On Adjustment Costs, Profit Uncertainty and Investment Behavior

SYNOPTIC ABSTRACT

We study a firm whose profit depends on a random disturbance, modeled by a continuous-time stochastic process, which is the sum of a trendless diffusion and a trend-corrected jump process. A production factor may be quickly adjusted at each instant of time, incurring an adjustment cost. The problem is to choose a strategy for investment in this factor to maximize the expected present value of the profit flow. We derive the expected dynamics of investment rate, and show that if marginal adjustment cost is convex, then profit uncertainty lowers the expected rate of change of investment. Our results generalize those of Pindyck (1982), who treated the case where the disturbance process is pure diffusion. We also derive an equation for the optimal investment rate itself in a special case, which generalizes an equation of Abel (1983).

Key Words and Phrases:

• stochastic processes
• optimal investment behavior
• Cobb-Douglas production function
• convex marginal adjustment cost