A Rehabilitation of Economic Replacement Theory

Our objective in this paper is to shed light on the economic forces and the specific way in which they combine to determine the service life, and hence the replacement demand for durables, in the short run and in the long run. For this purpose the received multiperiod economic replacement model is extended in the light of more recent theoretical developments and solved for the number and duration of replacements. Owing mainly to the intuition that the latter decisions are inexplicably related to the owner s profit horizon, aside from steady state replacement, the model is shown to yield a range of transitional and limiting replacement policies that have been largely ignored in the literature. In addition, the results indicate that : a) the optimal service life is consistently determined by such conventional forces of short-term variation as utilization, maintenance, operating safety, interest rate, uncertainty due to technological breakthroughs, the price of new and used durables, etc., b) switching among replacement policies produces bursts or slumps in replacement investment much like the spikes discovered recently at the plant level, and c) in non- stationary economic environments the error from applying steady state replacement, instead of the more appropriate transitory replacement policies reported in this paper, may be substantial.