Adjustment Costs and Irreversibility as Determinants of Investment: Evidence from African Manufacturing

Oxford University
Contributions in Economic Analysis & Policy 02/2005; 4(1):1228-1228. DOI: 10.2202/1538-0645.1228
Source: RePEc


In this paper we investigate if the predictions of three different models of capital adjustment costs are consistent with the observed investment patterns among manufacturing firms in five African countries. We document a high frequency of zero investment episodes, which is consistent with both fixed adjustment costs and irreversibility and inconsistent with quadratic adjustment costs. We model the decision to invest using a dynamic discrete choice model and find evidence of irreversibility and not fixed costs. We finally model the investment rate as a function of the size of the capital disequilibrium. The results confirm that irreversibility is an important factor affecting the investment behaviour of African manufacturing firms. Some implications of this finding are discussed.

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    • "This yields positive correlation in producer-level investment series and the prediction of negative duration dependence in the hazard, though one should not observe lumpy investment. Models with irreversibility also yield positive correlations in investment and the prediction of negative duration dependence in the hazard (Bigsten et al [2005]). However, there is a key difference between the irreversibility and convex adjustment cost models. "
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    • "Several studies show that more than 50% of African firms have zero investment at any point in time and the rate of investment (i.e. the investment to capital ratio) is very low despite exceptionally high profit rates (Bigsten et al., 1999). Investment also tends to be bulky and intermittent, a pattern consistent with uncertain investment climates (Bigsten et al., 2005; Shiferaw, 2006). The key point is that entrepreneurs tend to respond to uncertainty by opening new businesses rather than ploughing back their profits to enlarge an existing establishment, and this paper shows that such a strategy indeed reduces the risk of exit 14 . "
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    • "In the face of co-integrated series, the OLS estimate is consistent and we can reveal the desired capital from the fitted value of this specification. 5 Bigsten et al. (2005) follow the same approach. "
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