Irreversible investment and Knightian uncertainty

When firms make a decision about irreversible investment, they may not have complete confidence about their perceived probability measure describing future uncertainty. They may think other probability measures perturbed from the original one are also possible. Such uncertainty, characterized by not...

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Bibliographic Details
Published in:Journal of economic theory 2007-09, Vol.136 (1), p.668-694
Main Authors: Nishimura, Kiyohiko G., Ozaki, Hiroyuki
Format: Article
Language:English
Subjects:
Business investment
Corporate finance
Economic theory
Financial management
Investment
Investment strategies
Investment theory
Irreversible investment
Knightian uncertainty
Optimal stopping
Probability
Risk
Risk management
Studies
Uncertainty
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Summary:When firms make a decision about irreversible investment, they may not have complete confidence about their perceived probability measure describing future uncertainty. They may think other probability measures perturbed from the original one are also possible. Such uncertainty, characterized by not a single probability measure but a set of probability measures, is called “Knightian uncertainty.” The effect of Knightian uncertainty on the value of irreversible investment opportunity is shown to be drastically different from that of traditional uncertainty in the form of risk. Specifically, an increase in Knightian uncertainty decreases the value of investment opportunity while an increase in risk increases it.
ISSN:0022-0531
1095-7235
DOI:10.1016/j.jet.2006.10.011