Showing papers in "International Economic Review in 1985"

Investment and the Valuation of Firms When There is an Option to Shut Down

Abstract: An important lesson from elementary microeconomics is that a plant should be shut down if operating revenues are less than variable costs. This simple production rule has implications -which have received little attentionfor the initial decision to build the plant.2 This paper develops and studies a methodology for valuing risky investment projects, where there is an option to temporarily and costlessly shut down production (with no effect on future prices and costs) whenever variable costs exceed operating revenues. It is obvious that future revenues or costs must be uncertain if the shut-down option is to affect the investment decision otherwise, it is always known ex ante whether the plant is to be operated. Uncertainty is introduced in this paper by supposing that prices and costs follow a continuous time stochastic process.3 The firm in our model is a risk-neutral, price-taking value maximizer, which is owned by risk-averse investors. Risk aversion thus influences the investment decision by affecting the cost of capital faced by the firm. This is in contrast to the model in Sandmo [1971], in which the firm maximizes the utility of profits.4 Our treatment is descriptive of value-maximizing, publicly-owned firms and is widely used in the finance literature. The economics literature studying the effect of uncertainty on firm behavior has, however, tended to follow Sandhmo. The explicit modelling of the shut-down option and our treatment of risk aversion give us results that differ from those obtained by others who have studied the valuation of risky projects. Our principal results are: 1) Increases in the variance of the output price can either raise or lower the

Oligopoly extraction of a common property natural resource: The importance of the period of commitment in dynamic games

Abstract: The theory of noncooperative dynamic games has provided an extremely powerful framework for studying many of the classic questions in industrial organization - for example, questions about resource extraction, advertising, research and development, investment in new capacity; and barriers to entry where interactions over time among few firms are involved. However, an important methodological issue arises when economic competition over time is modeled as a dynamic game. The issue is the appropriate formulation of the players' strategy spaces.

Tied Aid and the Paradoxes of Donor-Enrichment and Recipient-Impoverishment

Abstract: It is part of received doctrine that, in a two-country world without hindrance of commodity taxes or other distortions and with market stability assured, international transfers necessarily harm the donor and benefit the recipient.2 However, in the case of most non-private international aid, those conditions fail. Donors often require that aid be spent in a manner not closely related to private preferences in the recipient countries, indeed not closely related to any well-behaved preferences and they normally finance the aid by means of distorting taxation. Hence, one cannot rule out by appeal to standard theorems the possibility that aid perversely leaves the donor better off and/or the recipient worse off. Let us say that aid is tied in the recipient if it is spent inefficiently in terms of individual preferences and that aid is tied in the donor if it is financed inefficiently. Thus, whether aid is tied is a question of how it is spent (or financed). It is not a question of the numeraire in terms of which aid is accounted nor of the form in which it is offered.3 Evidently the definition of tying is uncommonly broad. For example, aid may be tied in the recipient not because the donor attaches strings but because the government of the recipient is incompetent or unrepresentative. Moreover, the definition is relevant however the aid is applied whether to private or public goods, whether to consumption or investment goods. We follow the literature on "the transfer problem" in assuming that aid is spent on private consumption goods, like hospital services and powdered milk. This is a matter of convenience and continuity only.4 In the present note, we seek to rework the economics of foreign aid under novel assumptions. In particular, allowance will be made for the possibility that aid is tied, in whole or in part, in the donor or in the recipient. It will be verified that the donor may benefit and the recipient suffer and that these outcomes are com-

Joint Confidence Intervals for Income Shares and Lorenz Curves

Abstract: In a recent paper, Beach and Davidson [1983] extended the principles of statistical inference to Lorenz curves and income shares by establishing the (asymptotic) distribution and covariance structure of a vector of Lorenz curve ordinates corresponding to a set of quantile abscissae. One can thus use the Lorenz curve and income shares, no longer just as descriptive devices for summarizing distribution information, but now also as analytical tools for comparing alternative distributions and carrying out conventional statistical inference on them. It would clearly be desirable, however, to extend and complement this work by providing a method for computing a set of joint confidence intervals about these income shares and for illustrating graphically a joint confidence band about a set of estimated Lorenz curve ordinates. The present paper provides a new and simple technique for doing this. When analyzing differences between sets of income shares or Lorenz curves, one typically wants to elicit more detailed information than is provided by a standard joint chi-square test on the overall set of shares. That is, when the hypothesis of two sets of shares being the same is rejected, we generally want to know further which particular differences in shares are different from zero, and of these nonzero differences which are positive and which negative (Savin [1980]). A natural way of providing such information is through multiple comparison procedures developed in this paper. In a recent work, Richmond [1982] has developed a general method of finding multiple comparison intervals that is particularly suited to the present problem and in this situation appears to dominate other conventional alternatives. In contrast, for example, to Scheff&'s S-projection method, Richmond's approach focuses on a set of primary points of interest (income shares) among a more general set of points (including the Lorenz curve ordinates) and optimizes the joint confidence interval lengths on this primary set of points. Since estimated Lorenz curve ordinates are built up from underlying income shares, these shares (perhaps further supplemented) are natural choices for the primary set. The method, however, also provides a joint confidence band that geometrically bounds the set of Lorenz curve ordinates (and interpolated segments between them). The present

