Optimal Investment under Price and Wage Uncertainty

Jinwu Huang

doi:10.4236/jmf.2013.31013

Abstract

The effects of future output price uncertainty and wage uncertainty on a firm’s investment decision are examined in this paper, by assuming the competitively risk-neutral firm maximizes the expected value of the sum of discounted cash flows. We find that the optimal investment behavior is such that the expected proportional growth rate of investment is invariant over time, although there exists a tradeoff between the effects of the two uncertainty on firm’s investment because the shift in output price has positive effects on firm’s investment, whereas the shift in wage has negative impacts on firm’s investment. And what’s more important, fluctuations in output price and wage are correlated so that changes in output price tend to be accompanied by changes in wage.

Highlights

During the past decades, many scholars studied the effects of uncertainty on a firm’s input and output decisions
We find that the optimal investment behavior is such that the expected proportional growth rate of investment is invariant over time, there exists a tradeoff between the effects of the two uncertainty on firm’s investment because the shift in output price has positive effects on firm’s investment, whereas the shift in wage has negative impacts on firm’s investment
Hartman [1] examined the impacts that increased uncertainty in future output prices, wage rates and investment costs has on the quantity of investment undertaken by a firm, and pointed out current investment doesn’t decrease with increased uncertainty in future output prices as well as wage rates, and invariant to increased uncertainty in future investment costs

Summary

Introduction

Many scholars studied the effects of uncertainty on a firm’s input and output decisions. The effects of demand and cost uncertainty on a firm’s investment, output and pricing decisions are examined in Pindyck [9], the conclusion suggested the desired capital stock and output level will be higher/lower if marginal adjustment costs are rising at an increasing/decreasing rate, under the condition that demand shifts stochastically. Abel [10] demonstrated the results of Hartman [1] continue to hold using the stochastic specification of Pindyck [9] and the analysis of Pindyck’s applies to a so called “target” investment rate which is not optimal in general, by developing a special case of the model in Pindyck’s to verify the effects of output price uncertainty on investment decision for a risk-neutral competitive firm with convex adjustment costs.

Model Description

Capital accumulation equation at time t is defined by

The Effects of Uncertainty on Investment

Concluding Remarks