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Irreversible Investment, Incremental Capital Accumulation, and Price Uncertainty

Author

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  • Luis H.R. Alvarez E.

    () (Department of Economics, Quantitative Methods in Management, Turku School of Economics)

Abstract

We consider optimal incremental capital accumulation in the presence of investment irreversibility and general price uncertainty. We present a set of general conditions under which the optimal capital accumulation path can be explicitly characterized in terms of an ordinary threshold rule stating that investment is optimal whenever the underlying price exceeds a capital-dependent threshold. We also present a set of general conditions under which increased price volatility expands the region where investment is suboptimal and decreases both the expected cumulative present value of the marginal revenue product of capital and the value of the future expansion options.

Suggested Citation

  • Luis H.R. Alvarez E., 2006. "Irreversible Investment, Incremental Capital Accumulation, and Price Uncertainty," Discussion Papers 4, Aboa Centre for Economics.
  • Handle: RePEc:tkk:dpaper:dp4
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    File URL: http://www.ace-economics.fi/kuvat/ACE4%20Alvarez.pdf
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    References listed on IDEAS

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    1. Andrew B. Abel & Avinash K. Dixit & Janice C. Eberly & Robert S. Pindyck, 1996. "Options, the Value of Capital, and Investment," The Quarterly Journal of Economics, Oxford University Press, vol. 111(3), pages 753-777.
    2. Alvarez, Luis H R & Koskela, Erkki, 2003. "On Forest Rotation under Interest Rate Variability," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 10(4), pages 489-503, August.
    3. Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1992. "Waiting to Invest: Investment and Uncertainty," The Journal of Business, University of Chicago Press, vol. 65(1), pages 1-29, January.
    4. Ricardo J. Caballero & John V. Leahy, 1996. "Fixed Costs: The Demise of Marginal q," NBER Working Papers 5508, National Bureau of Economic Research, Inc.
    5. Dixit, Avinash, 1995. "Irreversible investment with uncertainty and scale economies," Journal of Economic Dynamics and Control, Elsevier, vol. 19(1-2), pages 327-350.
    6. L. Wade, 1988. "Review," Public Choice, Springer, vol. 58(1), pages 99-100, July.
    7. Pindyck, Robert S, 1991. "Irreversibility, Uncertainty, and Investment," Journal of Economic Literature, American Economic Association, vol. 29(3), pages 1110-1148, September.
    8. Alvarez, Luis H. R. & Koskela, Erkki, 2005. "Wicksellian theory of forest rotation under interest rate variability," Journal of Economic Dynamics and Control, Elsevier, vol. 29(3), pages 529-545, March.
    9. Caballero, Ricardo J., 1999. "Aggregate investment," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 12, pages 813-862 Elsevier.
    10. 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.
    11. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
    12. 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.
    13. Andrew B. Abel & Janice C. Eberly, 1995. "Optimal Investment with Costly Reversibility," NBER Working Papers 5091, National Bureau of Economic Research, Inc.
    14. Anders ├╗ksendal, 2000. "Irreversible investment problems," Finance and Stochastics, Springer, vol. 4(2), pages 223-250.
    15. Luis H. R. Alvarez & Erkki Koskela, 2006. "Irreversible Investment under Interest Rate Variability: Some Generalizations," The Journal of Business, University of Chicago Press, vol. 79(2), pages 623-644, March.
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    More about this item

    Keywords

    Price uncertainty; irreversible investment; incremental capital accumulation.;

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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