Flexibility and Uncertainty (Ostroy)

The Review of Economic Studies, Ltd.
Flexibility and Uncertainty Author(s): Robert A. Jones and Joseph M. Ostroy Reviewed work(s): Source: The Review of Economic Studies, Vol. 51, No. 1 (Jan., 1984), pp. 13-32 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2297702 . Accessed: 15/02/2013 18:31
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Review of EconomicStudies(1984) LI, 13-32 ? 1984 The Societyfor EconomicAnalysisLimited
0034-6527/84/00020013$00.50
Flexibility
and
and
Uncertainty
ROBERT A. JONES
University of British Columbia
JOSEPH M. OSTROY
University of California, Los Angeles
The preserving of flexibility whenfacedwith uncertainty is a neglectedaspectof behaviour factorin decisionsto hold liquidassets or delay irreversible underrisk. Yet it is an important investment.This paperformalizesthe notion of flexibilityin a sequentialdecisioncontext,and an agentexpectsto receive. A rudimentary relatesits valueto the amountof information money as an economic these ideas, and the historyof flexibility demandmodel is developedembodying conceptis traced.
1. INTRODUCTION Choicesare frequentlymade between alternativesthat imply differentdegrees of future commitment-between a short-term investment that leaves future options open, for example, and a long-term one that, by its very nature, forecloses those options. The relative attractivenessof the two depends on their probabilitydistributionsof payoffs over time. A basic considerationin this choice is the recognitionthat beliefs about the risks governingthese payoffsmay change. Currentdoubts may be partiallyresolved in of the longer term committhe near future. This prospectdecreasesthe attractiveness ment, in that one is able to respondless fully to new information,and, even if it does not directlyaffect the risks associatedwith shorterterm choices, enhancestheir appeal. This paper formalizesthe above remarksby establishingconnectionsbetween the followingtwo (partial)orderings:The firstis an orderingbased on variabilityof beliefs. One set of beliefs is more variable than another if more final risk is resolved at an intermediatestage. The more one expects to learn by an intermediateperiod, relative to what one knowstoday, the more variationone is anticipating in beliefs aboutthe final outcome. The second is an orderingof currentactions,or positions,based on flexibility. One position is more flexible than another if it leaves available a larger set of future positions at any given level of cost. These two orderingsare incorporatedin a simple sequential decision model to suggest the following behaviouralprinciple:The more variableare a decision-maker's beliefs, the more flexible is the position he will choose. This principlepotentially applies whenever (i) there will be opportunitiesto act after furtherinformation is received,and (ii) currentactionsinfluenceeitherthe attractiveness or availability of differentfutureactions. The applicationof this principle to macroeconomicphenomena is of particular interest. Considerthe newspaperheadline:"Decreasein confidenceleads to cutbackin capitalgoods orders". The decrease in confidencecan be interpretedas an increasein of beliefs-the less confidentarecurrent beliefs,the greateris the likelihood the variability of substantial revisionin the near future.As a consequence,there is a fall in the demand for inflexiblepositions (commitments to new capitalgoods) and a rise in the demandfor flexiblepositions (postponement,waiting,or holdingliquid assets). At the other end of the liquidity spectrum, Section 5 below shows that variabilityof beliefs generates a demandfor money even when money is dominatedby all other assets in terms of yield
13
14
REVIEW OF ECONOMIC STUDIES
andthe cost of reversing positionsin otherassetsis modest.Decreasedconfidenceinduces a temporary premiumof liquidityand discounton illiquidity. The analysis of choices under uncertainty conventionally revolves around the decision-maker's attitude towardrisk. The demandfor flexibility,however, is basically unconnectedwith risk aversion.This is because havingmany ratherthan few positions availablefor future choice implies nothing about the variabilityof final payoffs. One individual might value flexibility because, by appropriatelyadapting choices to the informationreceived, it permits a more nearly certain pecuniaryreward;but another might value it because it allows the making of informed higher risk bets at the last moment. The way flexibilityis used to exploit forthcoming information may be dictated by attitudestowardrisk; but flexible positions are attractivenot because they are safe stores of value, but becausethey are good stores of options. The next two sections define the orderingof beliefs based on variabilityand the ordering of choices based on flexibility. Section 4 states qualified versions of the propositionrelatingthese two orderings.Section 5 illustratesthe principlein a simple asset choice context. Discussionof the work of others and the extensivehistoryof these conceptsis reservedfor Section 6. 2. COMPARISON OF BELIEFS BASED ON VARIABILITY Let S be a set of states, with elements s, and Y an index set of messages/observations, with elements y. The sets of possible probabilityvectors on S and Y are, respectively,
As -{7r = (r): sr, 0,
1}
and
Ay {q = (qy): q, ' O, E q = 1}.
The set of possibleconditionaldistributions of s given y is A Y=(As)Y. An element Ir E As will be called a belief (about the possibilitiesin S), with Ir(y) e As denoting a belief conditionalon observingthe message y and 11a matrixwhose columnsare Ir(y), y E Y. Let
(n, q) E AYX Ay.

