The dynamic effects of real options and irreversibility on investment and labour demand

Abstract

This paper shows that, contrary to common beliefs, the real options effect of uncertainty plays no role in the long run rate of investment. This is proven for both the standard investment model with Cobb-Douglas production and Brownian motion demand, and also for a broader class of models with multiple lines of capital, labor and general demand stochastics. Real options and irreversibility, however, are shown to play an important role in the short run dynamics of investment and labor demand. Specifically, they reduce the short run response of investment and hiring to current demand shocks, and lead to a lagged response to past demand shocks.