Working Paper: NBER ID: w1980
Authors: Robert S. Pindyck
Abstract: A model of capacity choice and utilization is developed \nconsistent with value maximization when investment is irreversible \nand future demand is uncertain. Investment requires the full \nvalue of a marginal unit of capacity to be at least as large as \nits full cost. The former includes the value of the firms option \nnot to utilize the unit, and the latter includes the opportunity \ncost of exercising the investment option. We show that for \nmoderate amounts of uncertainty, the firm's optimal capacity is \nmuch smaller than it would be if investment were reversible, and a \nlarge fraction of the firm's value is due to the possibility of \nfuture growth. We also characterize the behavior of capacity and \ncapacity utilization, and discuss implications far the measurement \nof marginal cost and Tobin's q.
Keywords: Investment; Capacity Choice; Firm Value; Irreversibility; Uncertainty
JEL Codes: D81; E22; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| uncertainty of future demand (D84) | marginal value of a unit of capacity (D24) |
| uncertainty of future demand (D84) | optimal capacity of firms (D25) |
| installed capacity and options for future investment (E22) | value of the firm (G32) |
| uncertainty of future demand (D84) | value of growth options (D25) |
| marginal value of a unit of capacity (D24) | total cost of capacity (D24) |