Uncertainty, and the Trade-Off Between Scale and Flexibility in Investment
17 Pages Posted: 23 Mar 2011
Date Written: March 16, 2011
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: Suggested Citation