American Economic Association

Investment Under Uncertainty: Keeping One's Options Open

Author(s): R. Glenn Hubbard
Source: Journal of Economic Literature, Vol. 32, No. 4 (Dec., 1994), pp. 1816-1831
Published by: American Economic Association
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Journal of Economic Literature

Vol. XXXII (December 1994), pp. 1816-1831

Under
Investment
Uncertainty:
Open
Keeping
One's
Options
By R. GLENN HUBBARD
Columbia University and the National Bureau of Economic Research
I am grateful to Avinash Dixit, Mark Gertler, Kevin Hassett,
Charles Himmelberg, Anil Kashyap, Gilbert Metcalf, and Robert
Pindyck for helpful comments and suggestions, and to the Federal
Reserve Bank of New York and the John M. Olin Visiting Professorship at the Center for the Study of the Economy and the State
of the University of Chicago for support.

1. Introduction and Overview of Book

CONSIDERABLE

INTELLECTUALatten-

tion has been focused on models of derivative financial instruments, including options. The theoretical intuition embodied in
early option pricing models has been applied
to other financial decisions by individuals and
businesses as well. Despite these applications, options as financial instruments are not
central to the lives of most of us. However, a
wide variety of options is: We all face significant choices about whether we should spend
our resources today or wait, thereby "keeping
our options open."
In an important new book, Dixit and Pindyck (1994) illustrate how modern "options"
intuition can be used to analyze a number of
individual and business decisions. Focusing
their attention on investment decisions, they
offer both a cogent methodological discussion
of a new view of investment theory (to which
they are individually major contributors) and
Investment Under Uncertainty. By AVINASH K.
DIXIT AND ROBERT S. PINDYCK.Princeton: Prince-

ton University Press, 1994. Pp. xiv, 486. $39.50.

ISBN 0-691-03410-9. Another recent survey of
models in this literature can be found in Pindyck
(1991).

a cook's tour of practical applications. The

book should be required reading both for researchers interested in investment models
and for business school professors teaching
capital budgeting. Portions of the book are
also appropriate for practitioners, particularly
given the intuitive presentation of much of
the material.1 Readers interested in a nontechnical treatment of many of the ideas are
offered guidance for so doing, and purely
methodological issues (e.g., solution techniques) are treated in separate chapters.
Investment Under Uncertainty provides
both economic analysis and the clear message
that such analysis be advanced broadly as a
new view for studying investment. Accordingly, I believe it is appropriate to judge the
book's contributions in three respects. First,
are the theoretical advances offered in response to practical problems not addressed
by earlier approaches? Second, does the theory offer predictions consistent with observed
investment decisions? Finally, are there empirical tests that could test the predictions of
the new view against those of conventional
models? To summarize this review in ad1 The authors even offer a literary etymology of
"one-hoss-shay depreciation" (p. 205).

1816

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Hubbard: Investment Under Uncertainty

vance, I will argue that the answers are "yes,"
"yes," and "quite possibly."
Before examining the book's analytical arguments and developing more formal answers
to the questions just posed, let me offer a
quick guide to reading the book. For all readers, Chapter 1 offers a careful and interesting
description of the differences between the familiar neoclassical investment model and the
new view embodied in the authors' "real options" approach. The chapter is useful for
practitioners as well as academic economists
because it offers intuitive applications to such
questions as why business investment appears
to be relatively unresponsive to interest rates,
when a firm should abandon an investment
program, why hysteresis (or path dependence) may be an important consideration in
investment decisions, why effects of public
policies (including tax, trade, and antitrust
interventions) may have complex effects on
investment, and (for the true homo economicus) why decisions regarding divorce
and suicide involve option values.
The second chapter should also be part of
the reading by both researchers and practitioners. The chapter uses simple two-and threeperiod examples to illustrate why, under assumptions of uncertainty and irreversibility, a
decision to wait is logically part of a valuemaximizing investment decision. It is also in
this chapter that Dixit and Pindyck develop
an analogy between real options in investment decisions and financial options. Chapters 3 and 4, likely of greater interest for
researchers (though, again, the writing incorporates a minimum of technical detail), generalize models of uncertainty hinted at in the
earlier numerical examples. Chapter 3 offers
an introduction to stochastic processes, while
Chapter 4, which addresses optimal sequential decision making under uncertainty, introduces the basics of dynamic programming.
These chapters present to the interested
reader a list of technical references, but they
are a relatively self-contained guide to stochastic processes and dynamic optimization
under uncertainty.
The crux of the book's analysis lies in
Chapters 5-7, which outline the new view's
theory of investment. As I explain in more
detail in Section 2, the neoclassical invest-

1817

ment model suggests that a firm should increase its capital stock when the market value
of the capital assets exceeds their replacement cost. Tobin's q, the ratio of the market
valuation of capital to its replacement cost, is
a convenient and often-used summary statistic in the neoclassical approach. In the new
view, the investment decision is a choice to
incur a sunk cost (because investment is assumed to be irreversible), a choice which
yields uncertain future returns. Because the
firm has the option of delaying the investment, it should increase its capital stock only
if q exceeds unity by a margin sufficient to
compensate the firm for the loss of the option
to delay. Dixit and Pindyck show that, under
certain assumptions, threshold values of q are
quite large, implying very high "hurdle rates"
consistent with those found in interviews with
managers responsible for capital budgeting
(see Lawrence Summers 1987).
The basic model introduced in Chapter 5
relies on a simplifying assumption of complete irreversibility of capital investments. In
fact, firms have a way out; they can temporarily or permanently scrap sufficiently unprofitable projects. Chapter 6 presents an extension to the case of "suspension":A firm may
discontinue a project's operation with the option of renewing it in the future. Hence, two
options are part of the investment decision,
the initial option of delay and a sequence of
operating options (related to suspension decisions). Chapter 7 pursues this extension for
the case of "abandonment,"which entails the
extinguishing of the option of restoring the
project at some point. In practice, of course,
firms typically must choose between suspension (with ongoing, say, maintenance expenditures) and abandonment (with costs of
severance and the lost option). Dixit and Pindyck describe analytically the choice among a
firm's operating, suspending, or abandoning a
project, then make their points more concretely in an illustration of investment decisions in crude oil tankers.
While Chapters 5-7 present the book's
core material on real options in firm decisions, they beg the question of how an industry equilibrium (at least outside of a simple
monopoly case) might be characterized in the
presence of these options. This important

