Market Power and Capital Flexibility: A New Perspective on the Pricing of Technology Shocks∗

In this paper we show that firms’ market power and flexibility in the utilization of capital crucially affect how investment-specific technology (IST) shocks impact asset prices. We develop a two-sector general equilibrium model in which households have recursive preferences and obtain three main results. First, the equilibrium price of risk for IST shocks changes sign from negative, under fixed capital utilization, to positive, when firms are allowed to optimally choose the intensity of capital utilization. Variable capital utilization provides flexible capital service input in the production of the consumption good and hence alters the intertemporal trade-off between current and future consumption (“discount rate effect”). Second, the firms’ equilibrium IST loadings change sign from negative, for perfectly competitive firms, to positive, for monopolistically competitive firms. Market power allows firms to benefit from the reduction in capital investment costs induced by a positive technology shock (“cash flow effect”). Finally, preference for early resolution of uncertainty, together with flexible capital utilization and high market power, can generate simultaneously positive price of risk and positive risk premium for IST shocks. These results indicate that variable capital utilization and market power are critical ingredients for production-based models that rely on IST shocks to explain observed properties of both asset prices and macroeconomic quantities. JEL Classification Codes: E22; G12; O30