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InvestmentUnderUncertainty(PrincetonU.press,1994)AvinashDixitandRobertPindyck(PrincetonU.press,1994)Chapter1ANewViewofInvestmentEconomicsdefinesinvestmentastheactofincurringanimmediatecostintheexpectationoffuturerewards.Firmsthatconstructplantsandinstallequipment,merchantswholayinastockofgoodsforsale,andpersonswhospendtimeonvocationaleducationareallinvestorsinthissense.Somewhatlessobviously,afirmthatshutsdownaloss-makingplantisalsoinvesting:thepaymentsitmustmaketoextractitselffromcontractualcommitments,includingseverancepaymentstolabor,aretheinitialexpenditure,andtheprospectiverewardisthereductioninfuturelosses.Viewedfromthisperspective,investmentdecisionsareubiquitous.Yourpurchaseofthisbookwasaninvestment.Thereward,wehope,willbeanimprovedunderstandingofinvestmentdecisionsifyouareaneconomist,andanimprovedabilitytomakesuchdecisionsinthecourseofyourfuturecareerifyouareabusinessschoolstudent.Mostinvestmentdecisionssharethreeimportantcharacteristicsitvaryingdegrees.First,theinvestmentispartiallyorcompletelyirreversible.Inotherwords,theinitialcostofinvestmentisatleastpartiallysunk;youcannotrecoveritallshouldyouchangeyourmind.Second,thereisuncertaintyoverthefuturerewardsfromtheinvestment.Thebestyoucandoistoassesstheprobabilitiesofthealternativeoutcomesthatcanmeangreaterorsmallerprofit(orloss)foryourventure.Third,youhavesomeleewayaboutthetimingofyourinvestment.Youcanpostponeactiontogetmoreinformation(butnever,ofcourse,completecertainty)aboutthefuture.Thesethreecharacteristicsinteracttodeterminetheoptimaldecisionsofinvestors.Thisinteractionisthefocusofthisbook.Wedevelopthetheoryofirreversibleinvestmentunderuncertainty,andillustrateitwithsomepracticalapplications.1Theorthodoxtheoryofinvestmenthasnotrecognizedtheimportantqualitativeandquantitativeimplicationsoftheinteractionbetweenirreversibility,uncertainty,andthechoiceoftiming.Wewillarguethatthisneglectexplainssomeofthefailuresofthattheory.Forexample,comparedtothepredictionsofmostearliermodels,realworldinvestmentseemsmuchlesssensitivetointerestratechangesandtaxpolicychanges,andmuchmoresensitivetovolatilityanduncertaintyovertheeconomicenvironment.Wewillshowhowthenewviewresolvestheseanomalies,andintheprocessofferssomeguidancefordesigningmoreeffectivepublicpoliciesconcerninginvestment.1Somedecisionsthataretheoppositeofinvestment-gettinganimmediatebenefitinreturnforanuncertainfuturecost-arealsoirreversible.Prominentexamplesincludetheexhaustionofnaturalresourcesandthedestructionoftropicalrainforests.Ourmethodsapplytothesedecisions,too.-2-Someseeminglynon-economicpersonaldecisionsalsohavethecharacteristicsofaninvestment.Togivejustoneexample,marriageinvolvesanup-frontcostofcourtship,withuncertainfuturehappinessormisery.Itmaybereversedbydivorce,butonlyatasubstantialcost.Manypublicpolicydecisionsalsohavesimilarfeatures.Forinstance,publicopinionabouttherelativeimportanceofcivilrightsoftheaccusedandofsocialorderfluctuatesthroughtime,anditiscostlytomakeorchangelawsthatembodyaparticularrelativeweightforthetwo.Ofcoursethecostsandbenefitsofsuchnon-economicdecisionsaredifficultorevenimpossibletoquantify,butourgeneraltheorywilloffersomequalitativeinsightsforthem,too.1TheOrthodoxTheoryHowshouldafirm,facinguncertaintyoverfuturemarketconditions,decidewhethertoinvestinanewfactory?Mosteconomicsandbusinessschoolstudentsaretaughtasimpleruletoapplytoproblemsofthissort.First,calculatethepresentvalueoftheexpectedstreamofprofitsthatthisfactorywillgenerate.Second,calculatethepresentvalueofthestreamofexpendituresrequiredtobuildthefactory.Finally,determinewhetherthedifferencebetweenthetwo-thenetpresentvalue(NPV)oftheinvestment-isgreaterthanzero.Ifitis,goaheadandinvest.Ofcourse,thereareissuesthatariseincalculatingthisnetpresentvalueJusthowshouldtheexpectedstreamofprofitsfromanewfactorybeestimated?Howshouldinflationbetreated?Andwhatdiscountrate(orrates;shouldbeusedincalculatingthepresentvalues?Resolvingissuesliketheseareimportanttopicsincoursesincorporatefinance,andespeciallycapitalbudgeting,butthebasicprincipleisfairlysimple-calculatetheNPVofaninvestmentprojectandseewhetheritispositive.Thenetpresentvalueruleisalsothebasisfortheneoclassicaltheoryofinvestmentastaughttoundergraduateandgraduatestudentsofeconomics,Herewefindtheruleexpressedusingthestandardincrementalormarginalapproachoftheeconomist:investuntilthevalueofanincrementalunitofcapitalisjustequaltoitscost.Again,issuesariseindeterminingthevalueofanincrementalunitofcapital,andindeterminingitscost.Forexample,whatproductionstructureshouldbeposited?Howshouldtaxesanddepreciationbetreated?Muchofthetheoreticalandempiricalliteratureontheeconomicsofinvestmentdealswithissuesofthissort.Wefindtwoessentiallyequivalentapproaches.One,followingJorgenson(1963),comparestheper-periodvalueofanincrementalunitofcapital(itsmarginalproduct)andanequivalentper-periodrentalcostorusercostthatcanbecomputedfromthepurchaseprice,theinterestanddepreciationrates,andapplicabletaxes.Thefirm'sdesiredstockofcapitalisfoundbyequatingthemarginalproductandtheusercost.Theactualstockis