Investment under Uncertainty, Irreversibility and the Arrival of Information Over Time

Abstract

In this paper, we consider a risk-neutral competitive firm which is uncertain about the true state of demand. We build upon Arrow by demonstrating that the irreversibility of investment in physical capital together with the anticipation of receiving information and of learning the state of demand lead to (1) cautious investment behaviour and hence, to lower investment levels than otherwise since the firm cannot disinvest if market conditions turn out to be less favourable than currently anticipated; (2) a time-varying risk premium, or marginal “adjustment cost” which is shown to arise endogenously and to be positively related to the investment level and to the anticipation of greater information in the sense of Blackwell (1951, 1953); (3) a gradual adjustment of the capital stock to the desired level, defined as the optimal capital stock corresponding to the true state of demand.

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