IDEAS home Printed from https://ideas.repec.org/a/eee/deveco/v52y1997i2p259-277.html
   My bibliography  Save this article

Investment in new activities and the welfare cost of uncertainty

Author

Listed:
  • Aizenman, Joshua

Abstract

Recent literature has highlighted the importance of new activities in development and growth. It was shown that trade distortions such as tariffs are associated with first-order costs stemming from the induced drop in the formation of new activities. This paper demonstrates that uncertainty may induce similar costs. This argument is illustrated in the context of Romer's model of a dependent economy, where foreign direct investment is needed to enable the importation of capital goods and intermediate products used in domestic production. The present paper shows that uncertainty acts as an implicit tax on new activities, whose incidence is (in a certain sense) worse than that of a tariff in Romer's framework. As with a tariff, uncertainty inhibits the formation of new activities. Unlike the tariff, however, uncertainty does not benefit the government with revenue. The welfare cost of uncertainty applies also for a closed economy. The paper shows that uncertainty-averse entrepreneurs discount using a 'hurdle rate' that exceeds the risk-free interest rate. The gap between the two rates increases with the uncertainty embodied in the investment, being determined by the vagueness of the information and by the range of possible outcomes. Hence, growth may be inhibited by business uncertainty, where the 'rules of the game' for new activities are vague.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Aizenman, Joshua, 1997. "Investment in new activities and the welfare cost of uncertainty," Journal of Development Economics, Elsevier, vol. 52(2), pages 259-277, April.
  • Handle: RePEc:eee:deveco:v:52:y:1997:i:2:p:259-277
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0304-3878(96)00452-X
    Download Restriction: Full text for ScienceDirect subscribers only
    ---><---

