Uncertainty, Investment and Capital Accumulation

202 Pages·2009·2.78 MB·English

Uncertainty, Investment and Capital Accumulation:
A Structural Econometric Approach

GUIYING WU
Nuffield College
Department of Economics
University of Oxford

A THESIS SUBMITTED IN PARTIAL FULFILMENT
OF THE REQUIREMENTS FOR THE DEGREE OF
DOCTOR OF PHILOSOPHY IN ECONOMICS

JUNE 2009
ACKNOWLEDGEMENT

To my supervisors, Professors Steve Bond and Måns Söderbom, who teach
me how to do economic research. Some of the material presented in
Chapters 3, 4 and 5 draws on our earlier joint papers, which are available at:
http://www.nuff.ox.ac.uk/users/wu.

To my parents, who seed the belief in truth and beauty.

To my husband, Qu Feng, who completes me on the path to be "a couple of
economists".
I declare that this thesis represents my own work, except where
otherwise specified, and that it has not been previously included in a
thesis, dissertation or report submitted to this University or to any
institution for a degree, diploma or other qualifications.

Signature: Date:
ABSTRACT

This thesis contributes to the empirical literature about how uncertainty affects
firm-level investment behavior and capital accumulation using a structural
econometric approach. Chapter 2 surveys the literature and highlights that there
are two key channels through which uncertainty may affect investment decisions.
One reflects the non-linearity of operating profits in stochastic demand or
productivity parameters, summarized as the Hartman-Abel-Caballero (HAC)
effect. Another reflects frictions in capital adjustment, summarized by different
forms of capital adjustment costs: partial irreversibility, a fixed cost of
undertaking any investment and quadratic adjustment costs. Chapter 3 presents
simulation evidence about the effects of uncertainty on investment dynamics and
capital accumulation through different forms of adjustment costs. Using the
Method of Simulated Moments, Chapters 4 and 5 estimate fully parametric
structural investment models, for panels of Brazilian and UK manufacturing firms,
respectively. Chapter 4 investigates the effects of reducing capital adjustment
costs. Counterfactual simulations indicate that investment would be much more
responsive to new information about profitability if firms in Brazil faced a lower
level of adjustment costs. A lower level of adjustment costs would also induce
firms to operate with substantially higher capital stocks. Both these effects are
mainly due to the importance of the estimated quadratic adjustment costs. Chapter
5 then investigates the effects of changing the level of uncertainty. The estimated
investment models predict a small effect of uncertainty on investment dynamics in
the short-run, and a negative and potentially large effect of uncertainty on capital
accumulation in the long-run. The long-run effect of uncertainty operates through
the negative effect of quadratic adjustment costs in the baseline model, or through
a richer combination of effects in an extended model that allows discount rates to
vary with the level of uncertainty.

Word Account: 47,500 =190 pages*250 words/page
CONTENT

Chapter 1: Introduction………………………………………………………….. 1

Chapter 2: Uncertainty, Investment and Capital Accumulation: What Do We
Know and What Do We Not Know?..…………………………………………… 7
2.1 Introduction……………………………………………………….………….. 8
2.2 Theoretical Framework……………………………………….…………….... 8
2.3 The Effects of Uncertainty…………………………………………………… 13
2.4 A Structural Econometric Approach……………………………………….... 19
Figures...……………………………………………………………………… 23

Chapter 3: The Effects of Adjustment Costs and Uncertainty on Investment
Dynamics and Capital Accumulation…………………………………………... 24
3.1 Introduction………………………………………………………………….. 25
3.2 An Investment Model under Uncertainty…………………………………… 28
3.3 The Effects of Adjustment Costs and Uncertainty………………………….. 37
3.4 The Effects of Other Model Parameters…………………………………….. 47
3.5 Conclusion…………………………………………………………………... 51
Appendix A: Proof………………………………………………………….. 53
Appendix B: Numerical Methods…………………………………………… 57
Figures………………………………………………………………………. 63