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1818

Journal of Economic Literature, Vol. XXXII (December 1994)

subject is treated in Chapters 8 and 9. The

essential complication is this: In the context
of a competitive industry, two types of uncertainty are relevant and must be distinguished,
aggregate (or industry-level) uncertainty and
uncertainty specific to the firm (see the discussion in Section 5 that follows).
If, indeed, investment responds sluggishly
to news in the presence of uncertainty, one
might inquire whether government intervention could increase efficient investment. It
depends: Such intervention will improve efficiency only if a benevolent government has
different opportunity costs of waiting from
private agents. Chapter 9 addresses potential
market failures that might stimulate intervention. As is common in academic discussions
(though, lamentably, not in public policy discussions) of intervention, Dixit and Pindyck
show that only very precise policy tools can
address market failures associated with incomplete markets for risk.2 Indeed, to the extent that public policy itself becomes uncertain, incentives to postpone investment arise.
(I elaborate on this point in the context of tax
policy in Section 6.)
The analysis in Chapters 5-9 focuses on investments that involve essentially a single decision. Chapters 10 and 11 extend the examination to "sequential" and "incremental"
investment, respectively. In the former case,
a firm may complete projects in a sequence
as it updates its expectation of future profitability. As the firm commences an investment
sequence, most costs are not yet sunk; hence,
the firm will proceed only in response to very
high expected future profitability. Over time,
as more project steps are in place, proceeding
is justified by a smaller profitability threshold. An example of this process is the familiar
learning curve, in which production costs decrease with cumulative output. In this setting,
an increase in uncertainty diminishes the
value of future declines in cost, slowing down
the rate of investment. The analysis of incremental investment in Chapter 11 focuses on
choices for capacity expansion. Using their
2 For example, a competitive equilibrium under
uncertainty can be consistent with periods of supernormal profits or losses, calling into question
antitrust or trade policies that focus on snapshot
measures of industry equilibrium.

own work as well as recent contributions by

others, Dixit and Pindyck illustrate the relationship between optimal capacity expansion
in the new view and familiar models based on
"adjustmentcosts."
Chapter 12, the book's concluding chapter,
emphasizes applications, including the development of oil reserves and the choice by electric utilities between investing in scrubbers
or purchasing tradeable emission permits to
meet emission standards. It is only at the very
end of the monograph that general empirical
implications of uncertainty and irreversibility
for analyses of investment are discussed.
While econometric testing of the theory
against other investment models is in its infancy, more direction as to how such tests
might be developed would have been useful.
In the interest of brevity, I focus my attention on what I believe to be the book's major
contributions. The balance of the review is
organized as follows. To fix ideas, Section 2
describes the familiar neoclassical model and
summarizes complications introduced by uncertainty and irreversibility. Section 3 reviews
the roles played by uncertainty and irreversibility in a simple new view investment
model; Section 4 generalizes this discussion
of the firm's investment problem. The leap to
predictions regarding investment in a competitive industry equilibrium occurs in Section 5. Section 6 discusses consequences of
policy intervention and policy uncertainty in
the new view, focusing on tax policy. Section
7 suggests empirical tests that may help distinguish between predictions of irreversibility
models and other investment models. Section
8 concludes.

2. From the Neoclassical Model to the

New View
Before discussing the analytical advances

summarized in Investment Under Uncertainty, let me set the stage by reviewing the

basic predictions of the traditional neoclassical model.3 Neoclassical models of invest3 I, intend the term "neoclassical model" to refer
both to the models I discuss herein and to standard net present value rules frequently taught in
business schools (see, e.g., Richard Brealey and
Stewart Myers 1991).

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Hubbard: Investment Under Uncertainty

ment begin with the intuition of marginal
valuation basic to economic analysis: In this
case, a firm should invest up to the point at
which the marginal cost of capital just equals
the marginal return to capital. Going from intuition to practice has been the subject of a
significant body of applied research on valuation of marginal units of capital and firms'
costs of capital, technological descriptions
of production, and effects of tax policy on
marginal benefits and cost of investing (see,
e.g., the reviews in Robert Chirinko 1993,
and Jason Cummins, Hassett, and Hubbard
1994).
Applied analyses of neoclassical investment
models generally fall into two groups. The
first follows the tradition of the "user cost of
capital" approach of Dale W. Jorgenson
(1963) and Robert Hall and Jorgenson
(1967). Treating capital investment as a purchase of a durable good, Jorgenson defines
the user of cost of capital to be the rental cost
of the capital (determined by the purchase
price, opportunity cost of funds, depreciation
rates, and taxes). Firms' desired stocks of
capital are determined by the equality of the
value of the marginal product of capital and
the user cost of capital. Transformingthe theory's intuition to a model of "investment"requires additional assumptions to generate dynamics, such as "delivery lags" or "costs of
adjustment."
The other approach, the origin of which
traces to James Tobin (1969), compares the
replacement cost of a marginal investment to
its capitalized value. Tobin's q, or marginalq,
is the ratio of this capitalized value to the replacement cost of the investment.4 Tobin's q
approach provides a simple rule to guide investment: If q > 1, the firm should invest,
and, if q < 1, the firm should not invest and
should shrink its existing capital stock. The
firm's equilibrium capital stock is achieved
when q = 1. As with the user cost approach,
tax parameters can be introduced in the definition of q. Also like the user cost approach,
4 Empirical research generally focuses on average q, the ratio of the market value of a firms'
capital stock to the replacement cost of the capital
stock. Under certain assumptions, average q and
marginal q are equivalent (see, e.g., Fumio
Hayashi 1982).

