Robert S. Pindyck

Options, the Value of Capital, and Investment

Capital investment decisions must recognize the limitations on the firms ability to later sell or expand capacity. This paper shows how opportunities for future expansion or contraction can be valued as options, how their valuation relates to the q theory of investment, and their effect on the incentive to invest. Generally, the option to expand reduces the incentive to invest, while the option to disinvest raises it. We show how these options determine the effect of uncertainty on investment, how they are changed by shifts of the distribution of future profitability, and how the q-theory and option pricing approaches are related.

Interfuel substitution and the industrial demand for energy : an international comparison

Work supported by the RANN Division of the National Science Foundation under Grant #GSF SIA 75-00379.

Economic instability and aggregate investment

Recent literature suggests that because investment expenditures are irreversible and can be delayed, they may be highly sensitive to uncertainty. We briefly summarize the theory, stressing its empirical implications. We then use cross-sectional and time-series data for a set of developing and industrialized countries to explore the relevance of the theory for aggregate investment. We find that the volatility of the marginal profitability of capital-a summary measure of uncertainty-affects investment as the theory suggests, but the size of the effect is moderate and is greatest for developing countries. We also find that this volatility has little correlation with indicia of political instability used in recent studies of growth, as well as several indicia of economic instability. Only inflation is highly correlated with this volatility and is also a robust explanator of investment.

Investments of Uncertain Cost

I study irreversible investment decisions when projects take time to complete, and are subject to two types of uncertainty over the cost of completion. The first is technical uncertainty, i.e., uncertainty over the amount of time, effort, and materials that will ultimately be required to complete the project, and that is only resolved as the investment proceeds. The second is input cost uncertainty, i.e., uncertainty over the prices and quantities of labor and materials required, and which is external to the firms investment activity. I derive a simple decision rule that maximizes the firms value, and I use it to show how these two types of uncertainty have very different effects on investment decisions. As an example. I analyze the decision to start or continue building a nuclear power plant during the 1980s.

Uncertainty and exhaustible-resource markets

Demand and reserve uncertainty are included in a simple model of an exhaustible resource market by allowing the demand function and the reserve level to fluctuate via continuous-time stochastic processes. Thus, producers always know current demand and reserves but do not know what demand and reserves will be in the future. I show that demand uncertainty has no effect on the expected dynamics of market price, while reserve uncertainty shifts the expected rate of change of price only if extraction costs are nonlinear in reserves. However, if the demand function is nonlinear, both demand, and reserve uncertainty affect the dynamics of production, whatever the character of extraction costs. The model is also extended to include exploration, first as a means of reducing uncertainty and second as a means of accumulating reserves, with uncertainty over the future response of discoveries to exploratory effort.

Gains to Producers from the Cartelization of Exhaustible Resources

Three cartels are examined to determine the potential gains to producers of forming cartels to market exhaustible resources by calculating both monopolistic and competitive price trajectories. Included in the study are the Organization of Petroleum Exporting Countries (OPEC), International Council of Copper Exporting Countries (CIPEC), and the International Bauxite Association (IBA). An optimal pricing model is described and applied to each of the cartels. Cartels are concluded to have an advantage for petroleum and bauxite, but not for copper. The smaller market shares of CIPEC and short-term lag adjustments seem to be the determining factors rather than resource exhaustion. Future research is needed to determine the effects of competitive firms changing their price expectations and cartel formation of consuming countries. 27 references.

Optimal timing problems in environmental economics

Abstract Because of the uncertainties and irreversibilities that are often inherent in environmental degradation, its prevention, and its economic consequences, environmental policy design can involve important problems of timing. I use a simple two-period model to illustrate these optimal timing problems and their implications for environmental policy. I then lay out and solve a continuous-time model of policy adoption in which the policy itself entails sunk costs, and environmental damage is irreversible. The model generalizes earlier work in that it includes two stochastic state variables; one captures uncertainty over environmental change, and the other captures uncertainty over the social costs of environmental damage. Solutions of the model are used to show the implications of these two types of uncertainty for the timing of policy adoption.

The Comovement of Stock Prices

We test whether comovements of individual stock prices can be justified by economic fundamentals. This is a test of the present value model of security valuation with the constraint that changes in discount rates depend only on changes in macroeconomic variables. Then, stock prices of companies in unrelated lines of business should move together only in response to changes in current or expected future macroeconomic conditions. Using a latent variable model to capture unobserved expectations, we find excess comovement of returns. We show that this excess comovement can be explained in part by company size and degree of institutional ownership, suggesting market segmentation.

The Present Value Model of Rational Commodity Pricing

The present value model relates an assets price to the sum of its discounted expected future payoffs. I explore the limits of the model by testing its ability to explain the pricing of storable commodities. For commodities the payoff stream is the convenience yield that accrues from holding inventories, and it can be measured directly from spot and futures prices. Hence the model imposes restrictions on the joint dynamics of spot and futures prices, which I test for four commodities. I find close conformance to the model for heating oil, but not for copper or lumber, and especially not for gold. The pattern is the same for the serial dependence of excess returns, These results suggest that for three of the four commodities, prices at least temporarily deviate from fundamentals.

Determining Benefits and Costs for Future Generations

The United States and others should consider adopting a different approach to estimating costs and benefits in light of uncertainty. In economic project analysis, the rate at which future benefits and costs are discounted relative to current values often determines whether a project passes the benefit-cost test. This is especially true of projects with long time horizons, such as those to reduce greenhouse gas (GHG) emissions. Whether the benefits of climate policies, which can last for centuries, outweigh the costs, many of which are borne today, is especially sensitive to the rate at which future benefits are discounted. This is also true of other policies, e.g., affecting nuclear waste disposal or the construction of long-lived infrastructure.