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Irreversible Investment

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.

Type

Book Chapter

Author(s)

Janice C. Eberly

Date Published

2008

Citations

Eberly, C. Janice. 2008. Irreversible Investment.

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