A Markup Interpretation of Optimal Rules for Irreversible Investment

Avinash Dixit, Robert S. Pindyck, Sigbjorn Sodal

NBER Working Paper No. 5971
Issued in March 1997
NBER Program(s):   IO   PR

We re-examine the basic investment problem of deciding when to incur a sunk cost to obtain a stochastically fluctuating benefit. The optimal investment rule satisfies a trade-off between a larger versus a later net benefit; we show that this trade-off is closely analogous to the standard trade-off for the pricing decision of a firm that faces a downward sloping demand curve. We reinterpret the optimal investment rule as a markup formula involving an elasticity that has exactly the same form as the formula for a firm's optimal markup of price over marginal cost. This is illustrated with several examples.

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Published: Dixit, Aumash, Robert S. Pindyck and Sighiorn Sodal. "A Markup Interpretation Of Optimal Investment Rules," Economic Journal, 1999, v109(455,Apr), 179-189.

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