(II, q) is a set of beliefs, one for each possible observationin Y, togetherwith a vector of probabilities.that each of those beliefs will be held. In the terminologyof Marschak
and Miyasawa, (II, q) is an information structure. The mean of (II, q) is
r-
q,7 (y)
and will be called the priorbelief for (II, q)-the belief before any messageis observed. Throughoutour discussionthe observations,Y, and the structureof beliefs, (LI, q), are exogenous to the individual.They are not objects of choice as they would be if the were able to select the experimentto perform. individual
A partial ordering of belief structures, denoted by (1, q) - (LI', q'), is defined by the
conditionthat (1) randomvariableof y, (1) maybe interpretedas saying Regarding7r(y)as a vector-valued

_ E q(D(7r'(y))
ZqyD(7T(y))
for all convex functions D: As -- R.
that the beliefs {7(y)} are more dispersed than are {1r'(y)}. Note that if (nI,q) can be compared to (I',q') via -, then their means, or prior beliefs, must be identical: (LI,q) ! (LI',q') implies
a(y qy.7
q ',7T'(y)
(2)
JONES & OSTROY
FLEXIBILITYAND UNCERTAINTY
15
We shall describecondition(1) as sayingthat the beliefs in (II, q) are more variablethan q'). in (LI', this ordering,considerits extremes. At one extreme,let (I*, q*) be To understand =,-. There is no variabilityof beliefs; they are such that q*(y)>0 implies that 7r*(y)) the same whichevermessageis received. At the other extreme,let (Il*, q*) be such that q *(y) >0 implies that each element of 7 *(y) is either 0 or 1. This representsmaximum of beliefs; receiptof a messageconveyscertaintyaboutwhichstate will occur. variability The definition of more variable beliefs is taken from earlier work in statistical decision theory. Let B be a finite set of actionsand u (b,s) be a payofffunctiondefined on B x S. Bohnenblust,Shapley and Sherman(1949) showed that (1) is equivalentto q'): the followingdefinitionof (II, q) as more valuablethan (LI', Y.q, maxb.B s) Z.srT(y)u(b, s)-Y,q'y maxbsB ,sr'(y)u(b, for all bounded u (b, s).
(3)
An individual'spreferencefor risk is embodied in the curvatureof his utility function. But, since the expressions in (3) can be viewed as attainable expected utilities, all individualsprefer greatervariabilityin beliefs, regardlessof their attitudetowardrisk. Another perspectiveis provided by regarding(II, q) as an "experiment"where y will be observed with probabilityqy, after which one's beliefs about S will be 7r(y). Blackwell(1951, 1953) showed that (1) is equivalentto the followingdefinitionof (II, q) q'): as more informativethan, or sufficientfor, (HI', There exists a non-negativen x n matrixM with columnssummingto 1, where n is the numberof elements in Y, such that (4) I '= IM and q=Mq'. If (4) is satisfied,one could constructa "blackbox" that acceptsy as inputsandgenerates with s as the y' associated outputslabelledy' thathave exactlythe same joint distribution with the experiment(II',q'). Thus greater variabilityof beliefs is desirablebecause it means that messagesconvey more informationabout s. Proposition 5 below utilizes a restrictedversion of-. We shall say that beliefs (n, q) are a star-shapedspreadingof (L', q'), indicatedby (H, q) 's (L', q'), if flq = 1'q', q = q', and there exists 0 'Ac _ 1 for each y E Y such that
7r'(y) = Ay7 (y) + (1 - Ay) fr. (5)
A star-shapedspreadingof beliefs implies more variablebeliefs, but the conversedoes not generallyhold. Figure 1(a) displaysthe beliefs of two informationstructuresthat do satisfy (II, q) 's (LI',q'), with three possible states. Figure 1(b) depicts a case where
(I, q) - (LI', q') without star-shaped spreading, and Figure 1(c) a pair of information
structuresnot rankableby either ordering. The two orderingsare equivalent,however, q') conveys no information,or (ii) q = q' and has only two positive when either (i) (LI',
state 3 A. B. C.
07r(4)
/
rb3
~
state 2
~~~
0
D(12)M
~0r3
Q
04(7 +
__0
71(1
O7r2)
\+72 MD
)3
+ 71(3 731(2) + +
71D1
7r(i)
state 1
FIGURE
Beliefs plotted in the unit simplex
16
elements (i.e. there are just two possible observations, as in the example of Section 5 below). A further instance of star-shaped spreading occurs when the messages' usefulness for prediction is contingent on the validity of some theory, which if false renders them valueless. Then, letting A = Ay be the probability that the theory is valid, any rise in A increases variability in the required fashion. The ordering is useful when certain functions of 7r are quasiconvex but not convex. Remark 1. Formally, the definition of more variable beliefs is closely related to the Rothschild and Stiglitz (1970) definition of beliefs that are more risky, an ordering on As. Assume that states can be associated with realizations of a random variable, x (s). Then ir is more risky than ir' if for all convex functions qf:R - R,
Z rVso(x(s)) ?Z i'fr(x(s)).
