Über die Autorin bzw. den Autor

Avinash K. Dixit is John J. F. Sherrerd '52 University Professor of Economics at Princeton University. His most recent book is Thinking Strategically, with Barry Nalebuff (Norton). Robert S. Pindyck is Mitsubishi Bank Professor of Economics at the Sloan School of Management, MIT. His books include Econometric Models and Economic Forecasts, with Daniel L. Rubinfeld (McGraw-Hill).

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"[The authors'] approach has powerful implications for investors in marketable assets as well. No investment professional or CFO can afford to ignore this brilliant new book."--Peter L. Bernstein, author ofCapital Ideas: The Improbable Origins of Modern Wall Street

"Avinash Dixit and Robert Pindyck have successfully applied to capital budgeting the ideas and techniques of option pricing that have so enriched our understanding of financial markets."--Merton H. Miller, Nobel Laureate in Economics

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"[The authors'] approach has powerful implications for investors in marketable assets as well. No investment professional or CFO can afford to ignore this brilliant new book."--Peter L. Bernstein, author ofCapital Ideas: The Improbable Origins of Modern Wall Street

"Avinash Dixit and Robert Pindyck have successfully applied to capital budgeting the ideas and techniques of option pricing that have so enriched our understanding of financial markets."--Merton H. Miller, Nobel Laureate in Economics

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Investment under Uncertainty

Princeton University Press

Contents

Preface.................................................................xi1 A New View of Investment..............................................32 Developing the Concepts Through Simple Examples.......................263 Stochastic Processes and Ito's Lemma..................................594 Dynamic Optimization under Uncertainty................................935 Investment Opportunities and Investment Timing........................1356 The Value of a Project and the Decision to Invest.....................1757 Entry, Exit, Lay-Up, and Scrapping....................................2138 Dynamic Equilibrium in a Competitive Industry.........................2479 Policy Intervention and Imperfect Competition.........................28210 Sequential Investment................................................31911 Incremental Investment and Capacity Choice...........................35712 Applications and Empirical Research..................................394References..............................................................429Symbol Glossary.........................................................445

Chapter One

Economics defines investment as the act of incurring an immediate cost in the expectation of future rewards. Firms that construct plants and install equipment, merchants who lay in a stock of goods for sale, and persons who spend time on vocational education are all investors in this sense. Somewhat less obviously, a firm that shuts down a loss-making plant is also "investing": the payments it must make to extract itself from contractual commitments, including severance payments to labor, are the initial expenditure, and the prospective reward is the reduction in future losses.

Viewed from this perspective, investment decisions are ubiquitous. Your purchase of this book was an investment. The reward, we hope, will be an improved understanding of investment decisions if you are an economist, and an improved ability to make such decisions in the course of your future career if you are a business school student.

Most investment decisions share three important characteristics in varying degrees. First, the investment is partially or completely irreversible. In other words, the initial cost of investment is at least partially sunk; you cannot recover it all should you change your mind. Second, there is uncertainty over the future rewards from the investment. The best you can do is to assess the probabilities of the alternative outcomes that can mean greater or smaller profit (or loss) for your venture. Third, you have some leeway about the timing of your investment. You can postpone action to get more information (but never, of course, complete certainty) about the future.

These three characteristics interact to determine the optimal decisions of investors. This interaction is the focus of this book. We develop the theory of irreversible investment under uncertainty, and illustrate it with some practical applications.

The orthodox theory of investment has not recognized the important qualitative and quantitative implications of the interaction between irreversibility, uncertainty, and the choice of timing. We will argue that this neglect explains some of the failures of that theory. For example, compared to the predictions of most earlier models, real world investment seems much less sensitive to interest rate changes and tax policy changes, and much more sensitive to volatility and uncertainty over the economic environment. We will show how the new view resolves these anomalies, and in the process offers some guidance for designing more effective public policies concerning investment.

Some seemingly noneconomic personal decisions also have the characteristics of an investment. To give just one example, marriage involves an up-front cost of courtship, with uncertain future happiness or misery. It may be reversed by divorce, but only at a substantial cost. Many public policy decisions also have similar features. For instance, public opinion about the relative importance of civil rights of the accused and of social order fluctuates through time, and it is costly to make or change laws that embody a particular relative weight for the two. Of course the costs and benefits of such noneconomic decisions are difficult or even impossible to quantify, but our general theory will offer some qualitative insights for them, too.

1 The Orthodox Theory

How should a firm, facing uncertainty over future market conditions, decide whether to invest in a new factory? Most economics and business school students are taught a simple rule to apply to problems of this sort. First, calculate the present value of the expected stream of profits that this factory will generate. Second, calculate the present value of the stream of expenditures required to build the factory. Finally, determine whether the difference between the two—the net present value (NPV) of the investment—is greater than zero. If it is, go ahead and invest.

Of course, there are issues that arise in calculating this net present value. Just how should the expected stream of profits from a new factory be estimated? How should inflation be treated? And what discount rate (or rates) should be used in calculating the present values? Resolving issues like these are important topics in courses in corporate finance, and especially capital budgeting, but the basic principle is fairly simple—calculate the NPV of an investment project and see whether it is positive.

The net present value rule is also the basis for the neoclassical theory of investment as taught to undergraduate and graduate students of economics. Here we find the rule expressed using the standard incremental or marginal approach of the economist: invest until the value of an incremental unit of capital is just equal to its cost. Again, issues arise in determining the value of an incremental unit of capital, and in determining its cost. For example, what production structure should be posited? How should taxes and depreciation be treated?

Much of the theoretical and empirical literature on the economics of investment deals with issues of this sort. We find two essentially equivalent approaches. One, following Jorgenson (1963), compares the per-period value of an incremental unit of capital (its marginal product) and an "equivalent per-period rental cost" or "user cost" that can be computed from the purchase price, the interest and depreciation rates, and applicable taxes. The firm's desired stock of capital is found by equating the marginal product and the user cost. The actual stock is assumed to adjust to the ideal, either as an ad hoc lag process, or as the optimal response to an explicit cost of adjustment. The book by Nickell (1978) provides a particularly good exposition of developments of this approach.

The other formulation, due to Tobin (1969), compares the capitalized value of the marginal investment to its purchase cost. The value can be observed directly if the ownership of the investment can be traded in a secondary market; otherwise it is an imputed value computed as the expected present value of the stream of profits it would yield. The ratio of this to the purchase price (replacement cost) of the unit, called Tobin's q, governs the investment...