The Effect of Mean Reversion on Entry and Exit Decisions Under Uncertainty
39 Pages Posted: 24 Oct 2009 Last revised: 4 May 2010
Date Written: October 20, 2009
Many economic variables of interest exhibit a tendency to revert to predictable long-run levels. However, mean reverting processes are rarely used in investment models in the literature. In most models, geometric Brownian motion processes are used for tractability. In this paper, a firm’s entry and exit decisions when the output equilibrium price follows an exogenous mean reverting process are examined, and then compared to the decisions of the firm under the usually employed assumption of lognormally distributed output price, presented in Dixit (1989a). By extending previous work by Sarkar (2003) to account for costly reversibility, we show that mean reversion has a significant effect, not only on firm-specific entry and exit decisions, but also on the balance of entering and exiting firms in an industry/market. Thus it would be erroneous to use the more tractable geometric Brownian motion process as an approximation for a mean-reverting process in models and investigations of aggregate industry investment.
Keywords: Investment, Uncertainty, Real options, Mean reversion
JEL Classification: C61, D81, D92, E22, G31
Suggested Citation: Suggested Citation