1819

the q theory yields a testable model of investment when dynamics (e.g., adjustment costs)
are imposed.
Both variants of the neoclassical model rely
on the net present value rule. A firm should
undertake investment projects with positive
net present value. They make two subtle assumption as well: First, invested capital can
be sold easily to other users (that is, it is reversible). Second, each investment opportunity facing the firm is a once-and-for-all opportunity; if the firm declines the project, it
will never have the choice to reconsider.
The starting point for the "new view"
stressed by Dixit and Pindyck is that many
real-world investment decisions violate these
subtle assumptions, and irreversibility and a
chance for delay are important considerations. This importance reflects the observation that the possibility of delay gives rise to a
call option: The firm has the right, though
not the obligation, to buy an asset (the investment project) at some future time at its discretion. To the extent that investment is irreversible-a
feature of the new view
models-making an investment extinguishes
the value of the call option, or "real option,"
in the terms of Dixit and Pindyck. (If investment were reversible, the neoclassical
model's guidance would be more applicable.)
The value of the lost option is a component of
the opportunity cost of investment. In the
terminology of the Tobin's q approach, the
threshold criterion for investment requires
that q exceed unity by the value of maintaining the call option to invest. Indeed, this additional component may account for the high
"hurdle rates" required by corporate managers actually making investment decisions.
An easy, though not satisfying, response to
this argument is that the neoclassical model
could be modified to incorporate the real option component. Even with this semantic
change, it is still necessary, to the extent that
the real option is valuable, to analyze how it
might be priced in firms' decisions.

3. Irreversibility, Delay, and the New

View
The "real option" approach to studying investment under uncertainty relies on the con-

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1820

Journal of Economic Literature, Vol. XXXII (December 1994)

cepts of irreversibility and delay. The significance of each is, of course, an empirical question. The illustrations of irreversibility (or,
equivalently, sunk costs) are not hard to provide in many cases, including firm-specific
marketing costs. The costs of even plant and
equipment investments may be sunk. This is
easy to see in the case of industry-specific
capital when aggregate uncertainty is important. Even less specific capital such as computers or general use machinery are (at least
partially) irreversible if secondary markets
are inefficient. Such markets may be inefficient because of classic "lemons"problems of
adverse selection or because regulatory or institutional impediments. As with irreversibility, a value to "delay"is also plausible
on a priori grounds. While delay entails possible costs (say, lost returns from a project or
entry by competitors), it confers benefits in
the form of new information about the project's value during the period of delay.

3A. A Simple Example

To make the significance of irreversibility
and delay more concrete, let me use a simple
two-period example, followed by a more formal basic model; similar motivation can be
found in Chapters 2 and 5. The managers of
the Ilova Watch Company are deciding
whether to invest in a new watch factory. To
fix ideas, let us assume that the investment is
totally irreversible; that is, Ilova will not be
able to recover any of the investment. A new
watch factory costs $800 and produces one
watch each year in perpetuity with no operating cost. (Oh, those efficient Swiss!) The
current price of Ilova watches is $100, but
the price will change next year to $150 with
probability one half and to $50 with probability one half, the new price then remains
forever. The firm's discount rate is 10 percent.
Using the neoclassical model's intuition,
note that the expected future price of
watches is $100, so that the present value of
the factory's revenue is $100 + 100/0.10, or
$1100. Because the factory costs $800, the
proposed project's net present value is $300,
so that the factory should be built. In the
context of the formal neoclassical models to

which I referred earlier, note that: (1) the

marginal return from the investment each
year ($100) exceeds the user cost (0.10 x
$800 = $80), and (2) the project's q
($1100/$800) exceeds unity. Those criteria
support the decision to invest.
These simple calculations ignore the opportunity cost of investing now in the form of
the lost option to delay. As an alternative,
suppose that Ilova's managers wait a year and
build the factory only if the price of watches
rises from $100 to $150. Now, the present
value of the cost of the investment is
($800/1.1), and the present value of returns
00

from investing is I 150/(l.l)t yielding a net

t=1

present value of $386, which is greater than

the net present value of $300 in the "invest
now" case. Likewise, Tobin's q in the "delay"
case (1650/727, or 2.27) exceeds the q for the
"invest now" case. Its value comes jointly
from uncertainty about returns and the assumptions of irreversibility and preservation
of the investment project even with delay.
The "real option"-the value of the call option of delay-is $386. The less completely
irreversible is the investment, the lower is the
value of waiting. An increase in uncertainty
over price (a mean-preserving spread in the
distribution for the next-period-and-forevermore watch price) increases the value of the
option to delay. This description of changes
in the value of the option to delay follows
closely related effects on the value of financial call options (see Dixit and Pindyck 1994,
Ch. 2; Brealey and Myers 1991; and Hubbard
1993, Ch. 9).
One could add other sources of uncertainty
to the two-period example just described, including uncertainty over costs (as in most research and development projects) or over interest (discount) rates. The latter is of
additional interest because it provides a way
to consider effects of uncertain tax policy on
the level and timing of investment. In all
cases, though, the intuition is that the valuemaximizing investment decision must consider the value of the option of delay when
comparing the marginal benefit and cost of
investing (or, equivalently, when calculating
the project's net present value).

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Hubbard: Investment Under Uncertainty

3B. A Simple Formalization
A simple and instructive formalization of
the roles played by irreversibility and delay is
the model of Robert McDonald and Daniel
Siegel (1986).5 McDonald and Siegel analyzed when a monopoly firm should pay a
sunk cost I to obtain an investment project
value V, where V is uncertain in future periods. This evolution is governed by a Wiener
process, or Brownian motion, which is a continuous-time stochastic process commonly
used for three reasons of analytical tractability. First, the process is a Markov process;
that is, the probability distribution of future
values of V is a function only of the current
value of V. Second, the probability distribution for a change in the process over a time
interval is independent of other time intervals (as long as they do not overlap). Third,
over any given interval of time, the changes
in the process are normally distributed, and
the variance increases linearly with the time
interval.6

McDonald and Siegel use a process of geometric Brownian motion with drift:

dV=aVdt+aVdz,

(1)

where dt is a time increment, dz is the increment of a Wiener process, and ot and a are
constants. The process for V describes the arrival of new information over time and is consistent with an uncertain future value of V.
The analytical advantage of this setup is
clear from the perspective of the new view.
The investment opportunity considered by
the firm is a call option with no expiration
date; that is, the firm has the right, though
not the obligation to undertake the project at
a prespecified price 1. At the same time, this
simple setup has some drawbacks in describing typical investment projects. For example,
if there are variable costs and the firm can
close the factory in periods when price is below variable cost, the process for V is not geos Predecessors of this formalization in the macroeconomics literature include the models of Alex
Cukierman (1980) and Ben Bernanke (1983).
6 For a more detailed description of stochastic
processes and their properties, see Dixit and Pindyck (1994, Ch. 3), Dixit (1993), Darrell Duffie
(1988), and Samuel Karlin and Howard Taylor
(1975, 1981).