(6)
The similarities help to point out the differences. In the older view contrasting risk and uncertainty, see Section 5.1, beliefs that were thought to be objectively fixed were "risks" while beliefs that were subject to fluctuations were "uncertainties". Just as condition (6) defines an ordering of risks, condition (1) establishes an ordering of uncertainties. Remark 2. In economic contexts there are two distinct sources of increased variability of beliefs. First, there may be an improvement in the information content of available observations. Surveys can be based on larger samples; econometric forecasts can become more accurate. Such changes correspond to performing "better experiments" in statistical decision theory. tSecond, there can be a change in the confidence with which prior beliefs are held. The revised belief, ir(y), combines the information contained in y with the information on which prior beliefs were based. If the amount of information embodied in 7r is large and regarded as relevant for s, then the individual is likely to make only small revisions upon observing y. Conversely, if the prior information is limited or its relevance becomes questionable, then subsequent observations carry more weight and the same observations result in greater variation in beliefs (see Jones (1981)). For example, suppose some event occurs (e.g. a government policy change) that causes an individual to "lose confidence" in his estimates of the parameters of his model of the economic environment. The change reduces the relevance of past experience and increases the anticipated impact of future observations on his beliefs. Changes arising from this source are relevant for macroeconomics since such a "loss of confidence" in beliefs is likely to be widely shared. It is this second possibility that led us to adopt the more neutral terminology, variability of beliefs, over the standard terminology, more informative information structure. 3. COMPARISON OF ACTIONS BASED ON FLEXIBILITY Consider an information structure joined to a sequential decision problem. In period one the individual chooses an initial position a e A. In period two, after observing y, there is an opportunity to choose a second period position b EB. A and B are assumed finite. In period three s is revealed. The consequence for the individual is described by a payoff function f: A x B x S - R. Flexibility is a property of initial positions. It refers to the cost, or possibility, of moving to various second period positions. To rank positions by their flexibility some part of the total payoff f(a, b, s) must be imputed to the move from a to b, as distinct from having been in positions a and b. The payoff must be decomposed into a form f(a,b,s)=r(a,s)+u(b,s)-c(a,b,s), (7)
JONES & OSTROY
FLEXIBILITY AND UNCERTAINTY
17
where r(a, s) is the direct return on the first period action, u (b, s) is the return on the second period action, and c (a, b, s) is the cost of "switching" from a to b. The nature of the switching cost function is summarized by the following construction. Let G:A xSxR -28 be defined by G(a,s,a)l{b: c(a,b,s)?a}a (8) G (a, s, a) is the set of second period positions attainable from a at a cost that does not exceed a in state s. Structure is added to the concept of switching costs by the following restrictions: Non-negative switching costs: G(a,s,a)=0 Zero switching cost alternatives: there exists g:A -+B such that g(a) e G(a, s, 0) for all (a, s) EA x S. If switching costs were negative, there would be an incentive to switch for its own sake. If they were always positive, they would include the unavoidable costs of simply moving from the first to the second period. We wish to represent switching costs as excluding both such possibilities. The move from a to g(a) will sometimes be described as staying in the "same" position. Notice that although g(a), and hence c(a, g(a), s), is independent of s, the overall payoff f(a, g(a), s) generally does vary with s. Thus positions offering zero switching costs need not offer perfectly certain returns. The mapping G is used to define a partial ordering on A. Position a is more flexible than a', denoted by a ZFad, when for all a _ 0 and s E S, G(a,s,a)DG(a',s,a)\g(a'). (9) In words, a ?F a' if the set of positions attainable from a always contains the set attainable from a', excluding its zero cost option g(a'). The position a * is said to be perfectly flexible if for all s, G (a *, s, 0) = B. From a perfectly flexible position, all second period positions can be reached with no switching cost. The position a* is irreversible if for all a ? 0 and s, G(a*, s, a) = {g(a*)}. From an irreversible position, only the second period alternative g(a*) can be reached. An economically irreversible position is defined by the condition that for all s and foralla<O, (a, s)eA xS.
