IRREVERSIBLE INVESTMENT WITH UNCERTAINTY AND SCALE ECONOMIES

Optimal irreversible investment policy is analyzed when profits underg o multiplicative geometric Brownian shocks. The marginal product of ca pital 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 c ost, reflecting the option value of waiting. The optimal policy in the increasing marginal product range obeys the same multiple, now applie d to the total return on an optimal discrete capacity addition. Implic ations for economic growth, and suboptimal equilibria under external e conomies, are examined.