A MODEL FOR THE LONG-TERM OPTIMAL CAPACITY LEVEL OF AN INVESTMENT PROJECT

Arne Løkka () and Mihail Zervos ()
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Arne Løkka: Department of Mathematics, Columbia House, London School of Economics, Houghton Street, London WC2A 2AE, UK
Mihail Zervos: Department of Mathematics, Columbia House, London School of Economics, Houghton Street, London WC2A 2AE, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2011, vol. 14, issue 02, 187-196

Abstract: We consider an investment project that produces a single commodity. The project's operation yields payoff at a rate that depends on the project's installed capacity level and on an underlying economic indicator such as the output commodity's price or demand, which we model by an ergodic, one-dimensional Itô diffusion. The project's capacity level can be increased dynamically over time. The objective is to determine a capacity expansion strategy that maximizes the ergodic or long-term average payoff resulting from the project's management. We prove that it is optimal to increase the project's capacity level to a certain value and then take no further actions. The optimal capacity level depends on both the long-term average and the volatility of the underlying diffusion.

Keywords: Capacity expansion; stochastic payoff; irreversible investment; singular control; ergodic optimization; Itô diffusion (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (6)

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DOI: 10.1142/S0219024911006322

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