A model of entry–exit decisions and capacity choice under demand uncertainty

Abstract

Many investment decisions of agribusiness firms, such as when to invest in an emerging market or whether to expand the capacity of the firm, involve irreversible investment and uncertainty about demand, cost or competition. This paper uses an option-value model to examine the factors affecting an agribusiness firm's decision whether and how much to invest in an emerging market under demand uncertainty. Demand uncertainty and irreversibility of investment make investment less desirable than the net present value (NPV) rule indicates. The inactive firm is more reluctant to enter the market when it takes into account demand uncertainty because it preserves the opportunity of making a better investment later. The active firm is more reluctant to abandon the investment because there is an option value of keeping the operation alive. There is a greater distance between the entry and exit thresholds under the option-value approach than under the NPV rule due to demand uncertainty. The results have implications for agribusiness decision-making.

Adoption of Labor-Saving Technologies in Agriculture

“…Dixit & Pindyck (1994) synthetized the option-value approach, stating that the model was based on a stochastic dynamic framework that analyzed investment decisions in the presence of uncertainty, irreversibility, and the flexibility to postpone investment. A large body of research in agricultural economics uses the option-value model (e.g., Chavas 1994, Purvis et al 1995, Zhao 2001, Isik et al 2001, Carey & Zilberman 2002, Isik et al 2003, Baerenklau & Knapp 2007, Livingston et al 2015. Early option-value models considered only one source of uncertaintysuch as input price, output price, yield, etc.-but more recent modeling has incorporated multiple sources of uncertainty.…”

Inertia in disinvestment decisions: experimental evidence

“…The real options theory has been used intensively in agricultural economics (e.g. Purvis et al, 1995;Winter-Nelson and Amegbeto, 1998;Pietola and Wang, 2000;Isik et al, 2003); however, most of these applications are normative, and thus they merely indicate the potential explanatory value of the real options approach for observed economic inertia. A few attempts have been made to provide empirical evidence for the validity of the real options approach in an agricultural context, such as Richards and Green (2003), Wossink and Gardebroek (2006) or Hinrichs, Musshoff and Odening (2008).…”

What is Making Investment in the Texas Vineyard Industry Tick? A Real Options Analysis of Entry and Exit

“…Applications include the decision to investment or remove a peach orchard (Price and Wetzstein, 1999) hog production capacity (Hinrichs et al, 2008) as well as grape variety selection in the Californian wine industry (Richards and Green, 2003). Similar approaches, specifically in terms of agricultural investment include Isik et al (2003) for agribusiness endeavours, Tauer (2006) in an examination of dairy farming and Luong and Tauer (2006) with respect to Vietnamese coffee planting. Similar approaches, specifically in terms of agricultural investment include Isik et al (2003) for agribusiness endeavours, Tauer (2006) in an examination of dairy farming and Luong and Tauer (2006) with respect to Vietnamese coffee planting.…”

“…The goal of the present study, however, is to actually model and estimate the critical Texas grape prices, for which entry and exit in vineyard investment would rationally take place, using the Dixit (1989) and Dixit and Pindyck (1994) framework. Similar approaches, specifically in terms of agricultural investment include Isik et al (2003) for agribusiness endeavours, Tauer (2006) in an examination of dairy farming and Luong and Tauer (2006) with respect to Vietnamese coffee planting.…”