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Irreversible investment in stochastically cyclical markets

  • Francisco Ruiz-Aliseda
  • Jianjun Wu

This paper presents a new framework for studying irreversible (dis)investment when a market follows a random number of random-length cycles (such as a high-tech product market). It is assumed that a firm facing such market evolution is always unsure about whether the current cycle is the last one, although it can update its beliefs about the probability of facing a permanent decline by observing that no further growth phase arrives. We show that the existence of regime shifts in fluctuating markets suffices for an option value of waiting to (dis)invest to arise, and we provide a marginal interpretation of the optimal (dis)investment policies, absent in the real options literature. The paper also shows that, despite the stochastic process of the underlying variable has a continuous sample path, the discreteness in the regime changes implies that the sample path of the firm’s value experiences jumps whenever the regime switches all of a sudden, irrespective of whether the firm is active or not.

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File URL: http://www.econ.upf.edu/docs/papers/downloads/1018.pdf
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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1018.

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Date of creation: Mar 2007
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Handle: RePEc:upf:upfgen:1018
Contact details of provider: Web page: http://www.econ.upf.edu/

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  1. Ron Adner & Peter Zemsky, 2005. "Disruptive Technologies and the Emergence of Competition," RAND Journal of Economics, The RAND Corporation, vol. 36(2), pages 229-254, Summer.
  2. Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July.
  3. Godfrey Keller & Sven Rady & Martin Cripps, 2005. "Strategic Experimentation with Exponential Bandits," Econometrica, Econometric Society, vol. 73(1), pages 39-68, 01.
  4. Guo, Xin & Miao, Jianjun & Morellec, Erwan, 2005. "Irreversible investment with regime shifts," Journal of Economic Theory, Elsevier, vol. 122(1), pages 37-59, May.
  5. Driffill John & Raybaudi Marzia & Sola Martin, 2003. "Investment Under Uncertainty with Stochastically Switching Profit Streams: Entry and Exit over the Business Cycle," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 7(1), pages 1-40, April.
  6. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
  7. Robert S. Pindyck, 1990. "Irreversibility, Uncertainty, and Investment," NBER Working Papers 3307, National Bureau of Economic Research, Inc.
  8. Kyle Bagwell & Robert W. Staiger, 1995. "Collusion over the Business Cycle," NBER Working Papers 5056, National Bureau of Economic Research, Inc.
  9. Decamps, Jean-Paul & Mariotti, Thomas, 2004. "Investment timing and learning externalities," Journal of Economic Theory, Elsevier, vol. 118(1), pages 80-102, September.
  10. Guiseppe Moscarini & Francesco Squintani, 2004. "Competitive Experimentation with Private Information," Cowles Foundation Discussion Papers 1489, Cowles Foundation for Research in Economics, Yale University.
  11. 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.
  12. Frank Riedel & Xia Su, 2011. "On irreversible investment," Finance and Stochastics, Springer, vol. 15(4), pages 607-633, December.
  13. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474.
  14. 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.
  15. Ben S. Bernanke, 1983. "Irreversibility, Uncertainty, and Cyclical Investment," The Quarterly Journal of Economics, Oxford University Press, vol. 98(1), pages 85-106.
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