1821

metric Brownian motion even if that for the

output price is. Second, if the firm had competitors, the price could not depart too much
from the industry's long-run marginal cost,
suggesting that the process for V may be
more complicated. Let me defer these concerns for now. (In Investment Under Uncertainty, they are addressed in Chs. 6-9.)
In what follows, I describe the solution to
the McDonald-Siegel problem7 by a dynamic
programming, and draw an analogy to the
predictions of the standard neoclassical
model. Recall that irreversibility and delay
lead to the creation of an option to invest;8
call its value F(V). The firm would like to
maximize the expected present value of this
option:
F(V) = maxE[(VT- I) e-pT],
where VT is the value of the project at the
unknown future time T of which the investment is made (so VT - I is the payoff from
investing), p is the appropriate discount rate,
and E is the expectation operator. To solve
the problem assume that ot < p; otherwise,
delay is always sensible and V increases indefinitely with T.
Because the option value of the investment
opportunity yields no dividends until it is exercised, the return from holding it takes the
form of capital appreciation. Hence, for values of V for which the firm should not yet
invest, Bellman's equation is given by:9
pF dt = E(dF).

(2)

Using Ito's Lemma,10 we can expand dF:

dF = F'(V)dV + '/2F" (V)(dV)2

(3)

7 For a more thorough discussion of the model,

see Dixit and Pindyck (1994, Ch. 5) or McDonald
and Siegel (1986).
8While uncertainty over future returns affects
the value of the option, the option may still be
valuable even under certainty.
9 For an intuitive description of Bellman's equation (also known as the fundamental equation of
optimality), see Dixit and Pindyck (1994, Ch. 3).
10Consider a function F(x,t) that is (at least)
twice differentiable in x (a state variable) and once
in t (time). Ito's Lemma gives the total differential
dF as:
dF = aF/Jt + DF/Ax dx + %/2
(dX)2
pJ
~DX2

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1822

Journal of Economic Literature, Vol. XXXII (December 1994)

In the McDonald-Siegel problem, dV = axVdt

+ oVdz, so that we can rewrite (3) (because
E(dz) = 0) as:
E (dF) = aV F'(V)dt +

1/2a2 V2

F" (V) dt.

Dividing through by dt produces Bellman's

equation:
1/2

a2 V2F"(V)+ aVF'(V)- pF = 0.

(4)

While the Bellman equation is a second-order differential equation, F(V) must also satisfy three boundary conditions. First, given
the stochastic process used, V will remain at
zero if it goes to zero (hence, F(M)= 0). Second, if V4 is the value at which it is optimal to
invest, upon investing the firm receives a net
payoffV - I (hence,F(V0)= V' - I); see Dixit
and Pindyck (1994) or Dixit (1993) for a discussion. The third condition, known as the
"smooth-pasting"
conditionrequiresF' (V4) = 1,
so that F(V) is continuous at the threshold of
V4. The need for a third condition arises because of the existence of a "free boundary."
While the first boundary is given by V = 0,
the second boundary position V4 must be determined as part of the solution. As Dixit and
Pindyck show, such "free boundary" problems occur in many applications.
The solution to the McDonald-Siegel problem is relatively straightforward. One can
guess a functional form and verify its success.
Given the first boundary condition mentioned above, the solution must assume the
form:
F(V) = AV1,

where A is a constant to be determined and

1 > 1 is a known constant, the value of which
depends on the parameters ot, p, and (r of the
differential equation (4).
The other two boundary conditions help us
solve for the other unknowns: V4 (the threshold value at which the firm should invest) and
A (the constant mentioned above). Specifically:
V*= [PAN - 1)] I,
and
A = (V*- I)/V*pI= (l - 1)P1/[03 i l-P1].

(5)

The basic intuitive point is this: Irreversibility and the possibility of delay generate a range of inaction (not present in the
neoclassical model) in which V> I, yet the
firm does not invest. (This is because,
pi>1,PiA/pi - ) > l, and V* > L)
How large is this wedge between the traditional net present value investment criterion
and that in the new view? Without going into
algebraic detail, let me indicate some channels. First, as uncertainty about future returns (measured by a) rises, the wedge
1/(P1 - 1) also rises. Second, ceteris paribus,
an increase in the discount rate p increases
the wedge. Third, given p, an increase in
trend value growth a increases the wedge.
To compare these results with the predictions of the neoclassical model, it is useful to
revisit predictions of the q approach. If we
define q as the ratio of the expected value of
profits from an investment-conditional on
its completion-to its construction cost, then
q = V/I. A firm should invest when V > I. If
we acknowledge the loss of the option to invest when the project is completed, the installed project should raise firm value by
V - F(V), not by V. While in this alternative
setup the threshold criterion for investment
is V> I + F(V), the threshold q expressed in
the more conventional q terms defined earlier is 01/(Pl - 1) > 1. That is, fluctuations in V
can still yield a region of inaction in which q
exceeds unity with no investment response.1
11 In some respects, the wedge between the
investment criteria in the neoclassical model and
the new view is likely to be at its upper bound in
geometric Brownian motion examples in which defay can be arbitrarily long. An alternative model
(also considered by Dixit and Pindyck) would re-

flect the likelihoodthat projectvalue will decline

discontinuouslyat some point in the future (because of, e.g., patent expirationor entry generally). Analytically,the example just described
wouldbe augmentedby the possibilityof a downwardPoissonjump:
dV = a Vdt+ a Vdz- Vdq,

wheredq,anincrement
ofaPoissonprocesswithamean
arrivalrateX, is independent
of dz. Whenthe "event"
(ofpatentexpiration,
entry,etc.)occurs,q declineswith
probability
one by somefraction4 (betweenzeroand
one). Intuitively,
while V fluctuates(withgeometric
Brownianmotion),overeachinterval(dt),thereis a
probability
( Adt)thatitwilldropafraction
oftheoriginal
value(1 - 4) andcontinuefluctuating
(withgeometric

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Hubbard:Investment Under Uncertainty

4. Generalizing a (Monopoly) Firm's
Problem in the New View
Dixit and Pindyck offer many generalizations of the basic problem of investment under uncertainty for a monopoly firm. Here, I
focus on four arising in many applications,
encompassing: (a) more explicit descriptions
of price uncertainty, (b) consequences of depreciation, (c) combined effects of price and
cost uncertainty, and (d) costs of exit and
scrapping.

