Incentivizing Irreversible Investment

Abstract

Existing dynamic investment models that show that a manager can be incentivized to implement the optimal investment policy rely on the assumption that the firm is operating in an ever-expanding product market. This paper presents an analytically tractable, discrete-time, neoclassical model with irreversible investment and the possibility of unfavorable demand events. We show that even when the principal is uninformed about changes in demand for the firm's output, there exists a performance measurement system that leads to goal congruent investment incentives for the manager. If the principal can observe the unfavorable demand events, then goal congruence can be achieved using very simple accrual accounting rules, such as straight-line depreciation.