The uncertainty-investment relationship with endogenous capacity

Abstract

This paper revisits the uncertainty-investment relationship with a real-option model. Unlike existing models, the firm chooses both timing and size of investment, hence we use a new composite measure of investment that takes into account both timing and size. With this modification, we show that investment is not necessarily a monotonically decreasing function of uncertainty (or volatility) as predicted by the existing literature. For most parameter value configurations, investment is initially an increasing function and subsequently a decreasing function of uncertainty. This result also holds with the newer Knightian measure of uncertainty. Comparative static analysis indicates that uncertainty is more likely to have a positive effect on investment when demand growth rate and demand volatility are low, and interest rate and operating cost are high. The effect also depends on the production technology; with decreasing-returns-to-scale technology it is more likely to be positive. Finally, it is shown that investment is more sensitive to uncertainty for decreasing-returns-to-scale technology, high cost of production capacity, low operating cost and less market power. While there is some empirical evidence in support of a non-monotonic uncertainty-investment relationship and the role of market power, the other implications of the model have not been empirically tested yet.