4A. Price Uncertainty

The first step toward generalizing the basic
model for the firm is to specify sources of
value fluctuations. Suppose that the proposed
project produces a physical flow of one unit
of output each period in perpetuity. The
price depends on the inverse demand function P = YD(1), where D is a measure of nonstochastic flow demand and Y is a stochastic
shift variable. In the simplest case, with no
variable costs of operating the project, we can
write a process for P reminiscent of the
geometric Brownian motion used earlier to
study V:
dP = a Pdt + a Pdz

(6)

The relationship to V is a simple one. Discounting future revenues at rate p gives

V = P/(p - a), where P is the current price.
The solution for the threshold price at which
investment should occur is P*= [01/(01- 1)]
(p - a) I, so that the threshold value is again
V*= [01/(01-1)] 1. Or, in the context of the q
model, the firm should invest if q > q*
= 1/(3iI - 1).
Placing the problem in terms of a threshold
price for investment serves as a useful segue
to the more realistic consideration of the case
with operating costs. In this case, the firm
will want to suspend operations if operating
costs cannot be covered. For simplicity, assume that a project's operation can be costlessly ceased when P is less than operating
cost C, and can be costlessly restarted if P
Brownianmotion) until the next event occurs. In this
case, holding other parameters constant, the option
value F(V) falls relative to pure geometric Brownian
motion example (see, e.g., Dixit and Pindyck 1994,
ch. 5).

1823

rises above C. McDonald and Siegel (1985)

note that such a project gives the firm an infinite set of options: to receive P by paying C
at any time t the option is exercised. Dixit
and Pindyck (1994, ch. 6) show the reader a
simple way of valuing the project as a single
claim that is a function of P. There are now
two regions for V(P), depending on whether
P - C or P < C. Once V(P) is determined,
it is straightforward to solve for the option
value F(P) for the case of a geometric
Brownian motion process for P. As in the earlier examples, an increase in uncertainty increases F(P), increasing the threshold criterion for investment.
4B. Depreciation
A second generalization of the basic model
addressed in Chapter 6 considers depreciation. A priori, this is an important extension
because the option to invest in a depreciating
project may seem less valuable than the option to invest in a nondepreciating project.
The simplest case is the one most generally
used in applied research, exponential decay.
In the language of stochastic processes, the
depreciating project has a random lifetime
following a Poisson process with arrival rate
X. The probability that the project depreciates to zero before any period T is 1' - eT.

Returning to the simple process for the

output price P with no variable costs, let the
initial price be P, which evolves according to
a geometric Brownian motion with trend
growth rate a; the discount rate is p. The expected value of the project's profits if it lasts
T periods is:
T

EJ e-PtPtdt = P[1 - e-P -

a)T/(p -

a).

To calculate the expected value of the project

V(P) we apply the probability density function of the lifetime in a Poisson process:
C00

V(P)=

f Xe

TP[l -

e(p-a)T]/(p

a)dT

=P/(X+p-a).

(7)

Intuitively, though the project can be analyzed as infinitely lived, future profits are discounted at a higher rate reflecting the probability of "death."

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Journal of Economic Literature, Vol. XXXII (December 1994)

1824

To obtain the option value in this case

F(P),we have to decide whether the firm has

the right to invest in the project once or in
perpetuity. In the former case, the investment threshold P4 can be calculated analogously to the price process example in Section 4A:
P[*1/(l
=

- 1)] (p - a + X)1,

(8)

where "p- a + X"replaces "p- a." Depreciation per se does not affect the option value in
this case. That is, the threshold investment
criterion is V*= I/(PI- 1) T > I, where PI is
as before. This is because the firm's opportunity to invest is assumed to be available only
once; hence, exercising the option is irreversible even though the project has a finite
life.
The option value can be reduced, however,
if the option to invest is available in perpetuity (that is, when the firm has the right to
start a new project at some point after the
first one dies). This is because exercising an
option to invest is less irreversible when the
option to invest again is always available.
While, simulated threshold q values in this
case remain above unity, they fall significantly in the presence of modest rates of depreciation.
4C. Uncertainty Over Both Price and

Cost
Chapter 6 also considers the possibility that
both price and the cost of investing are uncertain. While the intuition for arriving at a
threshold investment criterion does not differ
substantively in this case, the solution process
is mathematically more difficult. Both the
value of the project and the value of the investment option are now functions of both P
and 1. The solution must then find regions of
(P,I) values in which investment will occur.
Dixit and Pindyck present a sketch of a solution when both P and I follow geometric
Brownian motion. It is still the case that the
threshold q criterion for investment exceeds
unity on account of the option value.
4D. Costs of Exit and Scrapping
The final aspects of investment decisions
by a monopoly firm I want to address are

costs of exit and scrapping (see Ch. 7). The

examples in Section 4A, while nicely connected to the simple solutions with which we
began in Section 3, rely on the unrealistic assumptions of costless suspension and restarting. One way to gauge the impact of such
costs on investment options is to consider an
example in which the investment cost I must
be reincurred if a project's operation has
been previously suspended, as if the project
had rusted or decayed in the interim. Intuitively, a new option value arises-the value of
maintaining the project's operation given the
cost of restarting it. Now it is the abandonment decision which has a higher threshold
on account of the option value (in the sense
that the rate of loss must exceed a certain
critical positive level rather than simply
zero).
This case considered by Dixit and Pindyck
is one in which operating costs are constant
and demand uncertainty affects the output
price, which follows a geometric Brownian
motion as before. Investment, as before, requires a cost I; the firm must pay an amount
E if it wishes to abandon the project.12 We
can build upon the discussion in Section 4A
of the option value to invest under demand
uncertainty. Having invested, the firm's live
project still has an option component related
to abandonment. If the firm exercises that
option, it reacquires one of the original type,
the option to invest.
The solution to this problem conforms with
one's intuition. Imagine two threshold prices
PH and PL* On the one hand, if a firm does
not have a project in operation, it will remain
idle when the price P < PH, and will invest
when P 2 PH On the other hand, if a firm
has an active project, it will keep the project
going when the price exceeds PL. These
ranges of inaction stand in contrast to the
more knife-edge investment and abandonment decisions featured in most intermediate
microeconomics texts.
Dixit and Pindyck illustrate these ideas in
an analysis of capacity investment in mines
12 The example I consider here focuses on abandonment. Chapter 7 also considers temporary
abandonment, in which maintenance costs are required during the period in which a project is
mothballed.

