Working Paper: CEPR ID: DP2405
Authors: Sumru Altug; Fanny S. Demers; Michel Demers
Abstract: Political risk is widely present in developing but also in developed countries, and stems from a variety of sources. The objective of this paper is twofold. First, we develop a theoretical model to investigate the impact of political risk on irreversible investment. Second, we apply our model to an analysis of the risk of separation of the province of Quebec from the Canadian federation. We consider the investment decisions of a monopolistically competitive firm under uncertainty about demand and about the tax-adjusted price of investment goods. We develop a model of irreversible investment which incorporates learning and a regime switch with time-varying transition probabilities. If a given regime represents a riskier environment in terms of the state of demand or the state of investment price, then attaching a positive probability to a switch to that regime increases the marginal adjustment cost of investing, reduces the expected marginal value of capital, and reduces irreversible investment. We use annual sectoral data for the Quebec economy for the period 1983-1996 to match the behaviour of actual investment with simulated series from our model
Keywords: irreversible investment; learning; trends; political risk; regime shifts; Quebec investment; Canada
JEL Codes: D92; E22; O11; O16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increases in political risk (F69) | increase in marginal adjustment cost of investing (G31) |
| increase in marginal adjustment cost of investing (G31) | decrease in expected marginal value of capital (E22) |
| decrease in expected marginal value of capital (E22) | decrease in irreversible investment (G31) |
| increases in political risk (F69) | decrease in irreversible investment (G31) |
| increase in probability of regime switch to a riskier environment (D81) | increase in marginal adjustment cost of investing (G31) |
| increase in variability of profits in the bad regime (D89) | decrease in irreversible investment (G31) |