The Effects of Labor Choice on Investment and Output Dynamics

Abstract

We incorporate both labor and capital as production inputs and discuss the effects of labor choice on a firm's optimal investment decision and output dynamics based on real options framework. In particular, we introduce different levels of labor flexibility and examine how it affects the firm's investment and employment strategy. We show that upward-only adjustable labor, which can arise from employment protection, discourages investment and makes a negative short-run impact on labor employment but a positive impact in the long-run. We also show that the firm invests earlier and produces more at the investment timing when it is either highly labor-intensive or highly capital-intensive. However, the impact of labor share on output changes over time; it is more pronounced over time when labor is fully flexible or upward-adjustable but less pronounced with downward-adjustable labor. Furthermore, we show that uncertainty can make both positive and negative impacts on investment, but that the latter is more pronounced when the labor share is high.

Keywords: labor share, labor flexibility, investment, capital expansion, real options

JEL Classification: D24, D25, G31