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Irreversible Investment with Uncertainty and Scale Economies

  • Avinash Dixit
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    This paper analyses optimal irreversible investment policy when profits are subject to a multiplicative geometric Brownian motion shock. The marginal product of capital is increasing initially and decreasing thereafter. In the latter range, optimal policy is familiar: capacity is added gradually as the shock rises to a threshold where the expected return on the marginal unit is a required multiple of the cost of capital. The multiple reflects the option value of waiting. The optimal policy in the increasing marginal product range obeys the same multiple, now applied to the total return on the discrete increase in capital. Implications for economic growth, and suboptimal equilibria under external economies, are examined.

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    File URL: http://sticerd.lse.ac.uk/dps/te/te240.pdf
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    Paper provided by Suntory and Toyota International Centres for Economics and Related Disciplines, LSE in its series STICERD - Theoretical Economics Paper Series with number 240.

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    Date of creation: May 1992
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    Handle: RePEc:cep:stitep:240
    Contact details of provider: Web page: http://sticerd.lse.ac.uk/_new/publications/default.asp

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