= a
(a)
maxb,s {u (b, s) -
u (g(a), s)},
G(a, s, d5(a))= {g(a)}. Since a(a) is the most that can conceivably be gained by switching from a to some alternative in B, there is no distinction for an optimizer between an irreversible and an economically irreversible position. The notation a*, a* and (11*,q *), (f1*, q*) for extreme elements of the orderings on first period positions and belief structures, respectively, is retained throughout the paper. We further adopt the convention of assigning a payoff of -00 to inadmissible sequences of positions in order to allow f( ) to reflect irreversibilities. When A contains only two alternatives, and when for some a c A f (a, b, s) is bounded below for all b EB and s, then the more flexible position may always be characterized as perfectly flexible (i.e. there exists an alternative decomposition of f which characterizes a as perfectly flexible). If A contains three of more alternatives, or if each position is irreversible for some state, perfectly flexible positions may not exist. However the positions may still be ranked by (9). The costs of switching from a are extreme if G (a, s, a) does not vary with s or a. Thus for all s and a ' 0, G(a, s, a) = Ba c B, where g(a) E Ba. Ba is the set of second period positions that are costlessly available from a, while the alternatives in B\Ba are
18
prohibitivelycostly or require an expendituregreater than a(a). Note that both the positionshave the propertyof extremeswitchingcosts. perfectlyflexibleand irreversible The ordering?!F is completeif for any a, a' E A either a ZF a' or a' >F a. In the special case where !F is both completeand extreme,we shallsay that switchingcosts are nested. when the choices availablein Remark 3. In some decision problems,particularly A are identicalto B, there is a naturaldecompositionof f into (7) where c satisfiesthe non-negativityand existence of zero-cost alternativeassumptions.For example, when a and b are portfoliosof assets, r(a, s) and u (b,s) can be the portfolio yields over the two time periods and c (a, b, s) can be the cost of liquidatingthose assets in a that are not in b. Whenthe sets A andB are quitedifferent,the selectionof g(a) maynevertheless be clear from the context. For example, if the initial choice is the technologyto install in a plant and the second period choice is the outputlevel at whichthe plantis operated, one might associate with each technology, a, that output level yielding lowest average cost for a and call that g(a). In other contexts, a decompositionof f into (7) may result in a seemingly arbitrary imputationof switchingcosts. The imputationdoes not affect of the strategyin the optimal strategy,of course, but it does affect any rationalization termsof flexibility. 4. RELATION BETWEEN THE VALUE OF FLEXIBILITYAND THE VARIABILITY OF BELIEFS The three period two-choice sequentialdecision problemthus gives rise to two partial of beliefs, indicating structures accordingto variability orderings:One ranksinformation the amount to be learned from future observation;the other ranks initial positions accordingto flexibility,indicatingthe range of alternativesleft open at any given level of switchingcost. We explore the relationbetween these two orderings. An optimal strategyfor the sequential decision problem consists of a first period position, a, and a set of second period positions, {by},to be taken depending on the observationy E Y received, which maximizethe expected total payoff. The expected principleof dynamic usingthe maximum payoffso obtainedcan be expressedrecursively programming: J(H7, q) =
maxaEAj{by}EB
= maxaEAZyqy
(y)f(a, b, s) Is qyirs maxbB Zs irs (y)f(a,b, s).

y
(10)
Decomposingf(a, b, s) into r(a, s)+u(b, s)-c(a, and separating terms gives

J(1I,
b, s), utilizing #rs yZqym, (y) (see (2)),
q) = maxa [ s 4rsr(a,s) +y qymaxb Es rs(y)(u(b,s) -c(a, b, s))]

=
maxa
[F(a) +y qyv(a; ir(y))] (11)
= maxa [F(a) + V(a; [I, q)]
The expected first period return to position a, 1(a), depends only on the prior belief ii. Since #r must be the same for all informationstructurescomparablein terms of variability,the (opportunity)cost of flexibilityis independent of what the individual expects to learn. The functionv (a; ir) is the maximumexpected second period return, q) is the expected including switching costs,for a givenbelief andinitialposition. V(a; HI, second period returnto takinginitialposition a with informationstructure(I1,q)-i.e. the expected value of v (a; ir). We now pose the followingquestion:Supposethat a (respectivelya') is optimalin the firstperiod when the structureof beliefs is (H,l q')). If (LI, q) q) (respectively(LI', (H',q'), and a and a' are rankedby zF, must we have a -Fa'? In other words, does
JONES & OSTROY
19
to be receivedbetween periodsresult in the information the prospectof an improvement decision? in a more flexiblefirst-period Stated more formally,let A (H, q) be the set of optimal initial positions, the ones for which f(a) + V(a; H, q) is a maximum. We shall say that - induces an orderpreservingrelationon tF whenever A) (ii)a q)A (Ht, q) (ii) a(HE)1H,q)anda'EA) (', q') (iii) eithera A(Hi',q') or a' A(H, q) implya _Fa'. (iv) a and a' are F-comparable If a and a' satisfy (i)-(iii), the condition stipulates that either a and a' are not of beliefsnever -F-comparable or else that a' Fa'. That is, an increasein the variability leads to the choice of a less flexibleposition. It will be shown what this requires. by {r,v, (HI, q)}, For our purposes,the three period decisionproblemis summarized
where r:AxS -R and v:AxAs -R are as defined above. Note that v(a;lr), as a
