Irreversible Investment Research Articles

Irreversible investment with fixed adjustment costs: a stochastic impulse control approach

We consider an optimal stochastic impulse control problem over an infinite time horizon motivated by a model of irreversible investment choices with fixed adjustment costs. By employing techniques of viscosity solutions and relying on semiconvexity arguments, we prove that the value function is a classical solution to the associated quasi-variational inequality. This enables us to characterize the structure of the continuation and action regions and construct an optimal control. Finally, we focus on the linear case, discussing, by a numerical analysis, the sensitivity of the solution with respect to the relevant parameters of the problem.

Real options valuation of an IoT based healthcare device with interval Type-2 fuzzy numbers

Medical devices have attained increasing importance in diagnosis and treatment in the healthcare system in recent years due to technological advancements. Along with this progress, the IoT property in these devices reduces the supply time, which is very critical in increasing their up periods. Often, certain medical devices used in treatment require a major portion of the investment. Such huge capital goods are generally irreversible investments. Depending on the strategic view and irreversibility, medical device assessment requires a sophisticated evaluation method called real options. However, there are many ambiguities during the investment period and while gathering the data for the evaluation. Interval type-2 fuzzy logic fits like a glove for such vague conditions and lack of data. In this study, an interval type-2 fuzzy set integrated real option analysis is offered for medical treatment device evaluation. Possibilistic mean value and possibilistic variance of interval type-2 fuzzy sets are found for the purpose of the real options analysis. This offered method is applied to a real case in a healthcare system. Sensitivity analysis provides many different viewpoints. At the end of the procedure, the institution decides whether to perform the investment now or one year later.

Exchange rate uncertainty and firm-level investment: Finding the Hartman–Abel effect

Motivated by Lee and Shin (2000, AER), we study the interplay of the share of variable input, investment irreversibility, and market power in shaping the relationship between investment and uncertainty. Employing a large panel of Chinese manufacturing firms, combined with industry-specific exchange rates for the period 1998–2006, our system Generalized Method of Moments (GMM) estimation finds that uncertainty significantly encourages (discourages) investment for firms with high (low) labor share or low (high) investment irreversibility, and the impact is magnified for firms with low market power. Our paper demonstrates the importance of the share of variable input, investment irreversibility, and market power in the Hartman–Abel paradoxical effect that predicts a positive relationship between uncertainty and investment in the international economics context.

The Effect of Risk on Investment: New Evidence

Previous results on the relation between risk and investment are mixed, partly due to endogeneity. To allievate the effects of this bias, we adopt a generalized method of moments (GMM) dynamic panel estimator to investigate the relation. We find that the puzzling positive sensitivity of investment (i.e. firm’s investment rate) to systematic risk as frequently documented in previous studies disappears. Further, we show that the more irreversible the firm’s investments are, the more valuable is the option to delay investment when risk is high, which supports the model with irreversible investment.

China’s Investment Incentive Strategy for Shale Gas Development

ABSTRACT Against the backdrop of the uncertainty and irreversibility of shale gas development investment, we use the real option analysis framework to study how the government can optimally arrange an investment incentive policy for shale gas development and promote the immediate investment of enterprises under shale gas price uncertainty. In this article, we present two types of investment incentive policies for shale gas development, namely tax reductions and production subsidies. The output characteristics of shale gas development are included in the real option model. From this study, the government incentive level required to trigger the immediate investment of enterprises will rise with an increase in shale gas price volatility and the output decline rate and decrease with an increase in the initial gas recovery rate. When shale gas price volatility and the output decline rate are less than a certain level or the initial recovery rate is greater than a certain level, enterprises’ investment will be spontaneous, even without government incentives. The study reveals that shale gas development incentives for the immediate investment of enterprises need to focus not only on the uncertainty of the external environment, but also on the shale gas resource endowment characteristics in Chinese regions.

Geopolitical Risk and Investment

Using a news-based index of geopolitical risk (GPR), we document a strong negative relationship between firm-level corporate investment and GPR. When the GPR index doubles, investment rate in the next quarter declines by 14% of its sample mean. The effect is more pronounced for firms with more irreversible investment or higher market power, confirming the real options theory. However, the effect is less significant for firms with a stronger ability to substitute labor for capital or with a higher labor-to-capital ratio, supporting the convex return theory. Furthermore, the impact of GPR on investment varies across geopolitically-sensitive sectors. It is stronger for firms in the tourism and its related sectors and is weaker for firms in the defense sector. Overall, our results suggest that the real options channel dominates the Oi-Hartman-Abel effect in driving the negative GPR-investment relationship.

