Northwestern
University
Janice C. Eberly
John L. and Helen Kellogg
Distinguished Professor of Finance
Northwestern University
Current Working Papers:
·
Optimal Inattention to the Stock Market with Information Costs and
Transactions Costs
Joint
with Andrew B. Abel and Stavros Panageas, May 2007, current version December 2007
Abstract: Recurrent
intervals of inattention to the stock market are optimal if it is costly to
observe asset values. When consumers observe the value of their wealth, they
decide whether to transfer funds between a transactions account from which
consumption must be financed and an investment portfolio of equity and riskless
bonds. Transfers of funds are subject to a proportional transactions cost, so
the consumer may choose not to transfer any funds on a particular observation
date. In general, the optimal adjustment rule–including the size and direction
of transfers, and the time of the next observation–is state-dependent.
Surprisingly, the consumer’s optimal behavior
eventually evolves to a situation with a purely time-dependent rule,
with a constant interval of time between observations that can be substantial
even for tiny observation costs. In the long run, but only in the long run, the
standard consumption Euler equation holds between observation dates if the
consumer is sufficiently risk averse.
·
Investment and Value: A Neoclassical Benchmark
Joint
with Sergio Rebelo and Nicolas Vincent, July 2006. [PDF file for
current version, May 2008]
Abstract:. Which investment model best fits
firm-level data? To answer this question we estimate alternative models using
Compustat data. Surprisingly, the two best-performing specifications are based
on Hayashi.s (1982) model. This model’s foremost implication, that Q is a
sufficient statistic for determining a firm’s investment decision, has been
often rejected because cash-flow and lagged-investment effects are present in
investment regressions. However, we find that these regression results are
quite fragile and ineffectual for evaluating model performance. So, forget what
investment regressions tell you. Models based on Hayashi (1982) provide a very
good description of investment behavior at the firm level.
·
Investment, Valuation, and Growth Options
Joint with Andrew Abel, June 2003. [PDF file for current version, October 2005]
Abstract: We
develop a model in which the opportunity for a firm to upgrade its technology
to the frontier (at a cost) leads to growth options in the value of the firm.
Variation in the technological frontier leads to variation in firm value that
is unrelated to current cash flow and investment, though variation in firm
value anticipates future upgrades and investment. We simulate this model and
show that in situations in which growth options are important, regressions of
investment on Tobin's Q and cash flow yield small positive coefficients on Q
and larger coefficients on cash flow, consistent with the empirical literature.
We also show that when growth options are important, the volatility of firm
value can substantially exceed the volatility of cash flow, as empirically
documented by Shiller (1981) and West (1988).
·
Q for the Long Run
Joint with Andrew Abel, February 2002. [PDF
file for current version, July 2002]
Abstract:
Traditional Q theory relates a firm's investment to its value of Q at
all frequencies; weekly or even daily fluctuations in Q should be just as
informative for investment decisions as quarterly or annual data. We develop a model in which investment is
more responsive to Q at long horizons than at short horizons; instantaneous investment
is responsive to contemporaneous cash flow.
These effects arise because a firm's value depends on both its existing
capital and its available technologies, even if they are not yet installed. In contrast, the firm's current investment
depends only on the currently installed technology. Thus, the value of the firm, and hence
Tobin's Q, are "too forward-looking" relative to the investment
decision. Cash flow, on the other hand,
reflects only current technology and demand.
The excessively forward-looking information in Tobin's Q, while
extraneous to high-frequency investment decisions, does predict future
adoptions of the frontier technology. In
this way, it is a better predictor of long-run investment than of short-run
investment. Short-run investment is
better predicted by the firm's cash flow.
·
Q Theory Without Adjustment Costs & Cash Flow Effects Without
Financing Constraints
Joint with Andrew Abel, October 2001. [PDF
file for current version]
Abstract:
Tobin's Q exceeds one, even without any adjustment costs, for a firm
that earns rents from monopoly power.
Even when there are no adjustment costs and marginal Q is always equal
to one, Tobin's Q is informative about the firm's growth prospects. We show that investment is positively related
to Tobin's Q (which is observable average Q). In addition, cash flow has a
positive effect on investment, and this effect is larger for smaller, faster
growing and more volatile firms, even though capital markets are perfect. These results provide a new theoretical
foundation for Q theory and also cast doubt on evidence of financing
constraints based on cash flow effects on investment.