functionof r, is a maximumof a finitenumberof linearfunctionsand is thereforeconvex in v. It followsfromthe definitionof (H1, q) - (H',q') that V(a; H, q) ' V(a; H',q')-the value of any initial position is a non-decreasingfunction of the variabilityof beliefs (comparethis with the notion of being more valuablein equation(3)). to causea shifttowarda more flexible(strictly However,for an increasein variability speaking,not less flexible)position, this gain in value must be greaterthe more flexible the position. The requiredrelationshipis (HI, q)-(tI', q') and a ZFa' (12) q'). V(a; H, q) - V(a; Hi',q') = V(a'; l, q) - V(a'; Hl', whenvalid,also saysthat anyincrement Remark4. Notice that sucha relationship, in flexibilityraises the value of any incrementin information. Thus, if the individual's choice were how much informationto purchase,with his flexibilitybeing exogenously given-the reverse of the conceptualexperimentwe have interestin-we could say that an increase in flexibility induces the rational agent to purchase a larger quantity of information(assuming,that is, that the total payoff is additive in the price paid for betweenflexibilinformation andthe profitobtainedfromexploitingit). The relationship factorsof production. is thus muchlike that between complementary ity and information Rewriting(12) as (13) leads to the following result that it is the convexity of the difference [v (a; v) - v (a'; i)] relationto be induced. This result is independent that is criticalfor an order-preserving definitionof flexibilityin the sense that ZF can be any orderingover A. of our particular
Eqy[v
Zyq,[v(a; vr(y))-v(a'; v (y))]
(a; r'(y))-v(a';
r'(y))]
Proposition 0. (a) If a -FaF' implies that [v (a; v) - v (a'; i)] is convex on As for all a, a' E A, then : induces an order-preservingrelation on ZF. (b) If there exists a zF a' such that a' F a and [v (a; v) - v (a'; i)] is not convex on As, then there exists (H, q)-><H'; q') and r: A x S -R such that {a'} = A(Hl, q) and {a} = A(H', q').
(Proofsof all propositionsare in the Appendix.) Thus the sought-afterrelationbetween variabilityof beliefs and flexibilityrequires on the admissible the differenceof two convexfunctionsto be convex,a definiterestriction functions. But although our behaviouralprincipleis not true in general, it does hold under some economicallyplausible conditions. The propositionsbelow, by restricting
20
informationstructuresand payoff functionsin variousways, describe circumstances in whichthe desiredrelationship may be obtained. The firsttwo propositions,includedfor historicalinterest (see 6.2), emphasizethat for some payoff structuresthe amount to be learned in the future has no effect on the initialchoice.
Proposition 1. When all positions are perfectly flexible, the optimal initial position is that which offersthe highest expectedfirstperiod return (determinedby priorbeliefs alone). Proposition 2. When all positions are economically irreversible,the optimal initial position depends only on prior beliefs r.
Propositions1 and 2 imply that the same initial position would be chosen for any two
information structures (H, q) > (H', q'). In the circumstances of Proposition 1, but not
in those of Proposition2, the optimal second period position depends on aspects of (H1, q) other than f.
Proposition 3. An increase in the variability of beliefs raises the value of any position relative to any economically irreversible position.
This propositionimpliesthat the prospectof more informationcan induce an agent to changefrom an irreversible initialpositionto one that is at least partiallyflexible,but never the other way around. Moreover, the disadvantageof irreversiblepositions increases monotonicallywith the degree of uncertaintyabout future beliefs. Capital formationdecisionsare frequentlyeconomicallyirreversible.Proposition3 thus suggests an inverserelationship between investmentand "lackof confidence"in beliefs. The next two propositionsprovide counterpartsto Proposition3 at the opposite end of the flexibilityspectrum:increasesin the amountto be learnedby waitingenhance the relativevalue of perfectlyflexiblepositions. Since holdingliquidassets, particularly money,providesgreatflexibility in manysituations,these resultssuggesta directrelationship between the demandfor liquidityand the expectationthat beliefs will change. of the paper,any element attainingmaxaEA Let a denote, for the remainder v (a; #). Position a offers the highest expected second period return from the perspective of prior beliefs. It is the choice that would be made if, for example, first period returns were independentof the actionchosen and no furtherinformation was expected.
Proposition 4. Anticipating some change in beliefs, as opposed to none, raises the value of any perfectlyflexible position relative to position a.
Since Proposition4 says nothing about positions other than a and a * (perfectly flexible)that might be chosen, it appliesmost usefullyto situationswhere the choice is between going ahead with what seems best at the moment versus waiting for more is not essential for a information. Its significancelies in the fact that irreversibility relationshipbetween learningand the value of flexibility. Proposition5 strengthensthe results of 4 in certain directions. By requiringthe cost of "undoing"a to be independentof both s and the position switchedto, and by requiringthat beliefs be comparableaccordingto the star-shapedordering,a monotonic is obtainedbetween the amountto be learnedand the advantageof perfect relationship flexibilityover a.
Proposition 5. Let switching costs satisfy c (d, b, s) = c (d) for all b $ g (ad). Then a star-shaped spreading of beliefs raises the value of any perfectly flexible position relative to position a-.
