A Markup Interpretation of Optimal Investment Rules

Avinash Dixit, Robert Pindyck and Sigbjorn Sodal

Economic Journal, 1999, vol. 109, issue 455, 179-89

Abstract: The authors reexamine the basic investment problem of deciding when to incur a sunk cost to obtain a stochastically fluctuating benefit. The optimal investment rule satisfies a trade-off between a larger versus a later net benefit; they show that this trade-off is closely analogous to the standard trade-off for the pricing decision of a firm that faces a downward sloping demand curve. The authors reinterpret the optimal investment rule as a markup formula involving an elasticity that has exactly the same form as the formula for a firm's optimal markup of price over marginal cost. This is illustrated with several examples.

Date: 1999
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