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Roberts, Kevin & Weitzman, Martin L, 1981. "Funding Criteria for Research, Development, and Exploration Projects," Econometrica, Econometric Society, vol. 49(5), pages 1261-1288, September.
    2. Rodrik, Dani, 1991. "Policy uncertainty and private investment in developing countries," Journal of Development Economics, Elsevier, vol. 36(2), pages 229-242, October.
    3. Robert S. Pindyck & Andrés Solimano, 1993. "Economic Instability and Aggregate Investment," NBER Chapters, in: NBER Macroeconomics Annual 1993, Volume 8, pages 259-318, National Bureau of Economic Research, Inc.
    4. Pindyck, Robert S., 1993. "Investments of uncertain cost," Journal of Financial Economics, Elsevier, vol. 34(1), pages 53-76, August.
    5. Dow, James & da Costa Werlang, Sergio Ribeiro, 1992. "Excess volatility of stock prices and Knightian uncertainty," European Economic Review, Elsevier, vol. 36(2-3), pages 631-638, April.
    6. Acemoglu, Daron & Zilibotti, Fabrizio, 1997. "Was Prometheus Unbound by Chance? Risk, Diversification, and Growth," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 709-751, August.
    7. Obstfeld, Maurice, 1994. "Risk-Taking, Global Diversification, and Growth," American Economic Review, American Economic Association, vol. 84(5), pages 1310-1329, December.
    8. Aizenman, Joshua & Marion, Nancy P, 1993. "Policy Uncertainty, Persistence and Growth," Review of International Economics, Wiley Blackwell, vol. 1(2), pages 145-163, June.
    9. Ramey, Garey & Ramey, Valerie A, 1995. "Cross-Country Evidence on the Link between Volatility and Growth," American Economic Review, American Economic Association, vol. 85(5), pages 1138-1151, December.
    10. Romer, Paul, 1994. "New goods, old theory, and the welfare costs of trade restrictions," Journal of Development Economics, Elsevier, vol. 43(1), pages 5-38, February.
    11. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-288, March.
    12. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
    13. Robert J. Barro, 1991. "Economic Growth in a Cross Section of Countries," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 106(2), pages 407-443.
    14. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June.
    15. Francisco L. Rivera-Batiz & Luis A. Rivera-Batiz, 2018. "Economic Integration and Endogenous Growth," World Scientific Book Chapters, in: Francisco L Rivera-Batiz & Luis A Rivera-Batiz (ed.), International Trade, Capital Flows and Economic Development, chapter 1, pages 3-32, World Scientific Publishing Co. Pte. Ltd..
    16. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 462-475, June.
    17. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
    18. Camerer, Colin & Weber, Martin, 1992. "Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-370, October.
    19. Costas Azariadis & Allan Drazen, 1990. "Threshold Externalities in Economic Development," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 105(2), pages 501-526.
    20. Daniel Ellsberg, 1961. "Risk, Ambiguity, and the Savage Axioms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 75(4), pages 643-669.
    21. Dow, James & Werlang, Sergio Ribeiro da Costa, 1992. "Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio," Econometrica, Econometric Society, vol. 60(1), pages 197-204, January.
    22. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    23. Kevin M. Murphy & Andrei Shleifer & Robert Vishny, 1989. "Income Distribution, Market Size, and Industrialization," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 104(3), pages 537-564.
    24. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    25. Lawrence H. Summers, 1987. "Investment Incentives and the Discounting of Depreciation Allowances," NBER Chapters, in: The Effects of Taxation on Capital Accumulation, pages 295-304, National Bureau of Economic Research, Inc.
    26. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 707-727.
    27. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
    28. Ethier, Wilfred J, 1982. "National and International Returns to Scale in the Modern Theory of International Trade," American Economic Review, American Economic Association, vol. 72(3), pages 389-405, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Gradstein, Mark, 2002. "Rules, stability, and growth," Journal of Development Economics, Elsevier, vol. 67(2), pages 471-484, April.
    2. Joshua Aizenman & Nancy Marion, 1995. "Volatility, Investment and Disappointment Aversion," NBER Working Papers 5386, National Bureau of Economic Research, Inc.
    3. Thomas Edward Flores & Irfan Nooruddin, 2011. "Credible Commitment in Post-Conflict Recovery," Chapters, in: Christopher J. Coyne & Rachel L. Mathers (ed.), The Handbook on the Political Economy of War, chapter 23, Edward Elgar Publishing.
    4. Andrea Bassanini, 2006. "Credibility, Irreversibility of Investment, and Liberalization Reforms in LDCs," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 35(2), pages 203-218, July.
    5. Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
    6. Fredriksson Per G & Mani Muthukumara, 2004. "Trade Integration and Political Turbulence: Environmental Policy Consequences," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 4(2), pages 1-28, February.
