Performing Department
Food and Resource Economics
Non Technical Summary
Conventional neoclassical economics suggests that firms invest less when interest rates are higher. However, Chetty (2007) shows, theoretically, that the investment demand curve is a backward-bending function of the interest rate when investments are irreversible and payoffs are stochastic. Chetty uses a dynamic model in which profit-maximizing firms can observe a noisy signal regarding potential payoffs by postponing investment. He concludes that firms invest immediately if the expected profits are positive and expected growth in profits from postponing is less than the interest rate, otherwise the firm postpones investment. In addition, real options theory has gained momentum in the finance literature as a means of explaining investment behavior in the presence of uncertainty, particularly for instances where it appears to be at odds with the expected utility hypothesis and the practice of investing if the net present value of the project is positive. Bloom, Bond and van Reenen (2007) show that real option values associated with irreversible investment decisions increase substantially with uncertainty. As a result, in uncertain times firms are likely to either exercise growth options and invest immediately to establish market share or postpone investing in positive net present value projects until some of the uncertainty is resolved, thus corresponding to an option to wait. Relatively little work has been done to empirically study the consequences of irreversible investment on the decisions under uncertainty of agribusiness firms. Exceptions include Isik, Coble, Hudson and House (2003) and Turvey (2001). This research paper continues the research agenda of Chetty (2007) by empirically testing the existence of a backward-bending investment function in terms of the interest rate using a large panel of firms. While several studies have attempted to provide empirical evidence of real options, the possibility of a backward-bending investment demand curve has yet to be tested. Moreover, we consider the role played by real option values associated with uncertainty.
Animal Health Component
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Research Effort Categories
Basic
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Applied
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Developmental
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Goals / Objectives
The SCC will provide a scientific/professional forum to facilitate the exchange of theoretical and methodological approaches to risk analysis, and to nurture the development of original concepts and preliminary research efforts related to agriculture and natural resources. Specific focus issues will include: a.Micro-level modeling of how risk affects a number of important natural resource and environmental risk issues, including forest, wildlife, and range management, ground- and surface-water pollution, the environmental sustainability of agricultural production systems, and conflicts in resource demands between agricultural and competing users. b.Firm-level analysis of production, financial, marketing, and environmental risks including analysis of how these risks impact (and are impacted by) technology adoption and access to information. c.Firm-level analysis of various risk management strategies such as forward pricing, insurance purchasing, and diversification and how government policies affect optimal risk management strategies. d.Economic theory and the behavioral foundations of decision-making under uncertainty, including extensions of expected utility theory, challenges to expected utility theory, behavioral impacts of asymmetrically distributed information, and understanding decision-maker risk attitudes within a portfolio context. e.The impact of public policy on the risk environment of individuals, firms, and sectors within the economy, including exogenous trade shocks, food safety regulations, commodity income support programs, changes in financial and agricultural insurance institutions, bioenergy, and resource pricing policies.
Project Methods
Our goal is to determine if agribusiness firms' investment behavior under uncertainty and irreversibility of the investments differs from the investment behavior of other firms in other industries. The dataset is an incomplete panel of firms representing 23 industries. The data used in the analysis are from the 2004 Stern Stewart Performance Russell 3000, which contains annual information on several variables of interest including net operating profit after tax, capital, cost of capital, and rate of return on assets. After deleting missing values we obtained a sample that runs from 1985 to 2003 and contains 2685 firms. Using the data, we estimate the investment function of agribusiness firms in terms of the interest rate, and adjusting for uncertainty and real option values. Since the dataset includes non-agribusiness firms such as banks, bio-technology firms and information technology firms, we estimate the model for both agribusiness and non-agribusiness firms. Then, we compare the investment demand curves of agribusiness firms to other firms in other sectors using a Chow test.