Investment under uncertainty: The nature of demand shocks and the expected profitability of capital

What is it about?

Over the years, an empirical literature emerged motivated by the debate on the sign of the uncertainty–investment relationship and its interplay with the different hypotheses about firm characteristics, namely the degree of capital irreversibility, demand elasticity and labour flexibility. We analyse the disparity regarding the sign of the investment–uncertainty relationship in models of investment under symmetric adjustment costs. We show that sign is determined by the shape of the profit function, which is related to the nature of demand shocks: (i) changes in the output price associated with a given demanded quantity or (ii) changes in demanded quantity at any given price. While only (i) is possible in the perfect-competition price-taker case, both (i) and (ii) are admissible in the non-competitive case, where the firm faces a negatively-sloped demand function.

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