JONES & OSTROY
21
The finalPropositioncomes closest in spiritto the generalconjecture. It establishes of beliefs and the flexibilityof the initial between the variability a monotonicrelationship payoffstructures. positionfor particular Recall that switchingcosts are nested if (i) for each a EA, there is a Ba such that for all s and a > 0, B_ = G (a, s, a) and (ii) for all a, a' eA, either Ba is containedin Ba' or vice versa. We shall say that the payoffstructuresatisfiesConditions1 and 2 if Condition1. Switchingcosts are nested.
EBa such that for all ir, Condition2. For each pair (a, b) e A x B, there exists b1 either,
maxb'EBa
maXb ,eB.
E iriu(b', s)
E,rsu
irsu(b, s)
or,
(b'
i rsu(b, s) s) Y.
To interpretCondition2, it statesthatwheneversome positionb wouldbe preferable to those availablein Ba, it is alwaysthe same position b EBa, which may depend on b, that is the best availableposition. Simply knowing that b is preferredto any element in Ba is enough to determine the optimal second period decision, without specific knowledgeof ir. satisfyConditions1 and 2. Then - induces Proposition6. Let thepayoffstructure relationon !Fan order-preserving Remark 5. Conditions1 and 2 are triviallysatisfiedwhen there are just two initial positions, one of which is irreversible(so the right-handside of (9) is the empty set), which reveals Proposition 3 to be a special case of 6. But there is another class of decision problems that meet its requirements. Assume that the total payoff has an additive form, r(a, s) + u (b, s), and that the second period choice is the level of a real-valuedcontrol variablesubject to an inequalityconstraintdeterminedby the first period choice: b _ z (a). Initialpositionsare completelyorderedin the mannerrequired for Condition 1 by their levels of z (a), with z (a) z (a') implying a >F a'. Further assume that u (b, s) is concave in b for each s. Then, whenever the expected second period returncould be increasedby removingthe constrainton b, b = z (a) must be the of the valueof r. Condition2 is thusmet. In particular choiceregardless best constrained applications,the constraintz (a) might signify the maximumcapacityof an otherwise constant marginalcost plant, a number of delivery options acquired,or quantityof a an increase in the variability naturalresource left unextracted. In such circumstances, of beliefs leads a rational decision-makerto choose a less binding constrainton this second period choice. The strengthof Condition2 is apparentwhen consideringa plausibleextension of this problem. Suppose b is a vector chosen subjectto x (b) z (a), with other aspectsof is preferred b violatingthis constraint the problemunchanged.Knowingthat a particular to all those satisfyingit tells us that the best availablechoice is on the boundaryof Ba, but the particular point on the boundarygenerallydependson r, violatingCondition2. 5. LIQUIDITY AS FLEXIBILITY:AN EXAMPLE Markets provide flexibility by allowing assets to be transformed,through sale and are effected purchase,into other assets. In a monetaryeconomy these transformations in two stages: the initial asset is exchangedfor money, the money is exchangedfor the desired good or asset. The liquidity (saleability)of an asset describes the ease, or costlessness,with which the first stage is accomplished.Money is the most liquid asset since costs associatedwith the firststage are avoidedcompletely. This section illustrates
22
the relation between flexibilityand the prospect of informationin a sequential asset choice problem,interpreting the demandfor money as a desire for flexibility. Suppose an individual must choose between three non-diversifiedportfolios: M, A1, A2 (money, asset 1, asset 2). In period one he chooses which asset to hold until period two; in period two, after furtherinformationis received, he chooses which asset to hold until period three. There are two ultimatestates that can occur,S = {s1,s2}, and two observations be as follows. thatcan be received, Y = {y1, Y }. Let the payoffstructure The return on portfolio M is 0 in both periods with certainty. In period one A1 and A2 both returnf > 0 with certainty;in period two they yield 1 and 0 respectivelywhen s1 occurs (which favors asset 1), 0 and 1 respectivelywhen s2 occurs. No costs are incurredif the individualswitchesfrom M in the first period to either A1 or A2 in the cost" second, or if he continuesto hold the same portfolioas before. But a "liquidation of e >0 is incurredif he switches from either A1 or A2 to a differentportfolio in the second period. Thus M is more flexiblethan both A1 and A2 in the sense of Section 3. The total payofffor each sequenceof actionsand state is given in Table I.
