Uncertainty, and the Trade-Off Between Scale and Flexibility in Investment

17 Pages Posted: 23 Mar 2011

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: March 16, 2011

Abstract

This paper presents a tractable model of a firm that chooses both the scale and timing of its investment. The value-maximizing investment policy is lumpy, and sensitivity analysis shows that greater demand volatility is associated with the firm choosing to invest in larger increments, less frequently. This is in contrast to the conventional wisdom, which is that greater volatility leads to investment in smaller increments, more frequently. Overall, the reduced frequency dominates the greater scale, so that the long-run average rate of investment is a decreasing function of demand volatility. The timing and scale of investment are most sensitive to volatility when there are substantial investment economies of scale.

Keywords: investment, uncertainty, real options, economies of scale

JEL Classification: D21, D92, G31

Suggested Citation

Guthrie, Graeme, Uncertainty, and the Trade-Off Between Scale and Flexibility in Investment (March 16, 2011). Available at SSRN: https://ssrn.com/abstract=1788042 or http://dx.doi.org/10.2139/ssrn.1788042

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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