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Public Capital and Private Investment, a Real Option Approach

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Listed author(s):
  • Bruno de Oliveira Cruz
  • Aude Pommeret

Abstract

In this paper, we extend the usual models of irreversible investment underuncertainty by introducing the stock of public capital as an input for the privatesector. Public investment takes place in a stochastic environment. Public capital thenincreases the productivity of private capital which is assumed to be fully irreversible.In our model, the government has an intertemporal budget constraint, i.e. taxes arecollected each period to fund the public debt. We provide a partial equilibriumanalysis, as it is standard in models of irreversible investment under uncertainty. Evenunder uncertainty, the optimal tax rate is then constant and does not depend on thesize of uncertainty, it is exactly the same as the one that would prevail in adeterministic world. We show that the government has an insurance role since itremoves part of the uncertainty faced by the firm.

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Paper provided by Instituto de Pesquisa Econômica Aplicada - IPEA in its series Discussion Papers with number 1177.

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Length: 27 pages
Date of creation: Apr 2006
Handle: RePEc:ipe:ipetds:1177
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Find related papers by JEL classification:
  • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
  • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
  • H41 - Public Economics - - Publicly Provided Goods - - - Public Goods

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  8. Turnovsky, Stephen J., 1999. "Productive Government Expenditure In A Stochastically Growing Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 3(04), pages 544-570, December.
  9. 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.
  10. BARRIOS, Salvador & BERTINELLI, Luisito & STROBL, Eric, 2003. "Dry times in Africa: Rainfall and Africa's growth performance," CORE Discussion Papers 2003061, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
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  13. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
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  18. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  19. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
  20. Glomm, Gerhard & Ravikumar, B., 1994. "Public investment in infrastructure in a simple growth model," Journal of Economic Dynamics and Control, Elsevier, vol. 18(6), pages 1173-1187, November.
  21. Paul Cashin, 1995. "Government Spending, Taxes, and Economic Growth," IMF Staff Papers, Palgrave Macmillan, vol. 42(2), pages 237-269, June.
  22. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  23. Arrow, Kenneth J & Lind, Robert C, 1970. "Uncertainty and the Evaluation of Public Investment Decisions," American Economic Review, American Economic Association, vol. 60(3), pages 364-378, June.
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