NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Irreversible Investment, Capacity Choice, and the Value of the Firm

Robert S. Pindyck

NBER Working Paper No. 1980
Issued in July 1986
NBER Program(s):   ME

A model of capacity choice and utilization is developed

consistent with value maximization when investment is irreversible

and future demand is uncertain. Investment requires the full

value of a marginal unit of capacity to be at least as large as

its full cost. The former includes the value of the firms option

not to utilize the unit, and the latter includes the opportunity

cost of exercising the investment option. We show that for

moderate amounts of uncertainty, the firm's optimal capacity is

much smaller than it would be if investment were reversible, and a

large fraction of the firm's value is due to the possibility of

future growth. We also characterize the behavior of capacity and

capacity utilization, and discuss implications far the measurement

of marginal cost and Tobin's q.

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Document Object Identifier (DOI): 10.3386/w1980

Published: American Economic Review, Vol. 78, no. 5, pp. 969-985, Dec. 1988. citation courtesy of

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