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

Vitor Carvalho, Diogo Barbosa and Paulo Jorge Pereira

No 5390, EcoMod2013 from EcoMod

Abstract: Inspired by the current European crisis, the main goal of this paper is to find how to promote investment, as we think that it has a crucial role on firms’ evolution and economic performance. In fact, our motivation is to find a possible solution to promote economic growth with few Government resources. However, in our approach we try to follow not only the firm point of view, but also the Government perspective. Accordingly, we try to obtain the optimal behaviour both for firms and Government by managing some key parameters to reduce the critical value and thus to hasten the private investment. Although we know that immediate exercise of the option to invest may not be optimal for individual projects, we try to maximize aggregate welfare by promoting that investment. Therefore, during economic crisis it may be crucial to hasten the investment, because it's when it is more necessary. By exploring the interaction between Government and firms, and the concerns of both, we develop a Real Options model (Dixit and Pindyck (1994)) which explores some key factors for decision-making. The outcome will be a model that drives the optimal behaviour for firms and Government on their decision to invest and promote investment, respectively. To be more realistic, the model will take in 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. For a better analysis, we study the sensitivity for the key parameters and define regions for different types of investment and consider alternative solutions too. 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. By calibrating the model for Portugal, we have also concluded that it could be better for the Portuguese Government to subsidize the investments in infrastructure and in other sectors with a high level of public inefficiency, while it could be more advantageous for the Government to implement directly public investment in sectors as education and healthcare.

Keywords: Portugal; Finance; Public finance and tax issues (search for similar items in EconPapers)
Date: 2013-06-21
New Economics Papers: this item is included in nep-ppm
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Citations: View citations in EconPapers (1)

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Working Paper: The interaction between firms and Government in the context of investment decisions: a real options approach (2013)
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