Timing of Lumpy Investment, Pricing and Technical Progess

In equipment-intensive sectors – such as water utilities, power generation, and gas – billions of dollars are spent in capital equipment. The nature of the investment is often lumpy: at some point a plant has to be replaced and a large investment is required. We characterize the dynamic optimal investment policy of profit-maximizing and welfare-maximizing firms. We first show that, when there is no technical progress, the duration of the plant is longer for a profit-maximizing firm. We then consider technical progress leading to either capacity expansion or to operating costs reduction. We show that duration tends to increase when the installed capacity increases over time, while it tends to decrease when technical progress reduces operating costs, both for profit-maximizing and welfare-maximizing firms. Under some conditions, when capacity expands over time the duration of the plant is longer for a profit-maximizing firm than for a welfare-maximizing firm.