Capital Accumulation, Green Paradox, and Stranded Assets: An Endogenous Growth Perspective

The existing studies on Green Paradox and stranded assets focus on dirty exhaustible assets (fossil fuel reserves) and show that environmental regulations, by changing the costs of dirty inputs relative to clean ones, lead to replacements of the former by the latter and stranding of dirty assets due to perfect substitution. It, in turn, induces acceleration of dirty resource extractions and pollution emissions for fear of dirty assets becoming stranded - the Green Paradox effect. This paper uses an endogenous growth framework to revisit the problem of Green Paradox and stranded assets by taking a new perspective that focuses on capital accumulation with investment irreversibility. We show that if 1) direct irreversibility of investment does not rule out the indirect channel of converting dirty capital goods into clean ones through final goods allocations, and 2) interactions between dirty and clean capital as imperfect substitutes can generate reciprocal effects, then environmental regulation, through directing investment towards clean capital, does not necessarily leads to asset stranding of dirty capital. Accumulation of clean capital with a pollution-saving effect offsets the polluting impact of dirty one and leads to reversed Green Paradox. We further propose an endogenous growth mechanism through which the accumulation of both dirty and clean capital, as well as environmental improvement, can be sustained in the long run without converging to the steady state.

Modelling the impact of market imperfections on farm household investment in stand-alone solar PV systems

Abstract Access to electricity in rural Sub-Saharan Africa, where livelihoods are predominantly based on small scale farming, is significantly low. Extending centralised national electricity grids to these rural areas faces significant technical and financial constraints. As a result, many see household-financed decentralised technologies such as small standalone solar photovoltaic (PV) systems as being important for achieving greater electricity access. However, rural farm households typically face a range of market imperfections including lack of access to credit, investment irreversibility (or absence of second-hand markets) and farm production/income risk which act as barriers to their ability and/or willingness to invest. This paper examines how these market imperfections impact on the adoption of standalone solar PV systems for small scale farm households in Uganda. We consider how temporary or permanent these barriers to adoption are when farm production/income is uncertain. We do so by using a dynamic programming model which captures household investment in small scale solar PV systems where significant positive benefits arise through assumed improved farm productivity or income effects, while allowing for credit constraints, investment irreversibility and income risk. Although strong positive incentives exist in the model to adopt a solar PV system, the results show that adoption rates are substantially lower for credit constrained households, with only 40% of these households adopting immediately, compared with over 70% of credit unconstrained households. While these adoption rates do increase over time, only 60% of credit constrained households have adopted within 5 years compared with nearly all credit unconstrained households adopting within the same time period. In the longer term for almost 30% of households the credit constraints act as a permanent barrier to adoption. The presence of a well-functioning second-hand market does increase household consumption and welfare but the impacts on overall adoption rates are rather small.

Target leaf spot of tomato incited by Corynespora cassiicola, an emerging disease in tomato production under Gangetic alluvial region of West Bengal, India

Tomato (Lycopersicon esculentum Mill.) is a cosmopolitan vegetable and widely cultivated in almost all the countries of the world including India. Irreversible investment – production ratio for tomato cultivation in recent Indian agricultural systems arise the question, is there any biotic backlogs responsible for such a production loss. Our present investigation is based on this fact. Target leaf spot disease of tomato is caused by Corynespora cassiicola, a serious and emerging disease in India. Prolonged real time surveillance of this disease on tomato from 2010–11 to 2016–17, reflects some remarkable features of pathogenic progress in Gangetic alluvial region of West Bengal. This pathogen is the natural barrier for tomato production with a disease severity ranged between 35% and 58% which ultimately causes tremendous loss of tomato foliage and fruits. C. cassiicola was identified on the basis of morpho-cultural (ITCC Accession No. 7542) and molecular characterization (Genbank Accession No. KJ767193). Homology searching of internal transcribed spacer region of CcHaTom isolate was highly matched with Genbank Accession No. KP666184 (Cynodondactylon/India), AB873045 (Vitex negundo/India) and JN541214 (Malvaviscus concinnus/USA) with 95% similarity. Phylogenetic analysis established that KJ767193 and C. cassiicola retrieved sequences were conspecific from a common ancestral origin, which supports its neighbourhood with this fungal pathogen. Optimum temperature between 24 and 25 °C, coupled with 80–85% relative humidity triggered the disease progress. From the emerging scenario, C. cassiicola infecting tomato is the real threat for indigenous cultivars.

