Paper Title
The Uncertainty-Investment Relationship with Endogenous Capacity

This paper revisits the uncertainty-investment relationship with a real-option model, where the firm chooses both the timing and size of the investment, unlike existing studies. Using a new composite measure of investment that takes into account both timing and size, it is shown that investment is generally a non-monotonic (initially increasing and subsequently decreasing) function of uncertainty. Thus, uncertainty can have a positive or negative impact on investment. Comparative static analysis indicates that uncertainty is more likely to have a positive effect on investment when demand growth rate and demand volatility are low, and interest rate and operating cost are high. The effect also depends on the production technology; with decreasing-returns-to-scale technology it is more likely to be positive, and with increasing-returns-to-scale technology it is more likely to be negative. It is also shown that investment is more sensitive to uncertainty for decreasing-returns-to-scale technology, high cost of production capacity, low operating cost and less market power. While there is some empirical evidence in support of a non-monotonic uncertainty-investment relationship and the role of market power, the other implications of the model have not been empirically tested yet. Keywords - Investment, Real-option model, Uncertainty, Volatility.