The Impact of Depreciation and Reinvestment 2002

Abstract:  this paper we will demonstrate that for many investment decisions this procedure is not appropriate. The reason behind is a central assumption in the Dixit and Pindyck framework. They implicitly assume that the assets have an infinite lifetime. Consequently, the aggregate output on the market may increase over time but it cannot decline as it is shown in figure 1, i.e. if assets do not need to be replaced and if prices cannot become negative (which is implicit for GBM) then the asset will be used for an infinite time. However, if one assumes that assets are subject to decay or that they have a limited lifetime, the price dynamics changes: There still is a certain trigger price that forms a reflecting barrier for an increasing demand parameter a t . However - and in contrast to the Dixit and Pindyck model - a decrease of a t can at least partly be compensated by a subsequent output decrease if there are some "depreciated" production facilities that will not be replaced because expected prices are lower than the trigger price. Hence, downward price reactions are dampened as it is shown in figure 1. Consequently, under competition the equilibrium investment trigger for assets with finite lifetime is lower than for identical investment opportunities that are exclusive