The cost of an irreversible investment cannot be recovered once it is installed. This restriction not only truncates negative investments, but also raises the threshold for positive investment. The threshold return that justifies an irreversible investment increases with uncertainty, or more precisely, with the probability mass in the lower tail of outcomes. Irreversibility constrains the ability to redeploy capital in ‘bad’ states, so the agent is particularly sensitive to these states when investing ex ante.
This finding is analogous to valuation and exercise of financial options, and irreversible investments are valued and understood by using option pricing techniques.
KeywordsAdjustment costs Irreversible investment Option pricing theory Option valuation Put–call parity Uncertainty
JEL ClassificationsD4 D10
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