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A model for the long-term optimal capacity level of an investment project

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We consider an investment project that produces a single commodity. The project’s operation yields payoff at a rate that depends on the project’s installed capacity level and on an underlying economic indicator such as the output commodity’s price or demand, which we model by an ergodic, one-dimensional Itˆo diffusion. The project’s capacity level can be increased dynamically over time. The objective is to determine a capacity expansion strategy that maximizes the ergodic or long-term average payoff resulting from the project’s management. We prove that it is optimal to increase the project’s capacity level to a certain value and then take no further actions. The optimal capacity level depends on both the long-term average and the volatility of the underlying diffusion.

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en

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http://eprints.lse.ac.uk/41650/

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