Pursuing the wrong options? Adjustment costs and the relationship between uncertainty and capital accumulation

The recent literature on uncertainty and capital accumulation has focused on the effects of ‘real options’ associated with irreversible investment (e.g. Dixit and Pindyck, 1994; Abel and Eberly, 1996). The focus has been primarily on short run mechanisms. For example it has been shown that, at a higher level of uncertainty, risk neutral firms are less likely to invest in response to a positive demand shock. Long run effects have been analyzed by Abel and Eberly (1999; henceforth AE). They prove that, in a dynamic model with complete irreversibility, the sign of the effect of demand uncertainty on expected long run capital stock is theoretically ambiguous. In this paper we study the effects of uncertainty on long run capital accumulation in a model in which adjustment costs are quadratic in the investment rate, a framework that has been the bedrock of investment modeling for a long time (e.g. Summers, 1981; Hayashi and Inoue, 1991; Abel, 2002). We find that a higher level of uncertainty tends to reduce the expected long run capital stock in the presence of quadratic adjustment costs, and that this effect may be substantial. 2. Investment model