Dynamic capital allocation with irreversible investments

Capital allocation models generally assume that the risk portfolio is constructed at a single point in time, when the underwriter has full information about available underwriting opportunities. However, in practice, opportunities are not all known at the beginning but instead arrive over time. Moreover, a commitment to an opportunity is not easy to change as time passes. Thus, to optimize a portfolio, the underwriter must make decisions on opportunities as they arrive while making use of assumptions about what will arrive in the future. This paper studies capital allocation rules in this setting, finding important differences from the static setting. The pricing of an opportunity is based on an expected future marginal cost of risk associated with that opportunity—one that will be fully understood only after the risk portfolio is finalized. The risk charge for today’s opportunity is thus a probability-weighted average of the product of the marginal value of capital in future states of the world and the amount of capital consumed by the opportunity in those future states. Our numerical examples illustrate how the marginal cost of risk for an opportunity is shaped by when it arrives in time, as well as what has arrived before it.

Instrument choice and stranded assets in the transition to clean capital

This paper compares the impact of different climate mitigation policies — mandates, feebates, performance standards, and carbon pricing — in a Ramsey model with clean and polluting capital, irreversible investment, and a climate constraint. These policy instruments imply different transitions to the same balanced growth path. The optimal carbon price minimizes the discounted social cost of the transition to clean capital, but may prompt premature retirement of existing polluting capacities and significant private costs in the form of stranded assets. Second-best mandates and feebates affect new investment decisions without providing incentives to under-use existing polluting equipment. These instruments lead to higher discounted social costs, but smoother abatement costs, and do not result in premature retirement or stranded assets. A phased-in carbon price can avoid premature retirement but still result in stranded assets, that is in a drop of wealth for the owners of polluting capital. We discuss a potential trade-off between the political feasibility and cost-effectiveness of climate mitigation policies.

Ratcheting with a bliss level of consumption

In this paper we study the portfolio selection problem of an agent who has a bliss point of consumption and does not tolerate a decline in consumption. We show that the optimal consumption process exhibits ratcheting and, as time elapses, the agent’s consumption approaches but never reaches the bliss level and her/his optimal investment in the risky asset approaches zero if the initial wealth level is not sufficient to maintain it. We use the martingale method and study the dual problem, which is similar to an incremental irreversible investment problem. We transform the dual problem into an optimal stopping problem, which has the same characteristic as finding the optimal exercise time of a perpetual American put option. We recover the value function by establishing a duality relationship and obtain a closed-form solution for the optimal consumption and portfolio strategy.

Geopolitical Risk and Corporate Investment

We find that shocks to aggregate geopolitical uncertainty are associated with an average decline in firm-level capital investment. The decline in investments increases in the degree of external financial constraints faced by firms, with the effect being stronger for more irreversible investments. A surprising and hitherto unexplored result is the role of firm-level liquidity as a necessary catalyst in linking investment plan revisions and uncertainty – without sufficient cash reserves, the negative relation between investments and uncertainty becomes insignificant.

What are the macroeconomic effects of high‐frequency uncertainty shocks?

SummaryThis paper evaluates the effects of high‐frequency uncertainty shocks on a set of low‐frequency macroeconomic variables representative of the US economy. Rather than estimating models at the same common low frequency, we use recently developed econometric models, which allow us to deal with data of different sampling frequencies. We find that credit and labor market variables react the most to uncertainty shocks in that they exhibit a prolonged negative response to such shocks. When looking at detailed investment subcategories, our estimates suggest that the most irreversible investment projects are the most affected by uncertainty shocks. We also find that the responses of macroeconomic variables to uncertainty shocks are relatively similar across single‐frequency and mixed‐frequency data models, suggesting that the temporal aggregation bias is not acute in this context.

