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COPYRIGHT 2000 MIT Press Journals
I. Introduction
THEORY IDENTIFIES several channels through which uncertainty may affect firms' investment outlays. These include the irreversibility of capital expenditures due to sunk costs (Dixit and Pindyck (1994)), financing constraints that may arise from asymmetries between borrowers and lenders (Greenwald and Stiglitz (1190)), firms' attitudes towards risk (Appelbaum and Katz (1986), Hartman (1976)) and the convexity of the marginal product of capital (Abel (1983)). The first three channels generally predict a negative sign for the investment-uncertainty relationship, whereas the latter channel predicts positive. Recent empirical analysis, using disaggregated U.S. and European manufacturing data, shows that, while uncertainty generally lowers investments, the estimated quantitative and qualitative inferences vary across the studies.
In this paper, we provide evidence on the importance of uncertainty in accounting for fluctuations in investment expenditures and attempt to assess the specific channels through which this effect might operate. In particular, we study how investment responds to changes in uncertainty about profits, and whether or not this response is different in industries that are dominated by small firms versus those dominated by relatively larger firms. We find that, while greater uncertainty lowers investment in the full sample of industries, the negative impact is much greater in industries dominated by smaller firms.
II. Related Literature
We briefly review the alternate theories and then summarize some of the empirical evidence. Greenwald and Stiglitz (1990) examine hoe informational asymmetries between borrowers and lenders can create financing constraints for certain types of borrowers. They study how investments may be affected by equity and credit rationing and make the following prediction regarding uncertainty:
"Increased uncertainty about profitability ... increases both the absolute and incremental risk of bankruptcy under quite general conditions at any level of investment and firm equity. Thus, firms respond by lowering investment since they cannot absorb the increased risks by issuing more equity."(p. 19)
Thus, uncertainty may force some entrepreneurs to rely on their own funds, whereas other could fund projects via outside equity or bank borrowing. The above theory, therefore, predicts that the impact of profit uncertainty on investment may differ across firms, depending on the access to capital markets. To empirically examine the above hypothesis, we need measures of profit uncertainty and capital market access. Following several notable studies such as Fazzari, Hubbard, and Petersen (1988) and Gertler and Gilchrist (1994), one can use firm size as proxy for capital market access.(1) Gertler and Gilchrist write:
"While size per se may not be direct determinant, it is strongly correlated with the primitive factors that do matter. The informational frictions that add to the costs of external finance apply mainly to younger firms, firms with a high degree of idiosyncratic risk, and firms that are not collateralized. These are, on average, smaller firms." (p. 314)
In our empirical analysis, we follow the above literature and use firm size to proxy capital market access and examine whether the impact of profit uncertainty on investment varies by firm size.
Dixit and Pindyck (1994) summarize and extend the literature on sunk costs. Theoretical results indicate that, with irreversibility, greater uncertainty is likely to lower investment due to an option value of waiting. Clearly, the magnitude of sunk costs will be a key determinant of the investment-uncertainty link.(2) Unfortunately, there does not appear to be any good measure of sunk costs or capital specificity. Thus, we are unable to directly disentangle the effect of irreversibility from, say, financing constraints. However, we pursue an indirect link. The industrial organization literature has examined the impact of sunk costs on firm size and industry structure. Baumol, Panzar, and Willig (1982) highlighted sunk costs as a barrier to entry. Tirole (1989, ch. 8) evaluates numerous models on the role of sunk costs as barrier to entry and mobility. A sunk capital cost to enter a market creates an asymmetry in the costs and risks faced by an entrant, thereby creating an entry barrier. The implication is that relatively atomistic markets would be less likely under high sunk costs; as a consequence of entry barriers, high sunk costs are more likely to lead to markets with relatively few large firms. Returning to our empirical analysis, because we focus on industries that are dominated by small firms, it seems less we focus on industries that are dominated by small firms, it seems less likely that sunk costs are high in these industries.(3) However, this is only an indirect control and more direct tests must wait until we have legitimate measures of sunk cost.
Finally, one of the oldest explanations relates to risk preferences. Theory indicates that, under uncertainty, firms with greater risk aversion will tend to have lower output and inputs (for example, Appelbaum and Katz (1986), Hartman (1976)). In Gul's (1991) model, agents place greater weight on "bad" outcomes than "good." Aizenman and Marion (1999) use this asymmetric weighting of the different states of nature to show that uncertainty may have first-order negative effects on firms' investment and economic activity. While in theory, firms can be modeled as having different attitudes towards risk, we are not aware of any work that allows us to argue a priori that attitudes towards risk vary systematically by firm size.
Several studies have used disaggregated data to examine the impact of uncertainty on investment.(4) Caballero and Pindyck (1996), Ghosal and Loungani (1996), and Huizinga (1993), for example, provide evidence using U.S. SIC four-digit industry data, and Leahy and Whited (1996) and Peeters (1997), for example, use U.S. and European firm-level data. Caballero and Pindyck measure uncertainty...
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