Irreversible Investment in General Equilibrium

Theories of investment suggest that the option value of waiting to invest is significant in many branches of economics, where investment is irreversible. The existing literature has generally failed to account for the general equilibrium feedback effects of lumpy investments on optimal consumption decisions. In this paper, we construct a general equilibrium theory of lumpy investments and show that such feedback effects can severely erode the option value of waiting even for moderate levels of risk aversion. Our analysis demonstrates that the implications of partial equilibrium models of investment should be evaluated with care, especially with regard to policy issues. It also shows that irreversibility and lumpiness in investment lead to time variation in risk aversion and produce a countercyclical equity risk premium.