A markup interpretation of optimal rules for irreversible investment

Abstract

We re-examine the basic investment problem of deciding when to incur a sunk cost to obtain a stochastically fluctuating benefit. The optimal investment rule satisfies a trade-off between a larger versus a later net benefit; we show that this trade-off is closely analogous to the standard trade-off for the pricing decision of a firm that faces a downward sloping demand curve. We reinterpret the optimal investment rule as a markup formula involving an elasticity that has exactly the same form as the formula for a firm's optimal markup of price over marginal cost. This is illustrated with several examples.