Equilibrium commodity prices with irreversible investment and non-linear technologies

Abstract We model oil price dynamics in a general equilibrium production economy with two goods: a consumption good and oil. Production of the consumption good requires drawing from oil reserves at a fixed rate. Investment necessary to replenish oil reserves is costly and irreversible. We solve for the optimal consumption, production and oil reserves policy for a representative agent. We analyze the equilibrium price of oil, as well as the term structure of oil futures prices. Because investment in oil reserves is irreversible and costly, the optimal investment in new oil reserves is periodic and lumpy. Investment occurs when the crude oil is relatively scarce in the economy. This generates an equilibrium oil price process that has distinct behavior across two regions (characterized by the abundance/scarcity of oil). We undertake three empirical tests suggested by our model. First, we estimate key parameters using SMM to match moments of oil price futures as well as other macroeconomic properties of the data. Second, we estimate an affine regime switching model of the oil price, which captures the main features of our equilibrium model and preserves the tractability of reduced-form models. Lastly, we compare the risk premium in short-maturity oil futures implied by our model to the data.

Preemptive investment under uncertainty

This paper provides a general characterization of subgame-perfect equilibria for strategic timing problems, where two firms have the (real) option to make an irreversible investment. Profit streams are uncertain and depend on the market structure. The analysis is based directly on the inherent economic structure of the model. In particular, determining equilibria with preemptive investment is reduced to solving a single class of constrained optimal stopping problems. Further tools are derived for analyzing Markovian state-space models. Applications to typical models from the literature complete commonly insufficient equilibrium arguments, show when uncertainty leads to qualitatively different behavior, and establish additional equilibria that are Pareto improvements.

Preemptive Investment under Uncertainty

This paper provides a general characterization of subgame perfect equilibria for strategic timing problems, where two firms have the (real) option to make an irreversible investment. Profit streams are uncertain and depend on the market structure. The analysis is based directly on the inherent economic structure of the model. In particular, the determination of equilibria with preemptive investment is reduced to solving a single class of constrained optimal stopping problems. The general results are applied to typical state-space models, completing commonly insufficient equilibrium arguments, showing when uncertainty leads to qualitatively different behavior, and establishing additional equilibria that are Pareto improvements.

Improvisation for innovation: The contingent role of resource and structural factors in explaining innovation capability

This paper focuses on resource and structural factors to explore the relationship between organizational improvisation and innovation capability. Although the role of improvisation has attracted increasing academic attention in fast-changing environments, little is known about the conditions under which firms benefit from improvisation. This paper addresses this gap using an organizational learning perspective that explains the role of a firm's organizational structure and organizational resources for improvisation and innovation. A large-scale survey in China finds that firms vary in their levels of (I) centralization and formalization of decision making and (II) resource slack and investment irreversibility and that these factors moderate the relationship between improvisation and innovation capability in distinct ways. Consistent with our theorizing, improvisation enhances innovation capability when firms have a decentralized but formalized structure or pursue the dual goals of maximizing resource slack and minimizing investment irreversibility.

The effects of policy uncertainty on investment: Evidence from the unexpected acceptance of a far-reaching referendum in Switzerland

Does increased economic policy uncertainty dampen investment of firms? We provide direct evidence on this question by examining the effects of an unexpectedly accepted and far-reaching referendum in Switzerland in February 2014. The outcome put several economically relevant agreements between Switzerland and its main trading partner, the European Union, at stake. Using firm-level panel data covering the 2009–2015 period and data from two special surveys levied shortly after the vote, we examine how the induced policy uncertainty affected investment of Swiss firms. Our Difference-in-Differences-in-Differences estimations and complementary survey results give strong evidence that the uncertainty caused by the vote dampened, as theoretically expected, investment of exposed firms with irreversible investment by as much as one quarter in the two years following the vote. Exposed firms that can reverse investment appear rather to increase investment in the year after the vote. Our survey evidence suggests that these firms engage in investment to streamline their production.

Bargaining Power Choices with Moral Hazard in a Supply Chain

A supply chain contract is established using a dynamic, Nash bargaining game which determines the optimal bargaining power allocation for the manufacturer, retailer, and society in an environment affected by moral hazard and irreversible investment. The results found that the manufacturer’s choice was to hold all bargaining power; however, due to the remaining information problem, the retailer still had a profit; in contrast, the retailer was only willing to give up bargaining power if the manufacturer’s profit was reserved. The optimal bargaining power allocation was found to be strongly related to the ability to convert and monitor technology, with the bargaining power gradually shifting to the manufacturer as the technology improved. A numerical simulation is given to examine the theoretical results.