Wright Meets Markowitz: How Standard Portfolio Theory Changes When Assets Are Technologies Following Experience Curves

43 Pages Posted: 11 May 2017 Last revised: 29 Aug 2018

See all articles by Rupert Way

Rupert Way

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School

Francois Lafond

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; University of Oxford - Smith School of Enterprise and the Environment; University of Oxford - Oxford Martin School

Fabrizio Lillo

Università di Bologna

Valentyn Panchenko

UNSW Business School, Economics, University of New South Wales

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School; Santa Fe Institute

Date Written: June 29, 2018

Abstract

We consider how to optimally allocate investments in a portfolio of competing technologies using the standard mean-variance framework of portfolio theory. We assume that technologies follow the empirically observed relationship known as Wright's law, also called a "learning curve" or "experience curve", which postulates that costs drop as cumulative production increases. This introduces a positive feedback between cost and investment that complicates the portfolio problem, leading to multiple local optima, and causing a trade-off between concentrating investments in one project to spur rapid progress vs. diversifying over many projects to hedge against failure. We study the two-technology case and characterize the optimal diversification in terms of progress rates, variability, initial costs, initial experience, risk aversion, discount rate and total demand. The efficient frontier framework is used to visualize technology portfolios and show how feedback results in nonlinear distortions of the feasible set. For the two-period case, in which learning and uncertainty interact with discounting, we compare different scenarios and find that the discount rate plays a critical role.

Keywords: Experience curves, Technological change, Learning-by-doing, Portfolio theory, Technology investment, Markowitz portfolio

JEL Classification: O33, G11, Q55, C63

Suggested Citation

Way, Rupert and Lafond, Francois and Lillo, Fabrizio and Panchenko, Valentyn and Farmer, J. Doyne, Wright Meets Markowitz: How Standard Portfolio Theory Changes When Assets Are Technologies Following Experience Curves (June 29, 2018). Available at SSRN: https://ssrn.com/abstract=2965695 or http://dx.doi.org/10.2139/ssrn.2965695

Rupert Way (Contact Author)

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

Francois Lafond

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

University of Oxford - Smith School of Enterprise and the Environment ( email )

United Kingdom

University of Oxford - Oxford Martin School ( email )

University of Oxford
34 Broad Street
Oxford, OX1 3BD
United Kingdom

Fabrizio Lillo

Università di Bologna ( email )

Via Zamboni, 33
Bologna, 40126
Italy

Valentyn Panchenko

UNSW Business School, Economics, University of New South Wales ( email )

Sydney, NSW 2052
Australia

HOME PAGE: http://research.economics.unsw.edu.au/vpanchenko

J. Doyne Farmer

University of Oxford - Institute for New Economic Thinking at the Oxford Martin School ( email )

Eagle House
Walton Well Road
Oxford, OX2 6ED
United Kingdom

HOME PAGE: http://www.inet.ox.ac.uk/people/view/4

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States
505-984-8800 (Phone)
505-982-0565 (Fax)

HOME PAGE: http://www.santafe.edu/~jdf/

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