Investment in New Activities and the Welfare Cost of Uncertainty

20 Pages Posted: 20 Sep 2000  

Joshua Aizenman

National Bureau of Economic Research (NBER)

Date Written: February 1995

Abstract

Recent literature has highlighted the importance of new activities in development and growth. It was shown that trade distortions such as tariffs are associated with first-order costs stemming from the induced drop in the formation of new activities. This paper demonstrates that uncertainty may induce similar costs. This argument is illustrated in the context of Romer's model of a dependent economy, where foreign direct investment is needed to enable the importation of capital goods and intermediate products used in domestic production. The present paper shows that uncertainty acts as an implicit tax on new activities, whose incidence is (in a certain sense) worse than that of a tariff in Romer's framework. As with a tariff, uncertainty inhibits the formation of new activities. Unlike the tariff, however, uncertainty does not benefit the government with revenue. The welfare cost of uncertainty applies also for a closed economy. The paper shows that uncertainty-averse entrepreneurs discount using a 'hurdle rate' that exceeds the risk-free interest rate. The gap between the two rates increases with the uncertainty embodied in the investment, being determined by the vagueness of the information and by the range of possible outcomes. Hence, growth may be inhibited by business uncertainty, where the 'rules of the game' for new activities are vague.

Suggested Citation

Aizenman, Joshua, Investment in New Activities and the Welfare Cost of Uncertainty (February 1995). NBER Working Paper No. w5041. Available at SSRN: https://ssrn.com/abstract=225820

Joshua Aizenman (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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