Political Risk And Irreversible Investment: Theory And An Application To Quebec

Sumru Altug, Fanny Demers and Michel Demers (michel_demers@carleton.ca)

No 2405, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Political risk is widely present in developing but also in developed countries, and stems from a variety of sources. The objective of this paper is twofold. First, we develop a theoretical model to investigate the impact of political risk on irreversible investment. Second, we apply our model to an analysis of the risk of separation of the province of Quebec from the Canadian federation. We consider the investment decisions of a monopolistically competitive firm under uncertainty about demand and about the tax-adjusted price of investment goods. We develop a model of irreversible investment which incorporates learning and a regime switch with time-varying transition probabilities. If a given regime represents a riskier environment in terms of the state of demand or the state of investment price, then attaching a positive probability to a switch to that regime increases the marginal adjustment cost of investing, reduces the expected marginal value of capital, and reduces irreversible investment. We use annual sectoral data for the Quebec economy for the period 1983-1996 to match the behaviour of actual investment with simulated series from our model

Keywords: Learning; Irreversible investment; Canada; Political risk; Regime shifts; Trends; Quebec investment (search for similar items in EconPapers)
JEL-codes: D92 E22 O11 O16 (search for similar items in EconPapers)
Date: 2000-03
References: Add references at CitEc
Citations: View citations in EconPapers (4)

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