The uncertainty-investment relationship with endogenous capacity

Sudipto Sarkar

Omega, 2021, vol. 98, issue C

Abstract: This paper revisits the uncertainty-investment relationship with a real-option model. Unlike existing models, the firm chooses both timing and size of investment, hence we use a new composite measure of investment that takes into account both timing and size. With this modification, we show that investment is not necessarily a monotonically decreasing function of uncertainty (or volatility) as predicted by the existing literature. For most parameter value configurations, investment is initially an increasing function and subsequently a decreasing function of uncertainty. This result also holds with the newer Knightian measure of uncertainty. Comparative static analysis indicates that uncertainty is more likely to have a positive effect on investment when demand growth rate and demand volatility are low, and interest rate and operating cost are high. The effect also depends on the production technology; with decreasing-returns-to-scale technology it is more likely to be positive. Finally, it is shown that investment is more sensitive to uncertainty for decreasing-returns-to-scale technology, high cost of production capacity, low operating cost and less market power. While there is some empirical evidence in support of a non-monotonic uncertainty-investment relationship and the role of market power, the other implications of the model have not been empirically tested yet.

Keywords: Uncertainty; Volatility; Investment; Real-option model (search for similar items in EconPapers)
JEL-codes: D2 G3 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jomega:v:98:y:2021:i:c:s0305048318314233

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DOI: 10.1016/j.omega.2019.102115

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