The interaction between firms and Government in the context of investment decisions: a real options approach

Given the global financial crisis and, particularly, the European sovereign-debt crisis, European countries have the urgent need to promote output growth. However, due to the current financial constraints, it is difficult for the Governments to stimulate economic growth by directly increasing investment. Alternatively, they can promote private investment, either by reducing the uncertainty and costs, or by directly subsidizing those investments. In this paper we try to analyze alternative solutions to promote investment, and hence economic growth, under a context of Government austerity. We develop a real options model in order to study optimal investment decisions, considering both the point of view of firms and Government. So, we incorporate the Government in the baseline real options model, and we use this extended model to drive the optimal behavior for firms and Government on their decision to invest and promote investment, respectively. To be more realistic, the model takes into account, not only inefficiencies (both concerning the implementation and management of the project), but also the economic benefits of investing, i.e., the investment multiplier effect in the economy. We also make a sensitivity analysis for the key parameters and define regions for different types of investment. Alternative solutions are also considered. Among the main conclusions we find that the probability of being optimal for the Government to subsidize private investment rather than investing directly is greater the larger the private investment multiplier effect, the tax rates, the private present value of the profit flows, the private cost of the investment and, also, the inefficiency level of the Government.