Instantaneous optimal investment decisions with costly and costless reversibility

Abstract

While many different theories have been put forward to explain investment behaviour, they are all generally based on dynamic optimization, and there are a number of different methods available to solve such problems. In such models, the optimal values of the control and state variables, namely investment and the capital stock respectively, become forward-looking, dependent on the future values of prices of both output and the factors of production, and on the (unknown) end period value of the capital stock. In this paper we suggest a new method to obtain optimal investment levels without requiring information on the future, or end period conditions. Thus the optimal paths of control and state variables are obtained without needing to know future values of variables. Instead of maximizing the discounted value of the cash flows from unit capital accumulation over an unobservable future time interval as a performance index, the firm is assumed to maximize the current value of the cash flow of a unit capital accumulation at each time t.