On Irreversible Investment
45 Pages Posted: 15 Jul 2006
Date Written: June 3, 2006
This paper develops a general theory of irreversible investment of a single firm that chooses a dynamic capacity expansion plan in an uncertain environment. The model is set up free of any distributional or any parametric assumptions and hence encompasses all the existing models. As the first contribution, a general existence and uniqueness result is provided for the optimal investment policy. Based upon an alternative approach developed previously to dynamic programming problems, we derive the optimal base capacity policy such that the firm always keeps the capacity at or above the base capacity. The critical base capacity is explicitly constructed and characterized via a stochastic backward equation. This method allows qualitative insights into the nature of the optimal investment under irreversibility. Finally, explicit solutions are derived for infinite time horizon, a separable operating profit function of Cobb--Douglas type and an exponential Levy process modelled economic shock.
Keywords: Irreversible Investment, Capacity Expansion, Singular Control Problem, Levy Processes
JEL Classification: C61, D81, E22, G11
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