Chapter 4: How Costly is Capital Adjustment? Empirical Evidence from a
Structural Estimation…………………………………………………………….. 75
4.1 Introduction…………………………………………………………………... 76
4.2 The Investment Model……………………………………………………….. 78
4.3 Data and Empirical Specification………………………………….…………. 84
4.4 Structural Estimation………………………………………………………..... 88
4.5 Empirical Results…………………………………………………………….. 94
4.6 Counterfactual Simulations…………………………………………………... 101
4.7 Conclusion…………………………………………………………………..... 104
Appendix A: Proof…………………………………………………………… 106
Appendix B: Numerical Methods……………………………………………. 109
Appendix C: Data……………………………………………………………. 115
Tables………………………………………………………………………… 116
Figures………………………………………………………………….…….. 122
Chapter 5: A Structural Estimation for the Effects of Uncertainty on Capital
Accumulation with Heterogeneous Firms………………………………………. 128
5.1 Introduction………………………………………………………………….. 129
5.2 The Effects of Uncertainty…………………………………………………... 132
5.3 Data and Empirical Specification…………………………………….……… 140
5.4 Structural Estimation………………………………………….……………... 147
5.5 Empirical Results……………………………….……………………………. 151
5.6 A More General Specification………………………………….……………. 157
5.7 Counterfactual Simulations………………………………………………….. 160
5.8 Conclusion………………………………………………………….………... 163
Appendix A: Proof……………………………………………….………….. 164
Appendix B: Numerical Methods…………………………………………… 169
Appendix C: Data…………………………………………………………… 173
Tables…………………………….…………………………………………. 174
Figures………………………………………………………………………. 182

Chapter 6: Conclusion and Extension …………………………………………. 187
6.1 Findings…………………………………………………………………….... 188
6.2 Limitations…………………………………………………………………… 189
6.3 Extension………………………………………………………….………….. 190