TABLE I Payoff f(a, b, s) I I , State 2 State 1
Initial position (a)
Second position (b)
Al
A1 m
A2
A1
~~~~~F-e
F-cr
1 0
r+1
rc+1
<-
-M
M
A2
0
0
0
1
A2
A1 M A2
F-c+1 r
r-c -c
F+1
Let the informationstructure(H1, q) be describedparametrically by a (l-p) ] q=[a] (14) 1- a 1-a (-p) #r = flq where 0 a q. Thus a- c1 and 0 ' p 1. For this class of information structures, the priorprobabilitythat states s1 will occur and the probabilitythat message y, will be receivedare the same and equal to a. Parameter p is the correlationcoefficientbetween y and s, viewing them as randomvariablestaking on values of 1 or 2. Raising p for given a increases the variabilityof beliefs, both in the sense of and of 's. When abouts; whenp = 0, nothingabouts can be inferred p = 1, y conveysperfectinformation from y. Assume the individualis risk neutraland wishes to maximixethe expected payoff. The optimalstrategyyields an expectedreturn
LL7sY)
[I
p +a(l -p)
1-p-a(1-p)
(15) J(1, q) = maxaeD Y2=l qjmaxbED ij=j iT(yj)f(a, b, si). In (15), D ={M, A1, A2} is the set of possible portfolios, and f(a, b, si) is the payoff
.2
function of Table I. Solution of the problem is straightforward but lengthy. Figure 2 presentsthose aspects of the solution which concernus. Regions A2, M, A1 (bounded by dotted lines) are the values of a and p for which it is optimalto initiallyhold those
JONES & OSTROY informativeness

p
23
I
A/
X
I~~~~~~~~
/ p A1 + I (to robabil ity ~~~~~~~~~~~p 1/2
1-r/
FIGURE 2
valuesfor whichAl, M, andA2 are the optimalassetsto hold initially Parameter
assets. Region M vanishes if eitlier r->cj/2 or > 1/2-money is never held if its opportunity cost overshadows either the alternatives' switching costs or the maximum second period yield at stake. Holding M can be rational because if Al or A2 is chosen initially, and subsequent observation indicates that the opposite position promises higher expected returns, then either cost c is incurred or the agent passes up the opportunity
to profit from the information. Varying the parameters has plausible effects on the demand for money. Reducing r, the yield on alternative assets, moves outward the vertical boundaries and downward the lower boundaries of region M, enlarging the set of beliefs for which money is the optimal first period asset. Raising c, the illiquidity of alternative assets, has a similar effect. Moving ax toward 1/2, increasing prior uncertainty about which asset has the highest yield, can move one into region M but not out of it. Increasing p, the information content of y, never causes a switch out of M. An alternative way to see how anticipated information affects the demand for money is to ask: at what r is the decision-maker indifferent between all three assets? Letting ax= 1/2,, so he is indifferent between A, and A2, the three regions intersect at p = 2F. The short term yield the individual is willing to forgo by holding money is thus r = p/2 (up to F = c/2, beyond which it stays constant to keep region M from vanishing). The greater is the information expected in the near term, the higher is the yield required for less liquid assets to be held. Although we assumed risk neutrality for this illustration, one can verify that the effect of risk aversion on the value of flexibility is ambiguous. Suppose the agent is extremely risk averse, concerned only with maximizing his minimum possible payoff. If y conveys less than perfect information, p < 1, then he must hold either Al for both periods or A 2; only in that way is he guaranteed at least r (see Table I). Alternatively, if y promises perfect information, p = 1, then he must hold M initially; only in that way is he guaranteed
24
a returnof 1. Since there are points in Figure 2 where M is held althoughp < 1, and points where A1 is held althoughp = 1, it is apparentthat risk aversionhas in one case enhancedand in the other case diminishedthe value of flexibility. This examplewas constructedto distinguishits motive for holdingmoney as much as possiblefrom the motivesembodiedin existingtheories of money demand. Risk was asset liquidationcosts were required, essential,but not riskaversebehaviour;differential (to meet, for example,unforeseen"cashrequirements"); liquidations but not compulsory yields on alternativeassets were uncertain,but money was dominated,in terms of both immediate(periodone) and future (periodtwo) yields, by all other assets-none yielded less than 0 in each period. Liquidityhas value becauseit permitsprofitableexploitation of information not yet received. Finally,notice that with a renamingof the positionsM, A1, A2, the structureof the exampleappliesto the heterogeneouscapitalinvestmentproblem. Let A1 and A2 refer no capital to two differenttypes of capitala firmmightacquire,andM referto acquiring at all (postponingchoice to period two). Both investmentscould be unambiguously profitable,but the firm may be unsure which will be the most profitable. If it expects to be partiallyresolvedby period two, it may rationallyreject investing this uncertainty currentlyin either type of capital. Investmentfalls becauseof the expectationthat more will be learned. 