Optimal Investment with Costly Reversibility

Andrew Abel and Janice Eberly

No 5091, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Investment is characterized by costly reversibility when a firm can purchase capital at a given price and sell capital at a lower price. We derive an explicit analytic solution for optimal investment by a firm facing costly reversibility. In addition, we derive a local approximation to the solution which highlights the effects of the parameters of the problem on the triggers for investment. More generally, we extend the Jorgensonian concept of the user cost of capital to the case of uncertainty and define cU and cL as the user costs of capital associated with the purchase and sale of capital, respectively. Optimality requires the" firm to purchase and sell capital as needed to keep the marginal revenue product of capital in" the closed interval [cU,cL]. This prescription encompasses the case of irreversible investment as well as the standard" neoclassical case of costlessly reversible investment. Finally, quantitative analysis suggests" that even when the difference between the purchase and sale prices of capital is small user costs associated with purchasing and selling capital are closer to those applicable under" complete irreversibility than to those applicable under costless reversibility."

Date: 1995-04
Note: EFG
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Published as Review of Economic Studies, vol.63, no.4, pp.581-593, August 1996.

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Journal Article: Optimal Investment with Costly Reversibility (1996)
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