A Stochastic Model of Investment, Marginal q and the Market Value of the Firm

Abstract: This paper presents closed-form solutions for the investment and valuation of a competitive firm with a Cobb-Douglas production function and a constant elasticity adjustment cost function in the presence of stochastic prices for output and inputs. The value of the firm is a linear function of the capital stock. The optimal rate of investmentis an increasing function of the slope of the value function with respect to the capital stock (marginal q). A mean preserving spread of the distribution of future price increases investment. An increase in the scale of the random component of a price can increase, decrease or not affect the rate of investment depending on the sign of the covariance of this price with a weighted average of all prices.(This abstract was borrowed from another version of this item.)

Structural implications of a class of flexible functional forms for profit functions

Abstract: Structural Implications of a Class of Flexible Functional Forms for Profit Functions Author(s): Ramon E. Lopez Source: International Economic Review, Vol. 26, No. 3 (Oct., 1985), pp. 593-601 Published by: Wiley for the Economics Department of the University of Pennsylvania and Institute of Social and Economic Research, Osaka University Stable URL: https://www.jstor.org/stable/2526705 Accessed: 29-08-2018 16:47 UTC

Trade in Goods and Factors with International Differences in Technology

Abstract: A general model of trade caused by international differences in production technology is developed using techniques of duality theory. For the caseof product-augmenting differences in technology, it is shown that there is a positive correlation between net export and technological superiority, such that a country will "on average" export goods for which the country has superior technolor. If some factors are permitted to be internationally traded, it is demonstrated via this correlation that the volume of trade must increase. Thus unlike trade caused by factor endowment differences, goods trade caused by product-augmenting differences in production technolody is always in this sense complementary with factor trade. For factor-augmenting technology differences, in the absence of factor trade the goods trade pattern is as if it was caused by factor endowment differences. With factor trade, goods trade and factor trade can then be either complements or substitutes.

Expected Consumer's Surplus and the Welfare Effects of Price Stabilization

Abstract: Suppose a consumer faces a price which is uncertain ex ante. A question which often arises is whether the consumer would benefit from a stabilization policy under which the price would then be fixed and known with certainty. Many authors have addressed this question by calculating the expected compensating variation of the price change; others have used expected Marshallian consumer's surplus, often with the explanation that it is a good approximation to expected compensating variation.2 An important unresolved issue, however, is whether expected compensating variation does in fact provide a valid ranking of stochastic prices against stabilized prices, i.e., a ranking in agreement with that given by expected utility. In Section 2, we demonstrate that expected compensating variation is not in general a valid utility indicator. In essence, while utility comparisons under uncertainty require the use of the cardinal properties of (von NeumannMorgenstern) utility functions, the expected surplus measures depend only on ordinal preference rankings. Expected compensating variation, then, is completely insensitive to, and cannot reflect, the precise factor of interest in suchstudies: the consumer's attitudes toward risk. We then derive a set of restrictions on the utility function which are necessary in order for expected compensating variation to be a valid measure. We see that price stabilization policies can only be evaluated with compensating variation if consumer preferences are assumed to satisfy quite stringent requirements. This is in constrast to the familiar certainty case in which compensating variation always provides correct rankings.

Inventories as an Asset: The Volatility of Copper Prices

Abstract: The spot price of copper metal is known to be extremely volatile. From 1958 to 1980, the mean monthly average price was $0.49 per pound (in constant 1967 dollars), while the standard deviation of month-to-month changes in the real price was $0.06. Claims to copper inventories are traded on the London Metal Exchange (LME), a competitive world asset market. This paper empirically investigates the dynamics of copper spot prices on the LME, focusing on the rate of return to holding copper metal and on the implications of inventory stockouts for this rate of return. We make one major departure from the standard economic theory of exhaustible resources.2 Instead of assuming constant short-run marginal cost (SRMC), we incorporate rising SRMC of extraction into the model.3 This technological assumption provides an economic motive for production smoothing by holding inventories. Equilibrium inventory holdings ameliorates rising SRMC by moving extraction to low SRMC time periods. We show that this amelioration is imperfect because of inventory stockouts. When stockouts can occur, the spot price of a resource reflects transient shocks to its scarcity value as well as permanent shifts. More specifically, the economic motive for inventory holding affects the equilibrium price dynamics of exhaustible resources in two ways. First, as long as positive inventories are being held, their holders should earn the competitive rate of return. Thus, the price of extracted resource should rise at the rate of interest in expected value. This result differs from most recent theoretical studies of exhaustible resources, which conclude that price minus marginal extraction cost should rise at the rate of