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Hubbard: Investment Under Uncertainty

and smelters by U.S. copper producers in the
1970s and 1980s. In the boom times of the
1970s, firms did not appear to restart previously profitable mines (that had been shuttered in earlier low-price periods) or invest in
new ones. In the period of very low copper
prices in the mid-1980s, the firms continued
to operate mines and smelters that are no
longer profitable. This behavior, with very
broad ranges of inaction, is consistent with
the new view's predictions.
5. Extending the New View: Competitive
Equilibrium
As I noted at the outset, Chapters 5-7 provide the core of the intuition of the new view
analyzed in Investment Under Uncertainty.
For researchers and practitioners interested
in empirical applications and potential policy
implications, however, the lessons of the new
view would be more compelling if couched in
an industryequilibrium.This is because most
firms constantly struggle with the prospect of
competition in investment from other incumbents and potential entrants. The concept of
irreversibility is also perhaps more appropriately analyzed at the industry level because
the liquidity of most assets in place is surely
greater within than outside the industry.
To see the need for this distinction, suppose that investment is completely irreversible and firms expect an industry-wide expansion of demand. A given firm recognizes
the qualitative implications of the favorable
demand shift for the industry price, and
would like to increase its capital stock. Of
course, the firm understands that other firms
in the industry are making a similar calculation. As a result, the competitive firm will not
increase irreversible investment by as much
as it would in the case of a monopoly. By
contrast, an unfavorable shift in industry demand has a larger effect relative to the monopoly case. Given the assumption of complete irreversibility, all firms suffer because
exit is not possible. There is, then, an asymmetry in the competitive response to uncertainty, an asymmetry that makes firms, all
else equal, more cautious in undertaking incremental investment. The asymmetry does
not arise in the case of firm-specific uncer-

1825

tainty. This is because a firm understands

that an idiosyncratic demand shift does not
imply similar fortunes for other firms; hence,
the firm behaves like a monopolist.
More formally, what is the effect of competition within an industry on the option value
of investment and, by extension, on the new
view's criticism of predictions of conventional
investment models? To answer these questions in a competitive setting, we must go a
bit further in characterizing demand or cost
uncertainty, and differentiate between firmspecific uncertainty and industry-wide uncertainty.'3

Focusing on demand uncertainty, consider

both firm industry shocks to a firm's price.
Any given firm's price for a unit of output is:
P = XY D(Q),

(9)

where Q is the current output flow; D(Q), a

decreasing function, is the nonstochastic portion of the inverse demand curve faced by the
industry; and X and Y are firm-specific and
industry-wide shocks, respectively. If we normalize firm output to unity, Q is a summary
statistic for the number of active firms in the
industry.
Let's suppose that X-shocks are symmetric
firm-specific price uncertainty; that is, firms
face, with equal probability, equal up or
down shifts of X. Note that if the firm delays
investing, it can reduce its exposure to an adverse shock; it preserves the option to invest
if the price rises while choosing not to invest
if the price falls (as in the Ilova watch example in Section 2). By waiting, the firm receives a payoff that is a convex function of X;
hence, the expected value of waiting rises
with an uncertainty in X. This is the now familiar option value of delay.
Let's alternatively consider industry-wide
uncertainty in which symmetric Y-shocks are
permitted. Unlike the X-shock case, when Y
rises, each firm understands that entry is now
attractive for all firms. When other firms indeed enter, the supply shift leads the price to
rise disproportionately less than Y. Price becomes a concave function of Y; an increase in
13 In general, of course, both firm-specific and
industry-wide uncertainty exist; see, e.g., Ricardo
Caballero and Pindyck (1992).

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1826

Journal of Economic Literature, Vol. XXXII (December 1994)

uncertainty in the aggregate shock Y reduces

the expected value of investing (relative to
that of not investing). Hence, while the
threshold investment criterion can still be described in terms that "q must exceed unity by
some given amount," an option value is not
responsible for the wedge.
Let me elaborate on the effects of industrywide uncertainty on investment decisions in
the competitive equilibrium. In this case,
X = 1, and the industry's inverse demand
curve is:
P = Y D(Q).

(10)

Let the aggregate shock Y evolve according to

a geometric Brownian motion process:
dY=aYdt+ sYdz.
Before new entry takes place, Q is fixed, rendering P proportional to Y, and:
dP = aP dt +aPdz.

(11)

Intuitively, there is some price P above which

new entry occurs. Hence, any one firm views
the price process as described by (11) as long
as P < P; the price cannot go higher without
triggering entry and a subsequent price decline.
Dixit and Pindyck solve first for P, which is
identical to that faced by a monopolist producing one unit of output subject to the same
demand process. There are key differences,
however. First while the monopolist's view of
the price process is not affected by potential
entry (at least in the example), the competitor's is. An opposing second effect arises because the monopolist has an option value of
waiting, while the competitive firms do not.
These differences offset one another precisely. Dixit and Pindyck solve formally, then,
for the competitive equilibrium for the industry by setting the entry threshold P? equal
to P.
Because of this effective upper barrier on
the price process under competition, the
threshold price for entry is above the usual
Marshallian level. The authors show that under assumptions of modest average industry
growth and demand uncertainty, the required
rate of return for a risk-neutral firm can be
significantly higher than the real interest

