Uncertainty and investment

Abstract

As seen in the preceding chapters, Jorgenson’s model did not perform well empirically and the q theorists attempted to resolve some of the problems within Jorgenson’s theory by incorporating rational expectations and adjustment costs explicitly into their models of firms’ optimizing behaviour. While the empirical performance of q theories was generally superior to that of Jorgensonian models, there were still signs that something was missing from these theories, either because the expectations assumptions embedded within these models did not properly capture the influences of uncertainty and/or because the basic assumptions underlying a model of profit maximizing investors were empirically fallible. In this chapter, the influence of uncertainty within orthodox models of investment is investigated. These models are based upon the insight that, in a world of irreversible investment, there are benefits in waiting to acquire more information about the likely success of investments. This insight can be incorporated into models of rational optimization to give a ‘real options’ theory of fixed asset investment, such as the theory developed by Dixit and Pindyck (1994). These models are based upon the insight that exercising an option to invest involves opportunity costs and these opportunity costs will rise as uncertainty increases the value of waiting for further information. So, on balance, there will be a negative relationship between investment and uncertainty.