An Equilibrium Model of Investment under Uncertainty
Posted: 25 Jun 2008
Date Written: 2007
We analyze the optimal investment decisions of heterogeneous firms in a competitive, uncertain environment, characterizing firms' investment strategies explicitly and deriving closed-form solutions for firm value. Real option premia remain significant, and are even unmitigated relative to the standard partial-equilibrium model when both are calibrated to observables. Firms consequently delay investment, choosing not to undertake some positive NPV projects. We compare competitive behavior to that of a strategic monopolist, and quantify the welfare loss associated with monopoly. Finally, the model predicts business cycle dependence on firm returns, with returns negatively skewed during industry expansions but positively skewed in industry recessions.
Keywords: G12, E22, R14
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