The Uncertainty-Investment Relationship with Endogenous Investment Size

Abstract

This paper revisits the uncertainty-investment relationship with a real-option model where the firm chooses both the timing and the size of the investment, unlike existing studies. Using a new measure of investment that takes into account both size and timing, it is shown that, in general, investment is a non-monotonic (initially increasing and subsequently decreasing) function of uncertainty. Thus, uncertainty can have a positive or negative impact on investment; however, it is more likely to be positive when demand growth rate and demand volatility are low, and discount rate and operating cost are high. The relationship also depends on the production technology, with decreasing-returns-to-scale technology it is more likely to be positive, and with increasing-returns-to-scale technology it is more likely to be negative.