IRREVERSIBLE INVESTMENT WITH UNCERTAINTY AND SCALE ECONOMIES

Optimal irreversible investment policy is analyzed when profits undergo multiplicative geometric Brownian shocks. The marginal product of capital increases initially and then decreases. In the latter range, it is optimal to add capacity gradually as the shock rises to a threshold where the expected return on the marginal unit is a multiple of its cost, reflecting the option value of waiting. The optimal policy in the increasing marginal product range obeys the same multiple, now applied to the total return on an optimal discrete capacity addition. Implications for economic growth, and suboptimal equilibria under external economies, are examined.