Investment Under Uncertainty and Time-Inconsistent Preferences

Stanford GSB Research Paper No. 1899

48 Pages Posted: 5 Aug 2005

See all articles by Steven R. Grenadier

Steven R. Grenadier

Stanford Graduate School of Business

Neng Wang

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2006

Abstract

The real options framework has been used extensively to analyze the timing of investment under uncertainty. While standard real options models assume that agents possess a constant rate of time preference, there is substantial evidence that agents are very impatient about choices in the short-term, but are quite patient when choosing between long-term alternatives. We extend the real options framework to model the investment timing decisions of entrepreneurs with such time-inconsistent preferences. Two opposing forces determine investment timing: while evolving uncertainty induces entrepreneurs to defer investment in order to take advantage of the option to wait, their time-inconsistent preferences motivate them to invest earlier in order to avoid the time-inconsistent behavior they will display in the future. We find that the precise trade-off between these two forces depends on such factors as whether entrepreneurs are sophisticated or naive in their expectations regarding their future time-inconsistent behavior, as well as whether the payoff from investment occurs all at once or over time. We extend the model to consider equilibrium investment behavior for an industry comprised of time-inconsistent entrepreneurs. Such an equilibrium involves the dual problem of entrepreneurs playing dynamic games against competitors as well as against their own future selves.

Keywords: irreversible investment, hyperbolic discounting, time inconsistency, real options

JEL Classification: G11, G31, D9

Suggested Citation

Grenadier, Steven R. and Wang, Neng, Investment Under Uncertainty and Time-Inconsistent Preferences (January 2006). Stanford GSB Research Paper No. 1899, Available at SSRN: https://ssrn.com/abstract=766804 or http://dx.doi.org/10.2139/ssrn.766804

Steven R. Grenadier

Stanford Graduate School of Business ( email )

Graduate School of Business
Stanford, CA 94305-5015
United States
650-725-0706 (Phone)
650-725-6152 (Fax)

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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