Identifying the free boundary of a stochastic, irreversible investment problem via the Bank-El Karoui representation theorem

DOI10.1137/11085195XzbMATH Open1298.91118arXiv1108.4886MaRDI QIDQ5494908FDOQ5494908

Authors: Maria B. Chiarolla, Giorgio Ferrari 

Publication date: 30 July 2014

Published in: SIAM Journal on Control and Optimization (Search for Journal in Brave)

Abstract: We study a stochastic, continuous time model on a finite horizon for a firm that produces a single good. We model the production capacity as an Ito diffusion controlled by a nondecreasing process representing the cumulative investment. The firm aims to maximize its expected total net profit by choosing the optimal investment process. That is a singular stochastic control problem. We derive some first order conditions for optimality and we characterize the optimal solution in terms of the base capacity process, i.e. the unique solution of a representation problem in the spirit of Bank and El Karoui (2004). We show that the base capacity is deterministic and it is identified with the free boundary of the associated optimal stopping problem, when the coefficients of the controlled diffusion are deterministic functions of time. This is a novelty in the literature on finite horizon singular stochastic control problems. As a subproduct this result allows us to obtain an integral equation for the free boundary, which we explicitly solve in the infinite horizon case for a Cobb-Douglas production function and constant coefficients in the controlled capacity process.

Full work available at URL: https://arxiv.org/abs/1108.4886

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zbMATH Keywords

free boundaryoptimal stoppingirreversible investmentsingular stochastic controlBank and El Karoui's representation theorembase capacity

Mathematics Subject Classification ID

Production theory, theory of the firm (91B38) Stopping times; optimal stopping problems; gambling theory (60G40) Applications of stochastic analysis (to PDEs, etc.) (60H30) Stochastic models in economics (91B70) Optimal stochastic control (93E20)

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