The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Irreversible Investment

  • Janice C. Eberly
Reference work entry
DOI: https://doi.org/10.1057/978-1-349-95189-5_2571

Abstract

The cost of an irreversible investment cannot be recovered once it is installed. This restriction not only truncates negative investments, but also raises the threshold for positive investment. The threshold return that justifies an irreversible investment increases with uncertainty, or more precisely, with the probability mass in the lower tail of outcomes. Irreversibility constrains the ability to redeploy capital in ‘bad’ states, so the agent is particularly sensitive to these states when investing ex ante.

This finding is analogous to valuation and exercise of financial options, and irreversible investments are valued and understood by using option pricing techniques.

Keywords

Adjustment costs Irreversible investment Option pricing theory Option valuation Put–call parity Uncertainty 
This is a preview of subscription content, log in to check access

Bibliography

  1. Abel, A.B.., and J.C. Eberly. 1994. A unified model of investment under uncertainty. American Economic Review 84: 1369–1384.Google Scholar
  2. Abel, A.B.., and J.C. Eberly. 1996. Optimal investment with costly reversibility. Review of Economic Studies 63: 581–593.CrossRefGoogle Scholar
  3. Abel, A.B.., and J.C. Eberly. 1997. An exact solution for the investment and value of a firm facing uncertainty, adjustment costs, and irreversibility. Journal of Economic Dynamics and Control 21: 831–852.CrossRefGoogle Scholar
  4. Abel, A.B.., A.K. Dixit, J.C. Eberly, and R.S. Pindyck. 1996. Options, the value of capital, and investment. Quarterly Journal of Economics 111: 753–777.CrossRefGoogle Scholar
  5. Arrow, K.J. 1968. Optimal capital policy and irreversible investment. In Value, capital, and growth, ed. J.N. Wolfe. Chicago: Aldine.Google Scholar
  6. Bernanke, B.S. 1983. Irreversibility, uncertainty, and cyclical investment. Quarterly Journal of Economics 98: 85–106.CrossRefGoogle Scholar
  7. Bertola, G. 1988. Adjustment costs and dynamic factor demands: Investment and employment under uncertainty. Ph.D. Dissertation, Cambridge, MA: Massachusetts Institute of Technology.Google Scholar
  8. Brennan, M., and E. Schwartz. 1985. Evaluating natural resource investments. Journal of Business 58: 135–157.CrossRefGoogle Scholar
  9. Caballero, R.J., and E.M.R.A. Engel. 1999. Explaining investment dynamics in U.S. manufacturing: A generalized (S,s) approach. Econometrica 67: 783–826.CrossRefGoogle Scholar
  10. Caplin, A.S., and D.F. Spulber. 1987. Menu costs and the neutrality of money. Quarterly Journal of Economics 102: 703–726.CrossRefGoogle Scholar
  11. Dixit, A.K., and R.S. Pindyck. 1994. Irreversible investment. Princeton: Princeton University Press.Google Scholar
  12. Eberly, J.C., and J.A. van Mieghem. 1997. Multi-factor dynamic investment under uncertainty. Journal of Economic Theory 75: 345–387.CrossRefGoogle Scholar
  13. Henry, C. 1974. Option values in the economics of irreplaceable assets. Review of Economic Studies 41: 89–104.CrossRefGoogle Scholar
  14. Jorgenson, D. 1963. Capital theory and investment behavior. American Economic Review 53: 247–259.Google Scholar
  15. Marschak, J. 1949. Role of liquidity under complete and incomplete information. American Economic Review 39: 182–195.Google Scholar
  16. McDonald, R.L., and D. Siegel. 1986. The value of waiting to invest. Quarterly Journal of Economics 101: 707–728.CrossRefGoogle Scholar
  17. Pindyck, R.S. 1988. Irreversible investment, capacity choice, and the value of the firm. American Economic Review 78: 969–985.Google Scholar
  18. Veracierto, M.L. 2002. Plant-level irreversible investment and equilibrium business cycles. American Economic Review 92: 181–197.CrossRefGoogle Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Janice C. Eberly
    • 1
  1. 1.