Business Investment under Uncertainty and Irreversibility1

Abstract: This article surveys developments in the literature on business investment that have shed light on important aspects of firms' investment behaviour. Recent contributions emphasize the relevance of idiosyncratic factors affecting investment decisions such as the degree of irreversibility and uncertainty, whose interaction may generate an opportunity cost equivalent to the exercise of an option. They add an important dimension to the neoclassical theory of investment in so far as they emphasize cross‐sectional differences in optimal investment behavior. The econometric evidence is consistent with the predictions of these models pointing to a slower response of investment to demand shocks at higher levels of uncertainty.