rate. This qualification, also expanded to include the possibility of exit in the authors'
application to copper prices, implies that the
industry price can exceed long-run average
cost for a long period of time in a competitive
industry without stimulating entry.
6. Policy Intervention and Policy
Uncertainty
The ninth chapter of Investment Under Uncertainty addresses whether policy interventions are suggested by the new view investment models. The existence of delay and
inertia per se does not, of course support the
desirability of intervention in the absence of
a clearly articulated market failure. It is indeed easy to imagine real-world interventions
that do more harm than good. For example,
Dixit and Pindyck consider potential market
failures associated with incomplete markets
for sharing risk. Studying price controls as a
way to reduce risk, they find that such controls may be welfare-decreasing in many
cases. Another rich area for application lies in
industrial organization and antitrust policy.
Returning to the description in the previous
section of competitive equilibrium, policy
makers might see incumbent firms in an industry earning supernormal profits, but with
no entry occurring. With Marshallian intuition, they might take inappropriate action
against assumed barriers to entry, when they
might be observing a competitive industry. In
the same regard, observing a price below the
minimum level of average cost need not indicate predation; the "dumping"firms might be
maintaining the option to keep their (sunk)
investments.
In this section, I focus on the chance that
policy uncertainty may have unintended consequences; to be concrete, I frame the discussion in terms of business investment incentives. In describing price uncertainty in
Section 4, I noted that different characterizations of uncertainty can have different
effects on the responsiveness of investment
to changes in the net return to investing. The
same holds for tax policy uncertainty. An instructive case is the U.S. investment tax
credit (ITC), which, following its introduc-

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Hubbard:Investment Under Uncertainty

tion in 1962, has been changed many times.14
The example that follows, draws largely on
the work of Hassett and Metcalf (1994) and
the analysis of their work in Dixit and Pindyck (1994, Ch. 9).
It is useful to begin with the basic geometric Brownian motion model. The firm
chooses its capital stock to produce a stream
of output in perpetuity to be sold at an aftertax price P, where:
dP= apPdt+ op Pdz,
where P subscripts refer to the output price
process. To capture the idea of an ITC (or
accelerated depreciation), we can add tax incentives which reduce the cost of capital.
Suppose the price of capital also evolves according to a geometric Brownian motion
process:

Using the description of investment tax

policy changes over the postwar period from
Cummins, Hassett, and Hubbard (1994),
Hassett and Metcalf argue that it is more realistic to model investment incentives as a
Poisson process. (Recall the description of
these processes in Section 3.) This is because
investment incentives appear to change randomly and in discrete amounts. Consider an
ITC at rate k that reduces the price of capital
from PK to (1 - k) PK. The tax process follows
a Poisson process, switching between "high"
(kH)and "low"(kL)values of the ITC. In particular, the ITC in the Hassett-Metcalf example switches between kH and kL with transition probabilities XH and XL. If no credit is
currently in effect, the expected time until
one is introduced is known, though the actual
time is not. In this structure:

dPK = aK PKdt + AKPKdz,

where the K subscript refers to the price of
capital. This setup yields a result similar to
that we saw earlier for price uncertainty; the
threshold Tobin's q value for investing, q, is:

1827

IkH-kL
dkt=

,XHdt

0
kL-kH

,(1- XH)dt
,XLdt

,(1 - XL)dt.

uncertainty over the price of capital increases

the threshold q criterion for investment. In
this sense, uncertain tax policy can lead to an
increase in the hurdle rate for investment
projects. 15

The solution to such a problem describes,

among other things, threshold prices PH and
PL for investment in the absence and presence of the ITC, respectively.
Hassett and Metcalf examine a mean-preserving spread to consider the effect of an
increase in uncertainty on investment (given
the Poisson description of investment incentives). In particular, they fix XH and XL, but
change kH and kL, keeping E(k) constant. In
this case, Tobin's q threshold for investment
actually decreases with an increase in uncertainty, and the median time to investment
falls.16 Put simply, investment is bunched in
periods in which the high ITC is in effect. If

14 Since its introduction, the average duration

of periods with no ITC is three years, and the average duration of a period in which a specific ITC
is in effect is 3.67 years (see Cummins, Hassett,
and Hubbard 1994).
15 In another type of exercise, Dani Rodrik
(1991) analyzed consequences for investment of
uncertainty over the enactment of policy reforms
designed to stimulate investment. In his model, if
the reform policy can be reversed with some probability each year, the consequent uncertainty reduces the salutary effect of 'he reform on investment.

16 Another case in which the interaction of uncertainty and irreversibility may increase investment is that of learning about some types of uncertain costs-as, for example, in large-scale R&D
projects. Pindyck (1993) calls this technical uncertainty: If prices of inputs were known, how many
inputs and what level of effort are required to
complete the project? This type of uncertainty (as
opposed to uncertainty about the cost of individual
inputs) can be resolved only by actually proceeding with the project, and hence can stimulate investment.

q* = PI/(I - 1) >1,
and PI1is defined as in (5). That is, the firm
will not invest until the returns are sufficient
to compensate it for the lost option of delay.
To focus on tax policy uncertainty, consider a mean-preserving spread in the price
of capital: da > 0. One can show that
1-

)]/aa > 0; that is, an increase in

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1828

Journal of Economic Literature, Vol. XXXII (December 1994)

policy makers increase the frequency with

which changes in the ITC occur, then it is
more likely that the high-ITC state (in which
most investment occurs) is reached quickly.
(One note of caution: While this experiment
holds E(k) constant, the average cost of capital for investment changes because investment is bunched in high-ITC periods.)
Hassett and Metcalf (1994) and the related
discussion in Dixit and Pindyck (1994, ch. 9)
usefully illustrate the significance of choosing
carefully the underlying stochastic process if
normative analysis is the object. Two additional steps seem promising here. The first is
to extend the consideration to a competitive
industry equilibrium. The second is to investigate whether the analytical and simulation
results can help empirical researchers to explain findings of insignificant effects of tax
parameters on investment (as in many of the
studies surveyed by Chirinko 1993) or significant effects of tax parameterson investment (as
in Cummins, Hassett, and Hubbard 1994).
7. Empirical Implications
At the beginning of this review, I raised
three questions. I think it is clear that the
literature summarized and analyzed in Investment Under Uncertainty addresses practical
problems in modeling investment and offers
predictions consistent with observations of
many case studies of investment. Let me now
turn to the question of general empirical tests
of predictions of the new view. Because many
of the theoretical advances in this literature
are recent, empirical work is not as well developed, though many studies are emerging.
Below, I comment briefly on studies in the
new view literature17and an alternative generalization of neoclassical models to incorporate capital-marketimperfections.
7A. Empirical Tests of Option-Based
Models
A key prediction of the new view investment models is that the threshold expected
return required to trigger investment is influ17A related line of inquiry (not reviewed here)
generalizes conventional models of adjustment
costs; see Andrew Abel and Janice Eberly (1993)
and Dixit and Pindyck (1994, Ch. 11).