Reference………………………………………………………………………….. 193
Chapter 1
Introduction

1
Investment is one of the most important and volatile components of macroeco-
nomic activity. In the short-run, the relationship between uncertainty and invest-
ment is central to understanding the business cycle. In the long-run, the e⁄ect
of uncertainty on capital accumulation has signi(cid:133)cant implications for economic
growth and development.
The main goal of this thesis is to contribute to the empirical literature about
how uncertainty a⁄ects (cid:133)rm-level investment behavior and capital accumulation.
Achieving such a goal requires three methodological ingredients: (cid:133)rst, (cid:133)rm-
levelinvestmentdata; second, amicroeconomicmodelofinvestmentthatisconsis-
tentwiththedata; andthird, aneconometricapproachthatallowsthesequestions
to be addressed. This thesis incorporates these ingredients in a uni(cid:133)ed structural
framework.
Under the assumptions of risk-neutrality, perfect capital markets, and no ad-
justment costs, within the framework of static neoclassical producer theory, a
(cid:133)rm(cid:146)s optimal investment policy would equalize the marginal revenue product of
capital and the user cost of capital, as derived by Jorgenson (1963). Two practical
features of investment change the static problem into a dynamic one: uncertainty
about future pro(cid:133)tability and costly adjustment of the capital stock. Optimal
investment then needs to take into account the intertemporal linkage between
current investment and future returns to capital.
Chapter 2 surveys consensus, controversies and open questions in the litera-
ture on investment and uncertainty in such a dynamic framework. It illustrates
that there are two key channels through which uncertainty may a⁄ect investment
dynamics and capital accumulation. One re(cid:135)ects non-linearity of the operating
pro(cid:133)ts with respect to the variables that characterize uncertainty, summarized
as the Hartman-Abel-Caballero (HAC) e⁄ect. Another re(cid:135)ects the frictions in
capital adjustment, summarized by di⁄erent forms of capital adjustment costs.
This implies that reliable evidence about the e⁄ects of uncertainty requires the
speci(cid:133)cation and estimation of an investment model, which incorporates these two
potential channels. This is achieved in a sequential order in Chapters 3 to 5.
2
ThetheoreticalanalysisinChapter3focusesexclusivelyonthesecondchannel.
It extends the investment model of Abel and Eberly (1999), by generalizing the
adjustment cost function from complete irreversibility only, to one which includes
partial irreversibility, a (cid:133)xed cost of undertaking any investment, and quadratic
adjustment costs. In order to abstract the HAC e⁄ect, some commonly-used func-
tional forms are chosen so that by construction, in the absence of any adjustment
costs, both investment dynamics and capital accumulation are invariant to the
level of uncertainty. This provides a useful benchmark that allows me to inves-
tigate two questions: (cid:133)rst, what are the e⁄ects of di⁄erent forms of adjustment
costs, compared with the frictionless benchmark; and second, what are the e⁄ects
of uncertainty in the presence of each of these forms of adjustment costs?
Chapter 3 (cid:133)nds that even such a simple investment model generates rich im-
plications for investment behavior, depending on the precise form of adjustment
costs. The impact e⁄ects of positive shocks to pro(cid:133)tability on capital adjustment
di⁄er dramatically, according to the form of adjustment costs. These e⁄ects may
be dampened, ampli(cid:133)ed or even reversed when translated into the expected level
of the capital stock. Other parameters in the model also a⁄ect the quantities of
interest in a substantial fashion. These (cid:133)ndings highlight the importance of the
empirical work undertaken in Chapters 4 and 5.
Using (cid:133)rm-level investment data for a panel of Brazilian manufacturing (cid:133)rms,
Chapter 4 estimates a fully parametric structural investment model similar to
that studied in Chapter 3, using the Method of Simulated Moments. Within this
model, investment and capital accumulation are determined by (cid:133)ve factors: the
Jorgensonianusercostofcapital, theproductiontechnology, thedemandschedule,
the stochastic process characterizing uncertainty in the pro(cid:133)tability, and di⁄erent
formsofadjustmentcosts. ForagivenJorgensonianusercostofcapital, structural
parameters for the other four factors are estimated by matching simulated model
moments to empirical moments.
Distinctivefeaturesofthemodelestimatedherearethat,Iallowforunobserved
heterogeneity across (cid:133)rms in long-run pro(cid:133)tability growth rate, and for measure-
3
ment errors in the (cid:133)rm-level data. The empirical results suggest an important role
for quadratic adjustment costs, although at least one type of non-convex adjust-
ment costs is also needed to match features of this (cid:133)rm-level dataset.
Theestimatedmodelisusedtoinvestigatehowthese(cid:133)rms(cid:146)investmentdynam-
icsandcapitalaccumulationwoulddi⁄eriftheyfaceddi⁄erentlevelsofadjustment
costs at the estimated level of uncertainty. Counterfactual simulations indicate
that investment would be much more responsive to new information about prof-
itability if (cid:133)rms in Brazil faced a lower level of adjustment costs. In the long run,
a lower level of adjustment costs would induce (cid:133)rms to operate with substantially
higher capital stocks.
BoththetheoreticalanalysisinChapter3andtheempirical(cid:133)ndingsinChapter
4 therefore highlight the importance of the adjustment costs. Meanwhile they also
raisethequestionstudiedinChapter5: giventhesecapitaladjustmentcosts, what
would be the e⁄ects on investment dynamics and capital accumulation if (cid:133)rms
faced a di⁄erence level of uncertainty? To address this, the model is extended to
allow for the HAC e⁄ect. Identi(cid:133)cation requires variation across (cid:133)rms in the level
of uncertainty, and a (cid:133)rm-level proxy for uncertainty to be available in the data.
This chapter uses panel data for UK manufacturing (cid:133)rms, which is observed over
a longer time period (1972-1991).
Chapter 5 captures the HAC e⁄ect by generalizing the investment model con-
sidered in Chapters 3 and 4. By modelling uncertainty in both productivity and
demand, the investment model in this chapter has two important implications,
based upon which I design a (cid:145)two-step(cid:146)identi(cid:133)cation procedure.
First, in the absence of adjustment costs, the expected capital stock level could
increase, decrease or be invariant to the level of uncertainty, depending on the rel-
ative weight of productivity and demand uncertainty in overall uncertainty. With
this property, the identi(cid:133)cation of the HAC e⁄ect is transformed into identifying
the relative weight of these di⁄erent sources of uncertainty.
Second,byconstructionthelinearhomogeneityoftheinvestmentmodelimplies
the HAC e⁄ect a⁄ects the level of variables from this model, but not ratios or
4