Investment under Productivity Uncertainty

17/11/2002 |  Menashe Yigal
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Investment under Productivity Uncertainty1
Yigal Menashe2


This paper investigates the effect of different types of productivity uncertainty on the delay of aggregate investment. The results of the model show that for risk–neutral competitive firms with constant returns to scale, the negative relation between uncertainty and aggregate investment exists in the case of aggregate uncertainty —when all firms in the industry face shocks to their productivity (like an oil shock), as in the case of relative uncertainty or when only some firms face those shocks (for instance adopting an innovation). The answer to the question, of which type of uncertainty leads to more delay of investment as a whole is ambiguous and depends two opposite effects which are determined by three parameters: the strength of the productivity shock, the elasticity of demand for output and the capital share in production. Assuming values of capital share which are consistent with empirical evidence (20-40 percent), the result is that there is more delay of investment under relative uncertainty than under the aggregate uncertainty. This result and the negative relationship between aggregate investment and productivity uncertainty are supported by the empirical evidence based on panel data of firms in the Israeli manufacturing industries in the first half of the 1990s.

Key words: irreversible investment, productivity shocks, aggregate and relative uncertainty.

JEL: C33, E22, D80, L60, O47

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1 This paper is part of my Ph.D. dissertation, under the supervision of Daniel Tsiddon.
  I thank Daniel Tsiddon ,Yona Rubinstein, Zvi Hercowitz and Jacob Braude for helpful comments.

2 Research Department, Bank of Israel and the Eitan Berglas School of Economic, Tel-Aviv University.