Irreversible Investment and Knightian Uncertainty

Kiyohiko G. Nishimura and Hiroyuki Ozaki
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Kiyohiko G. Nishimura: Faculty of Economics, University of Tokyo
Hiroyuki Ozaki: Faculty of Economics, Tohoku University

No CIRJE-F-176, CIRJE F-Series from CIRJE, Faculty of Economics, University of Tokyo

Abstract: When firms decide about irreversible investment, they may not have perfect confidence about their perceived probability measure describing future uncertainty. They may think other probability measures perturbed from the original one are also probable. Uncertainty characterized by not a single probability measure but a set of probability measures is called Knightian uncertainty. The effect of Knightian uncertainty on the value of irreversible investment opportunity is shown to be drastically different from that of the traditional uncertainty in the form of risk. Specifically, an increase in Knightian uncertainty decreases the value of investment opportunity while an increase in risk increases it.

Pages: 41 pages
Date: 2002-09
New Economics Papers: this item is included in nep-ent
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