    7. Aizenman, Joshua, 1998. "Buffer stocks and precautionary savings with loss aversion," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 931-947, December.
    8. Thomas Edward Flores & Irfan Nooruddin, 2009. "Democracy under the Gun Understanding Postconflict Economic Recovery," Journal of Conflict Resolution, Peace Science Society (International), vol. 53(1), pages 3-29, February.
    9. Keefer, Philip, 2004. "A review of the political economy of governance : from property rights to voice," Policy Research Working Paper Series 3315, The World Bank.
    10. repec:bla:econom:v:66:y:1999:i:262:p:157-79 is not listed on IDEAS
    11. Daniela Grieco, 2018. "Innovation and stock market performance: A model with ambiguity-averse agents," Journal of Evolutionary Economics, Springer, vol. 28(2), pages 287-303, April.
    12. Straathof, Bas, 2002. "Micro-uncertainty and growth," Research Memorandum 001, Maastricht University, Maastricht Economic Research Institute on Innovation and Technology (MERIT).
    13. Shin-ichi Fukuda, 2001. "A Model of Keynesian under Knightian Uncertainty," CIRJE F-Series CIRJE-F-115, CIRJE, Faculty of Economics, University of Tokyo.
    14. Brunetti, Aymo, 1998. "Policy volatility and economic growth: A comparative, empirical analysis," European Journal of Political Economy, Elsevier, vol. 14(1), pages 35-52, February.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Joshua Aizenman & Nancy Marion, 1995. "Volatility, Investment and Disappointment Aversion," NBER Working Papers 5386, National Bureau of Economic Research, Inc.
    2. repec:bla:econom:v:66:y:1999:i:262:p:157-79 is not listed on IDEAS
    3. Aizenman, Joshua, 1998. "New Activities, the Welfare Cost of Uncertainty and Investment Policies," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 3(2), pages 97-110, April.
    4. Daniela Grieco, 2018. "Innovation and stock market performance: A model with ambiguity-averse agents," Journal of Evolutionary Economics, Springer, vol. 28(2), pages 287-303, April.
    5. Joshua Aizenman & Brian Pinto, 2004. "Managing Volatility and Crises: A Practitioner's Guide Overview," NBER Working Papers 10602, National Bureau of Economic Research, Inc.
    6. Gancia, Gino & Zilibotti, Fabrizio, 2005. "Horizontal Innovation in the Theory of Growth and Development," Handbook of Economic Growth, in: Philippe Aghion & Steven Durlauf (ed.), Handbook of Economic Growth, edition 1, volume 1, chapter 3, pages 111-170, Elsevier.
    7. Ahsan Abbas & Eatzaz Ahmed & Fazal Husain, 2019. "Political and Economic Uncertainty and Investment Behaviour in Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 58(3), pages 307-331.
    8. Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
    9. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    10. Aizenman, Joshua, 1998. "Buffer stocks and precautionary savings with loss aversion," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 931-947, December.
    11. Mukerji, Sujoy & Tallon, Jean-Marc, 2003. "Ellsberg's two-color experiment, portfolio inertia and ambiguity," Journal of Mathematical Economics, Elsevier, vol. 39(3-4), pages 299-316, June.
    12. Shaw, W. Douglass & Woodward, Richard T., 2008. "Why environmental and resource economists should care about non-expected utility models," Resource and Energy Economics, Elsevier, vol. 30(1), pages 66-89, January.
    13. Charles I. Jones, 2019. "Paul Romer: Ideas, Nonrivalry, and Endogenous Growth," Scandinavian Journal of Economics, Wiley Blackwell, vol. 121(3), pages 859-883, July.
    14. Umberto Cherubini, 1997. "Fuzzy measures and asset prices: accounting for information ambiguity," Applied Mathematical Finance, Taylor & Francis Journals, vol. 4(3), pages 135-149.
    15. William Darity & Lewis S. Davis, 2005. "Growth, trade and uneven development," Cambridge Journal of Economics, Cambridge Political Economy Society, vol. 29(1), pages 141-170, January.
    16. Alain Chateauneuf & Luciano De Castro, 2011. "Ambiguity Aversion and Absence of Trade," Discussion Papers 1535, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    17. Bryan Routledge & Stanley Zin, 2009. "Model Uncertainty and Liquidity," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 543-566, October.
    18. Shin-ichi Fukuda, 2008. "Knightian Uncertainty and Poverty Trap in a Model of Economic Growth," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 652-663, July.
    19. Sujoy Mukerji & Jean-Marc Tallon, 2001. "Ambiguity Aversion and Incompleteness of Financial Markets," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 68(4), pages 883-904.
    20. Takao Asano, 2004. "Portfolio Inertia and [Epsilon]-Contaminations," ISER Discussion Paper 0610, Institute of Social and Economic Research, Osaka University.
    21. Zhihua Li & Julia Müller & Peter P. Wakker & Tong V. Wang, 2018. "The Rich Domain of Ambiguity Explored," Management Science, INFORMS, vol. 64(7), pages 3227-3240, July.

    More about this item

    JEL classification:

    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • F15 - International Economics - - Trade - - - Economic Integration

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:deveco:v:52:y:1997:i:2:p:259-277. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/devec .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.