The Quarterly Journal of Economics, Oxford University Press, vol. 104(2), pages 205-228.
- Lund, Diderik, 2005. "How to analyze the investment-uncertainty relationship in real option models?," Review of Financial Economics, Elsevier, vol. 14(3-4), pages 311-322.
- Diderik Lund, 2003. "How to analyze the investment–uncertainty relationship in real option models?," EPRU Working Paper Series 03-17, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
- Metcalf, Gilbert E. & Hassett, Kevin A., 1995. "Investment under alternative return assumptions Comparing random walks and mean reversion," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1471-1488, November.
- Gilbert E. Metcalf & Kevin A. Hassett, 1995. "Investment Under Alternative Return Assumptions: Comparing Random Walks and Mean Reversion," NBER Technical Working Papers 0175, National Bureau of Economic Research, Inc.
- Shackleton, Mark B. & Tsekrekos, Andrianos E. & Wojakowski, Rafal, 2004. "Strategic entry and market leadership in a two-player real options game," Journal of Banking & Finance, Elsevier, vol. 28(1), pages 179-201, January.
- Bessembinder, Hendrik, et al, 1995. " Mean Reversion in Equilibrium Asset Prices: Evidence from the Futures Term Structure," Journal of Finance, American Finance Association, vol. 50(1), pages 361-375, March.
- Lund Diderik, 1993. "The Lognormal Diffusion Is Hardly an Equilibrium Price Process for Exhaustible Resources," Journal of Environmental Economics and Management, Elsevier, vol. 25(3), pages 235-241, November.
- Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
- Richard Baldwin & Paul Krugman, 1989. "Persistent Trade Effects of Large Exchange Rate Shocks," The Quarterly Journal of Economics, Oxford University Press, vol. 104(4), pages 635-654.
- Richard Baldwin & Paul R. Krugman, 1986. "Persistent Trade Effects of Large Exchage Rate Shocks," NBER Working Papers 2017, National Bureau of Economic Research, Inc.
- Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Sarkar, Sudipto, 2000. "On the investment-uncertainty relationship in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(2), pages 219-225, February.
- Samuel Bentolila & Giuseppe Bertola, 1990. "Firing Costs and Labour Demand: How Bad is Eurosclerosis?," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 381-402.
- Pindyck, Robert S, 1991. "Irreversibility, Uncertainty, and Investment," Journal of Economic Literature, American Economic Association, vol. 29(3), pages 1110-1148, September.
- Pindyck, Robert, 1989. "Irreversibility, uncertainty, and investment," Policy Research Working Paper Series 294, The World Bank.
- Pindyck, Robert S., 1990. "Irreversibility, uncertainty, and investment," Working papers 3137-90., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Robert S. Pindyck, 1990. "Irreversibility, Uncertainty, and Investment," NBER Working Papers 3307, National Bureau of Economic Research, Inc.
- Herrera, Luis Oscar & Valdes, Rodrigo O., 2001. "The effect of capital controls on interest rate differentials," Journal of International Economics, Elsevier, vol. 53(2), pages 385-398, April.
- Herrera, L.O. & Valdes, R., 1999. "The Effect of Capital Controls on Interest Rate Differentials," Papers 50, Cambridge - Risk, Information & Quantity Signals.
- Luis Oscar Herrera & Rodrigo Valdés, 1999. "The Effect of Capital Controls on Interest Rate Differentials," Working Papers Central Bank of Chile 50, Central Bank of Chile.
- Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-638, June.
- Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
- Dumas, Bernard, 1991. "Super contact and related optimality conditions," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 675-685, October.
- Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
- McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-349, June.
- Bhattacharya, Sudipto, 1978. "Project Valuation with Mean-Reverting Cash Flow Streams," Journal of Finance, American Finance Association, vol. 33(5), pages 1317-1331, December. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:eee:dyncon:v:34:y:2010:i:4:p:725-742. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Dana Niculescu)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.