Irreversible investment and Knightian uncertainty

When firms make a decision about irreversible investment, they may not have complete confidence about their perceived probabilitymeasure describing future uncertainty. Theymay think other probabilitymeasures perturbed from the original one are also possible. Such uncertainty, characterized by not a single probability measure but a set of probability measures, is called “Knightian uncertainty.” The effect of Knightian uncertainty on the value of irreversible investment opportunity is shown to be drastically different from that of traditional uncertainty in the form of risk. Specifically, an increase in Knightian uncertainty decreases the value of investment opportunity while an increase in risk increases it. © 2007 Elsevier Inc. All rights reserved. JEL classification: C61; D81; D92