On the Sign of the Investment-Uncertainty Relationship

Abstract

Understanding the effects of uncertainty over any decision variable has fascinated economists for a long time. Risk aversion and incomplete markets are likely to make the investment-uncertainty relationship negative (e.g., Roger Craine, 1989; Joseph Zeira, 1989). What happens in the absence of risk aversion and incomplete markets is, however, ambiguous. Richard Hartman (1972) and Andrew B. Abel (1983, 1984, 1985) found that in the presence of (symmetric) convex costs of adjustment, mean-preserving increases in price uncertainty raise investment of a competitive firm as long as the profit function is convex in prices. On the other hand, the recent literature on irreversible investment (e.g., Robert S. Pindyck, 1988; Giuseppe Bertola, 1988) has shown that increases in uncertainty lower investment. All these results have been derived under either risk neutrality or complete markets.' Intuition suggests that the explanation for such a difference lies with the asymmetric nature of adjustment costs in the irreversible-investment case, as compared with the symmetry of the adjustment-cost mechanisms proposed by Abel and Hartman. Although this intuition is confirmed in this paper, asymmetric adjustment costs are shown not to be sufficient to explain why the results differ. In fact, a more hidden but at least as important difference between these two literatures is that the former assumes perfect competition and constant returns to scale, whereas the latter assumes either imperfect competition or decreasing returns to scale (or both).2 The purpose of this paper is to highlight the role of the decreasing marginal return to capital assumption (due to either imperfect competition or decreasing returns to scale [or both]) in determining the effects of adjustment-cost asymmetries on the sign of the response of investment to changes in uncertainty (under risk neutrality). For this, the paper develops a simple model with a cost-of-adjustment mechanism general enough to consider both symmetric-convexity and irreversibility as special cases. One of the most important findings is the lack of robustness of the negative relationship between investment and uncertainty under asymmetric adjustment costs3 to changes in the degree of competition. In fact, when firms are nearly competitive, the conclusion of Hartman and of Abel holds no matter how asymmetric adjustment costs are. Studying adjustment-cost mechanisms has a central role in understanding the dynamics of investment and its business-cycle implications, but conclusive results about the sign of the instantaneous relationship between uncertainty and investment should not be *Department of Economics, Columbia University, New York, NY 10027. I am grateful to Giuseppe Bertola, Prajit Dutta, Glen Hubbard, Anil Kashyap, Richard Lyons, and the referees for their useful comments. 1The financial literature on investment has considered risk aversion through a premium in the discount rate determined by the CAPM, (capital asset pricing model), intertemporal CAPM, or consumption CAPM. However, often this discount rate is left unchanged when studying the response of investment to uncertainty changes (e.g., Pindyck, 1988 pp. 974-5), thereby omitting the effect of changes in uncertainty on investment due to risk aversion (and incomplete markets). 2In the typical version of the irreversible-investment problem, there is no cost of upward adjustments; thus, imperfect competition and (or) decreasing returns to scale are required to bound the size of the firm. 3In this paper, asymmetric adjustment cost refers to the case in which it is more expensive to adjust downward than upward. Certainly, the opposite case is a trivial extension of the case studied in this paper.