Restructuring Investment in Transition: A Model of the Enterprise Decision

Abstract

This paper outlines a simple neoclassical model of the investment decision of the firm in the volatile environment of the post-Soviet transition. Conditions favoring and limiting investment in fundamental restructuring are explored, where successful restructuring leads to a substantial increase in expected profitability. In particular, the impact of the availability of alternative uses for investment resources, the degree of uncertainty and volatility in the economic environment, and the cost of capital as affected by credit constraints and investment subsidy policies is modeled and analyzed. It is shown that subsidizing investment in the presence of significant outside opportunities for the use of those funds, particularly when such opportunities are lost with successful restructuring, can be counterproductive, delaying that restructuring. The paper also explores the interaction of restructuring investment with investment in capacity, and shows that shrinking capacity can be an optimal alternative to restructuring investment in an unfavorable environment, while successful restructuring is optimally exploited by expanding capacity. Finally, there is an "unrestructured," low capacity trap, with investment effort largely directed toward outside activities. These results highlight some of the reasons for the limited amount of restructuring investment in Russia and many of the other former Soviet Republics.