·
Investment and q With Fixed Costs: An Empirical Analysis
Joint with Andrew Abel, revised 2002. [PDF
file for current version]
Abstract: Optimal investment depends both on expected
returns and the costs of acquiring and installing capital. Empirical work using q-theory has emphasized
the measurement of expected returns using Tobin's q, while more recent
theoretical work focuses on investment costs, particularly fixed costs and
irreversibility. This paper uses panel
data to estimate a model of optimal investment and disinvestment using q to
measure expected returns and allowing for a general "augmented adjustment
cost function" -- incorporating fixed, linear, and convex adjustment
costs. The results indicate both
statistically and economically important nonlinearities, potentially arising
from fixed costs, in the relationship between investment/disinvestment and its
determinants. Our model suggests that
investment and disinvestments should not be netted out empirically, and we find
that disinvestment is non-negligible and behaves differently than positive
investments. The nonlinearities we find
imply that the cross-sectional distribution of q affects aggregate investment,
so that the nonlinear model predicts annual aggregate investment substantially
more successfully than does the linear model, particularly during large
cyclical fluctuations.
Published Research Papers:
·
Irreversible Investment
New Palgrave Dictionary
of Economics, forthcoming 2007-08
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. With
uncertainty, 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 analagous to valuation and
exercise of financial options, and irreversible investments are valued and
understood using option pricing techniques.
·
Optimal Inattention to the Stock Market
Joint
with Andrew B. Abel and Stavros Panageas, American Economic Review Papers
and Proceedings, May 2007
[working
paper version, as forthcoming]
Abstract: Inattentive agents
update their information sporadically, rather than continuously, and thus
respond belatedly to news. We generate
optimally inattentive behavior by assuming that to observe the value of his
investment portfolio the consumer must pay a cost that is proportional to the
portfolio's contemporaneous value. It is
optimal for the consumer to check his investment portfolio at equally spaced
points in time, consuming from a riskless transactions account in the interim. The riskless transactions account that
finances consumption guarantees that funds are never unwittingly
exhausted. We show that the optimal
interval of time between consecutive observations of the value of the portfolio
is the unique positive solution to a nonlinear equation. Quantitatively, even a small observation cost
(one basis point of wealth) implies a substantial (8 month) decision interval
under conventional parameter values.
·
The Effects of Irreversibility and Uncertainty on Capital Accumulation
Journal of
Monetary Economics 44:3, December 1999, pp. 339-377, with Andrew B. Abel
[Full text
available from the Journal of Monetary Economics]
Abstract:
Irreversibility and uncertainty increase the user cost of capital which
tends to reduce the capital stock.
Working in the opposite direction is a hangover effect, which arises
because irreversibility prevents the firm from selling capital even when the
marginal revenue product of capital is low.
Neither the user cost effect nor the hangover effect dominates globally,
so that irreversibility may increase or decrease capital accumulation. Furthermore, an increase in uncertainty can
either increase or decrease the long-run capital stock under irreversibility
relative to that under reversibility. Other effects that we consider, however,
have unambiguous effects on long-run capital accumulation
·
The Mix and Scale of Factors with Irreversibility and Fixed Costs of
Investment
Carnegie-Rochester Conference Series on Public
Policy 48,
October 1998, pp. 101-135, with Andrew B. Abel.
[Full text
available from Elsevier Publishing]
Abstract:
When factors of production can be adjusted costlessly, the mix of factors
can be considered separately from their scale.
We examine factor choice and utilization when investment is irreversible
and subject to a fixed cost, so that the capital stock is a quasi-fixed factor
that is adjusted infrequently and by discrete amounts. We derive and analyze analytic approximations
for optimal investment behavior, and show how the quasi-fixity of capital
eliminates the dichotomy between factor mix and scale. In addition, the quasi-fixity of capital has
important implications for the dynamics of employment by the firm. We show that labor hoarding can arise, even
though labor is modeled as a purely flexible factor.
·
An Exact Solution for the Investment and Market Value of a Firm Facing
Uncertainty, Adjustment Costs, and Irreversibility
Journal of
Economic Dynamics and Control 21, August 1997, pp. 831-852, with Andrew B. Abel.
Abstract:
This paper derives closed-form solutions for the investment and value of
a competitive firm with a constant-returns-to-scale production function and convex
costs of adjustment. Solutions are derived for the case of irreversible
investment as well as for reversible investment. Optimal investment is a
non-decreasing function of q, the shadow value of capital. Relative to the case
of reversible investment, the introduction of irreversibility does not affect
q, but it reduces the fundamental value of the firm.
·
Multi-factor Dynamic Investment Under Uncertainty
Journal of
Economic Theory 75(2), August 1997, pp. 345-387, with Jan van Mieghem.
Abstract: We
characterize a firm's optimal factor adjustment when any number of factors face
"kinked" linear adjustment costs so that all factor accumulation is
costly to reverse. We first consider a
general non-stationary case with a concave operating profit function,
unrestricted form of uncertainty and a horizon of arbitrary length. We show that the optimal investment strategy
follows a control limit policy at each point in time. The state space of the firm's problem is
partitioned into various domains, including a continuation region where no
adjustment should optimally be made to factor levels. We then consider two specific model classes
and exploit their special structure to derive expressions for their
continuation regions.