enced by uncertainty and irreversibility. Testing this prediction is a bit less straightforward
than tests of conventional neoclassical models, however. This is because the new view
models, while offering a rigorous description
of threshold q values for investment (to draw
an analogy to the neoclassical model), do not
offer specific predictions about the level of
investment. To go this extra step requires the
specification of structural links between the
marginal profitability of capital and the desired capital stock (the usual research focus
in the traditional neoclassical literature).
Nonetheless, option-based models offer some
testable hypotheses. For example, a fall in the
average rate of growth of profitability or rise
in the volatility of profitability should depress
investment over some period. Dixit and Pindyck offer some applications in Chapter 12.
A potentially informative literature testing
new view models using disaggregated data is
in its early stages. Caballero and Pindyck
(1992) use data on U.S. manufacturingindustries to study the determinants of the return
required to trigger investment. They employ
a proxy for the required return using extreme
values of the marginal profitability of capital.18 Supportive of the intuition of optionbased models, they find the proxies for the
required return depend positively on the
volatility of the marginal profitability of capital.19 In an analogous cross-sectional test,
Pindyck and Andres Solimano study the relationship between uncertainty and investment
for a set of thirty countries. For each country,
they calculate a time-series for the marginal
profitability of capital over a 28-year period.
Decomposing the period into three nine-year
subperiods, Pindyck and Solimano calculate
the mean and standard deviation of each
country's investment-GDP ratio and the annual log change in the marginal profitability
of capital. Using the panel of data, Pindyck
and Solimano relate the investment-GDP ra18 This calculation requires making assumptions
about the production technology, of course; they
assume a Cobb-Douglas technology with constant
returns to scale.
19 Such a test is only suggestive, because the
maximumvalue of the constructed marginalprofitability and its variance are correlated even if there
is no causal link between investment and uncertainty.

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Hubbard: Investment Under Uncertainty

tio to the mean and standard deviation of the
(log change in the) marginal profitability of
capital in each period. Consistent with the
prediction of new view models, they find that
the investment-GDP ratio varies positively
with the mean of the log change in the marginal profitability of capital, and negatively
with the standard deviation. While such approaches offer results supportive of the new
view predictions, they are only reduced-form
tests. Nonetheless, they are suggestive of potentially promising results from more structural analysis (using, say, techniques to study
dynamic firm decisions and industry equilibrium described in Ariel Pakes 1993).
While empirical research has not quite
caught up with the rapidly changing theoretical developments in this literature, applied
researchers have an opportunity to apply new
view models rigorously in industry-level studies of investment dynamics and in panel data
studies of investment using firm-level or industry-level data. The most promising such
research would focus on testable differences
between conventional neoclassical models
and option-based models.20

7B. Empirical Tests of the Role of

Capital-Market Imperfections
At least part of the motivation for the option-based investment models in the new
view is the problem raised in many empirical
studies that investment's responses to
changes in the user cost of capital or q are
implausibly small (or, equivalently, that "ad20 John Leahy and Toni Whited (1994) study the
relationship between uncertainty and investment
using firm-level panel data from Comiustat. After
discussing alternative models of links between uncertainty and investment, they perform some reduced-form tests, regressing firms' investmentcapital ratio on uncertainty (measured by the
variance of the firms' daily stock price for each
year) and for Tobin's q. They find that, holding q
constant, the variance term has no statistically significant effect on firms' investment. However, in
another test, they note that the variance term has
a negative and statistically significant effect on the
value of q, suggesting an indirect impact of uncertainty on investment. This stylized fact indicates
potential gains from testing structural representations of the alternative "uncertainty" approaches.

1829

justment costs" are implausibly large). This

claim is subject to debate. Some recent studies find that tests of neoclassical investment
models using panel data on large firms produce quite sensible estimates of adjustment
costs (see, e.g., Hubbard, Anil K. Kashyap,
and Whited, forthcoming; and Cummins,
Hassett, and Hubbard 1994).
As with the option-based models, some
models of "financing constraints" on investment predict ranges of inaction; that is, the
user cost of capital or Tobin's q can fluctuate
in a given range with no (or an attenuated)
response of investment. In these models,
problems of adverse selection or moral hazard impart a wedge between the cost of external finance and internal finance. The "range
of inaction" can be explained as follows. For
firms with high levels of internal net worth
relative to investment opportunities, the neoclassical model holds; shifts in q or the user
cost of capital change desired investment.
For firms with lower levels of net worth, costs
of external finance vary inversely with the
level of internal net worth: When borrowers'
net worth improves, lenders become more
willing to lend, and additional investment can
be financed. Hence, while shifts in internal
net worth affect investment in such firms, observed movements in q or the cost of capital
may not. Empirical studies in this literature
have focused on theoretically consistent ways
to group high-net-worth and low-net-worth
firms in firm-level data or high- and low-networth periods in industry data (see, e.g.,
Steven M. Fazzari, Hubbard, and Bruce C.
Petersen 1988; Takeo Hoshi, Kashyap, and
David Scharfstein 1991; and Hubbard and
Kashyap 1992).
Additional research on firm-level investment decisions could attempt to distinguish
between the predictions of neoclassical models augmented by informational imperfections on the one hand and option-based models on the other hand. Such an integration
might proceed in two steps: (1) analyzing effects of "finance constraints" in the continuous-time-stochastic-process models described
earlier (as for example, the analysis of "borrowing constraints"and consumption in Hubbard and Kenneth Judd 1986), and (2) deriving empirical tests to discriminate between

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1830

Journal of Economic Literature, Vol. XXXII (December 1994)

the "range of inaction" predictions of the two

classes of models.
8. Conclusions
Let me conclude where I began. Investment Under Uncertainty, by Dixit and Pindyck, should be required reading for researchers interested in investment, professors
teaching capital budgeting, and many practitioners. The book not only summarizes a
growing literature on investment under irreversibility and uncertainty, but bridges methodological and intuitive gaps among alternative approaches. This integration, arguably
the book's greatest strength, will likely stimulate a substantial body of future research.
The authors' careful and enjoyable writing
style also ensures that, conditional on exercising your option to read the book, you will not
abandon it.
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