Theory Of Irreversible Investment Research Articles

Incorporating decision makers’ risk preferences into real options models

This study develops a framework to link the expected utility analysis to real options models in order to capture the joint effects of risk aversion and irreversibility. It aims at modifying the theory of investment under uncertainty by incorporating decision makers’ risk preferences and allows explicitly analysing the impacts of risk aversion, uncertainty and irreversibility on decisions such as investment and resource allocations. It addresses the shortcomings of the commonly used expected utility and investment under uncertainty models by generalizing the theory of irreversible investment to allow for risk-averse investors. It was found that uncertainty, irreversibility and risk aversion are important determinants of the optimal timing of irreversible decisions. Ignoring risk preferences in real options models would lead to overestimation or underestimation of the magnitude of investments.

A GAME MODEL OF IRREVERSIBLE INVESTMENT UNDER UNCERTAINTY

Most of the literature on real options considers the optimal decision of a firm in isolation from competitors. In reality, however, the actions of competing firms often affect each other's investment opportunities. We develop a game model where many firms compete for a single investment opportunity. When one of the firms triggers the investment the opportunity is completely lost for the other firms. The value of the project for the firms is assumed to follow a geometric Brownian motion. The model combines game theory and the theory of irreversible investment under uncertainty. We characterize the resulting Nash equilibrium under different assumptions on the information that the firms have about each other's valuations for the project. As an example, we present a case of building a telecommunications network.

Risk Aversion, Price Uncertainty, and Irreversibility of Investments

This paper generalizes the theory of irreversible investment under uncertainty by allowing for risk averse investors in the absence of complete markets. Until now this theory has only been developed in the cases of risk neutrality, or risk aversion in combination with complete markets. We introduce the class of logistic absolute risk aversion (LARA) utility functions to examine the effects of risk aversion, investment size, and other parameters on the optimal investment decision. We find that risk aversion reduces investment, particularly if the investment size is large. Moreover, we find that a rise in uncertainty increases the value of deferring irreversible investments. This effect is stronger for high levels of risk aversion. In addition, we provide, to the best of our knowlegde for the first time, analytical comparative statics formulas for the risk neutral investor.

Determinants of Cleaner Technology Investments in the U.S. Bleached Kraft Pulp Industry

This study identifies adoption determinants of selected cleaner technologies used in bleached kraft pulp production, with emphasis on incentives for voluntary environmental management. A double-hurdle model consistent with the theory of irreversible investment under uncertainty outperformed a probit specification, indicating the importance of option values as an adoption deterrent. Measures of public pressure for environmental performance, such as Toxics Release Inventory data and environmental group membership, were positively associated with cleaner technology adoption. The results suggest a role for environmental policy designs that accommodate the industry’ s private incentives while minimizing the value of waiting to adopt cleaner technologies.

Modelling the price of industrial commodities

The theory of irreversible investment under uncertainty and the theory of competitive storage are combined in a rational expectations model of the price formation of industrial commodities. In continuous time, an endogenous price zone arises from the opening and closure of capacity at boundaries of the price zone. Dynamics of the price process within the price zone are determined by competitive speculation. The model is scaled to the dimensions of the aluminium market and solved numerically. Simulated prices and inventories exhibit characteristics similar to the real series: volatile prices, asymmetric adjustment of production to price changes and long inventory cycles.

Irreversible investment under uncertainty in oligopoly

Abstract An oligopoly is studied where firms facing a stochastic inverse demand curve use capacity as strategic variable. Capacity may be adjusted continuously over time with linear cost. The analysis uses the technique of a fictitious social planner and the theory of irreversible investment under uncertainty. Examples indicate that qualitatively the price process will be similar in oligopoly and competitive equilibrium. When firms are nonidentical, e.g. in initial size, and even if they are alike in other respects, substantial time may pass until they are all the same size. Much of that time, one firm may dominate the market.

Demand uncertainty and the value of supply opportunities

The study considers the optimal timing of production decisions under demand uncertainty. In accordance with the modern theory of irreversible investment, the problem is modelled as one of optimal stopping. By taking an approach which is independent of dynamic programming and the smooth-fit principle, we derive explicitly both the value of the opportunity and the optimal-demand threshold. We prove that the optimal-demand threshold can be attained at a point where the smooth-fit principle is not valid. We also carry out the comparative static analysis of the optimal variables and derive conditions under which production incentives are held constant. A consequence of this analysis is that along the iso-incentive curve inflationary policy must be counteracted with strict monetary policy.

Costs of entry and exit from financial markets and capital flows to developing countries

Though the theory of irreversible investment under uncertainty is now well understood, no attempt has been made to empirically evaluate its predictions for foreign investment decisions. Yet costs of entry and exit from financial markets due to government restrictions certainly represent an important source of irreversibility. In this paper, a model with partial irreversibility of investment is used to derive a negative relation between costs of entry and exit from financial markets and foreign investment. Such a theoretical relation is consistent with empirical findings from a panel of 25 developing countries in 1987–1991.

Modeling energy technology choices: Which investment analysis tools are appropriate?

A variety of tools from modern investment theory appear to hold promise for unraveling observed energy technology investment behavior that often appears anomalous when analyzed using traditional investment analysis methods. This paper reviews the assumptions and important insights of the investment theories most commonly suggested as candidates for explaining the apparent ‘energy technology investment paradox’. The applicability of each theory is considered in the light of important aspects of energy technology investment problems, such as sunk costs, uncertainty and imperfect information. The theories addressed include the capital asset pricing model, the arbitrage pricing theory, and the theory of irreversible investment. Enhanced net present value methods are also considered. The relevance of the capital asset pricing model and the arbitrage pricing theory, given the special characteristics of energy technology investment decisions, appears limited to the value of the theories' conceptual insights. In contrast, the theory of irreversible investment and enhanced net present value are found to provide more useful modeling and analysis methods, each capable of providing important insights into the ‘energy technology investment paradox’.