Irreversibility, Uncertainty, and Investment

Robert Pindyck

No 3307, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Most investment expenditures have two important characteristics: First, they are largely irreversible; the firm cannot disinvest, so the expenditures are sunk costs. Second, they can be delayed, allowing the firm to wait for new information about prices, costs, and other market conditions before committing resources. An emerging literature has shown that this has important implications for investment decisions, and for the determinants of investment spending. Irreversible investment is especially sensitive to risk, whether with respect to future cash flows, interest rates, or the ultimate cost of the investment. Thus if a policy goal is to stimulate investment, stability and credibility may be more important than tax incentives or interest rates. This paper presents some simple models of irreversible investment, and shows how optimal investment rules and the valuation of projects and firms can be obtained from contingent claims analysis, or alternatively from dynamic programming. It demonstrates some strengths and limitations of the methodology, and shows how the resulting investment rules depend on various parameters that come from the market environment. It also reviews a number of results and insights that have appeared in the literature recently, and discusses possible policy implications.

Date: 1990-03
Note: ME
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Citations: View citations in EconPapers (356)

Published as Journal of Economic Literature, Vol. XXIX, pp. 1110-1148, (September 1991).

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Journal Article: Irreversibility, Uncertainty, and Investment (1991)
Working Paper: Irreversibility, uncertainty, and investment (1990)
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