·
International Evidence on Investment and Fundamentals
Abstract: If
a firm's costs of installing capital are not quadratic, then its optimal
investment is not a linear function of fundamentals, such as the returns and
costs of capital. This study specifies a model in which a firm may face fixed,
linear, and convex costs of investing, and estimates the resulting investment
function using firm-level data from 11 countries. The evidence suggests
important nonlinearities, consistent with the presence of fixed or other
non-quadratic costs, in the relationship between investment and fundamentals
for most countries. These findings are statistically signficant at the level of
the firm, and economically significant when aggregated by country.
· Options, the Value of
Capital, and Investment
Quarterly Journal of Economics 111(3), August 1996, pp.
753-777, with Andrew B. Abel, Avinash K. Dixit, and Robert S. Pindyck.
Abstract:
Capital investment decisions must recognize the limitations on the
firm's ability to later sell or expand capacity. This paper shows how opportunities for future
expansion or contraction can be valued as options, how their valuation relates
to the q theory of investment, and their effect on the incentive to
invest. Generally, the option to expand
reduces the incentive to invest, while the option to disinvest raises it. We show how these options determine the
effect of uncertainty on investment, how they are changed by shifts of the
distribution of future profitability , and how the q-theory and option pricing
approaches are related.
·
Optimal Investment with Costly Reversibility
The Review of Economic Studies, Vol. 63, No. 4. (Oct.,
1996), pp. 581-593, with Andrew B. Abel.
[Full text
available on JSTOR]
Abstract:
Investment is characterized by costly reversibility when a firm can
purchase capital at a given price and sell capital at a lower price. We solve
for the optimal investment of a firm that faces costly reversibility under
uncertainty and we extend the Jorgensonian concept of the user cost of capital
to this case. We define and calculate cU and cL as the
user cost of capital associated with the purchase and sale of capital,
respectively. Optimality requires the firm to purchase and sell capital as
needed to keep the marginal revenue product of capital in the closed interval [
cL,cU]. This prescription encompasses the case of
irreversible investment as well as the standard neoclassical case of costlessly
reversible investment.
·
Unified Model of Investment Under Uncertainty
The American Economic Review, Vol. 84, No. 5. (Dec.,
1994), pp. 1369-1384, with Andrew B. Abel.
Reprinted in Kevin
D. Hoover, Ed., The Economic
Legacy of Robert Lucas, Jr., Edward
Elgar Publishing, U.S. publication
October 1999.
[Full text
available on JSTOR]
Abstract:
This paper extends the theory of investment under uncertainty to incorporate
fixed costs of investment, a wedge between the purchase price and sale price of
capital, and potential irreversibility of investment. In this extended
framework, investment is a nondecreasing function of q, the shadow price of
installed capital. The optimal rate of investment is in one of three regimes
(positive, zero, or negative gross investment), depending on the value of q
relative to two critical values. In general however, the shadow price q is not
directly observable, so we present two examples relating q to observable
variables. (JEL E22)
·
Adjustment of Consumers' Durables Stocks: Evidence from Automobile
Purchases
The Journal of Political
Economy,
Vol. 102, No. 3. (Jun., 1994), pp. 403-436.
[Full text
available on JSTOR]
Abstract:
This paper tests an optimal (S, s) rule in household durable purchases
and examines directly the resulting aggregate expenditure dynamics. The observed
decision rule responds to income uncertainty and growth as predicted by an (S,
s) model resulting from transactions costs. Tests against liquidity constraints
find that about half the households purchase according to an optimal (S, s)
rule. Aggregating the (S, s) rule over households produces a cross-section
distribution of durables holdings. The empirical distribution is similar to
that predicted theoretically, as is its response to aggregate shocks.
Furthermore, simulations of aggregate expenditure based on the household
distribution exhibit dynamics consistent with those observed in the 1980s.
Published
Comments & Popular Publications:
· “Once you have a job offer –
what next?” AEA Committee on the Status of Women (CSWEP) Newsletter, Fall 2007.
[full text PDF]
· Time-varying Risk Premia and
the Cost of Capital: An Alternative Implication of the Q Theory of Investment,
Comment, Carnegie-Rochester
Conference Series on Public Policy 2001. [full
text PDF]
· The Stock Market and
Investment in the New Economy: Some Tangible Facts and Intangible Fictions,
Comments,
Brookings Papers on Economic Activity 2000:1, pp. 109-114. [Editors' Summary of the
Volume][full
text PDF]
· On Irreversibility and
Aggregate Investment: Comment, 1993 Macroeconomics Annual, National Bureau
of Economic Research, pp. 303-312.
Finance Department
| Kellogg | Northwestern University
