Public Capital and Private Investment, a Real Option Approach
Bruno de Oliveira Cruz
In this paper, public investment provision takes place in a stochastic environnement. The role of the government is to remove a part of the uncertainty faced by the firm. If the government simply maximizes the value of the firm, then the optimal tax is smaller under imperfect competition than it is under perfect competition since more public capital reduces the selling price. But if the government seeks to maximize the consumer surplus, tax and public capital provision are also a mean to correct the market and the optimal tax is then higher.
irreversible investment; public capital; uncertainty
In this paper, we extend the usual models of irreversible investment underuncertainty by introducing the stock of public capital as an input for the privatesector. Public investment takes place in a stochastic environment. Public capital thenincreases the productivity of private capital which is assumed to be fully irreversible.In our model, the government has an intertemporal budget constraint, i.e. taxes arecollected each period to fund the public debt. We provide a partial equilibriumanalysis, as it is standard in models of irreversible investment under uncertainty. Evenunder uncertainty, the optimal tax rate is then constant and does not depend on thesize of uncertainty, it is exactly the same as the one that would prevail in adeterministic world. We show that the government has an insurance role since itremoves part of the uncertainty faced by the firm.
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