Edited by Robert J. Brent
Rati Ram and Rajeev K. Goel* 1 Introduction This chapter discusses the application of cost–benefit analysis to decisions on irreversible investments. Although a wide variety of outlays might be characterized by irreversibility, we focus on investment irreversibility which has received considerable attention in recent years.1 In general, investment irreversibility reflects the inability of the investor to recover all or most of the investment outlay either through an alternative use or by sale of the asset. This property is often stated, as by Dixit and Pindyck (1994, p. 8), hereafter D&P, and other scholars, in terms of the investment expenditure being a ‘sunk cost’. The importance of considering the role of irreversibility in investment decisions arises from two related considerations. First, investment irreversibility is believed to be pervasive and not a characteristic of just a small fraction of investment outlays. Public investments are likely to be characterized by a higher degree, and wider prevalence, of irreversibility than private investments. Construction of a dam, setting up an irrigation system, building roads, bridges and other components of transport infrastructure, setting up a nuclear reactor, clearing a forest, and many other public investments are largely irreversible.2 Second, most investment decisions are made under uncertainty, which can take many forms. Although irreversibility may sometimes modify the decision rules even for the relatively rare cases where investment costs and benefits are certain, the presence of uncertainty compounds the effect of irreversibility. The major consequence of irreversibility in the presence of uncertainty relative to a...
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