The Hedging Effect of Low Durability Capital Assets in Competitive Industries

Abstract

We highlight the impact of physical capital durability on firms' investment behavior, output price dynamics, and industry equilibrium outcomes. In particular, we identify industry-wide depreciation of capital assets as a hedge against long-lasting episodes of overcapacity, and document that the equilibrium firm value might be negatively associated with capital durability. In particular, low demand elasticity increases the hedging effect of capital depreciation. In a dynamic model of equilibrium investment under uncertainty we develop endogenous output-price dynamics and closed-form solutions for optimal investment policies, firm value, as well as for the steady-state distribution of output prices. From this model we derive a set of testable predictions on expected equilibrium output prices, entry dynamics and the above mentioned hedging effect of low capital durability. We document broad empirical support for these predictions in a large sample of U.S. manufacturing firms.

Keywords: Capacity Options, Durability of Capital, Dynamic Investment under Uncertainty, Depreciation, Rational Expectations Equilibrium

JEL Classification: E2, E22, D25