6. CONNECTIONSWITH OTHER WORKS Risk and uncertainty of those beliefs Our distinctionbetween the risk embodiedin beliefs and the variability maintained betweenriskanduncertainty withthe distinction over time invitescomparison by some writers. The most well-knownjuxstapositionof risk and uncertaintyis that of for those events which cannot be Knight (1921). He reserves the term "uncertainty" assigned numericalprobabilities,and "risk"for those homogeneous, repetitive events whose relative frequenciescan be ascertained. The distinctionappearsto be based on formedestimates,withKnightunwillthe differencebetweenobjectivelyandsubjectively ing to considernumericalprobabilitiesattachedto events if there is no statisticalbasis for their estimation. Keynes too believed that economic risks involved more than just well defined degree of rationalbelief". chances. Propositionsand events vary in their "appropriate The highest degree is knowledge, or certainty; although that certainty may involve numericalprobabilities,such as those assignedto the outcomes of a spin of a roulette wheel known to be fair-what Knightmight have called risk. Keynes view was similar scaled; to Knight'sin that he did not believe that degrees-of-beliefneed be numerically but, unlike Knight, he was concernedwith buildinga theory that involved comparison of degrees-of-belief. (Keynes (1936) later replacesthe term "degreeof rationalbelief" with "confidenceof beliefs".) Our approachis similarto Keynes' if for no other reason in termsof our rankingbased than his concept of degree-of-beliefinvites interpretation over states on variability.We wouldsay that the degree-of-beliefin a priordistribution increasesas the variabilityof (11,q) decreases,and that the state of perfect certaintyor knowledge correspondsto the belief that there is nothing more to learn (i.e. 7r(y)=4 andcannot structures ordersinformation for all y). Furthermore, only partially variability scaled. be numerically Distinguishingrisk from uncertaintyin this sense is not new. It is explicit in the terminologyof Marschak(1938, 1949), Tinter (1942) and Hart (1942), among others, to describethe prospectof learning. Whatwe have added who use the term uncertainty of more informativeexperimentsby Blackwell(1951, 1953) and is the characterization and Miyasawa(1968), by Bohnenblust,Shapleyand Sherman(1949) (see also Marschak DeGroot (1962) and Kihlstrom(1973)) to describechangesin uncertainty.
JONES & OSTROY
25
Flexibilitywithand withoutuncertainty The notion of flexibility has arisen in numerous economic contexts. Without risk, flexibilityconsiderationscan still be important. Making investmentirreversiblealters the optimalpath of capitalaccumulation(Arrow,Beckmannand Karlin(1958), Arrow (1968), Nerlove and Arrow (1962)); asset liquidationcosts influence portfolio choice even when cashneeds are perfectlyforeseen (Baumol(1952), Grossman(1969), Niehans of choice" mighthave a distinctpreferencefor "postponement (1978)). Thatindividuals is exploredby Koopmans(1964). Thatpreferences in the absenceof riskand uncertainty for flexibilitycan be treated axiomaticallywithout reference to probabilities,although they may be equivalentto ones derived from expected utility theory, is demonstrated by Kreps (1979). Marschakand Nelson (1962) recognizethe usefulnessof flexibilityas an economicconcept and considerhow it mightbe formalized. A connection between random changes and the value of flexibilityis drawn by Lavington(1921), who provides a superb early discussionof what he terms "the risk arising from the immobility of invested resources". It re-emerges in the context of behaviourof the firm in Kalecki (1937) and in Stigler (1939), who describesone plant as being more flexiblethan anotherif it has a flatteraveragecost curve (this is pursued furtherby Tisdell (1968)). The effect of changes in risk on investment has been studied by Smith (1969), Rothschildand Stiglitz(1971), Hartman(1972) andNickell (1977), amongothers. These studies support a basically ambiguousrelation between risk and investment demand. We focussed on the possible inverse relationshipbetween uncertaintyand investment (inflexibility). Although this difference in emphasis reflects, in part, the distinction between changes in risk and changes in uncertainty(risk held constant),it also hinges of flexibility in investmentdecisions. Acquiringadditionalcapital on the characterization can representa choice of moreflexibility,for example,when it increasesplantcapacityinvestmenttoday permitsthe firmto producemore as well as less tomorrow. Regarding investmentas one-dimensionalvariationof a homogeneouscapital stock is certainlya possible specification. But if one regardsthe investmentdecision under uncertaintyas essentially a choice between no investment and various postponable additions to a heterogeneous capital stock, then the illiquidityof specific capital becomes a central consideration,with more investmentassociatedwith less flexibility(see remarksat the end of Section 5). The connectionbetween flexibilityand the prospect of learningis explicit in Hart risk from uncertaintyas we have, and takes the position that, (1942). He distinguishes little importance in economicanalysis". "rrisk has comparatively comparedto uncertainty, Hart points out that uncertaintycan be ignored when all choices are either perfectly flexibleor economicallyirreversible-our Propositions1 and 2. (Thisobservationis also made by Hirshleifer(1972) and Hicks (1974).) Concerningthe importanceof attitudes
toward risk when learning is involved, he states: " . . . the central problems of uncertainty
can be posed and largely solved under the assumptionof 'risk neutrality"'. Hart also of the Simon (1956)-Theil (1957) certainty-equivalence recentqualifications anticipated theorem. In the context of environmentalpreservation,Henry (1974a, 1974b) and Arrow and Fisher (1974) (see also Fisher, Krutilla and Cicchetti (1972)) show that it is sub-optimalto replace probabilitydistributionsby their mean values when choosing between irreversibleand perfectly flexible alternatives,even though all other requiretheorem might be fulfilled. Propositions3 and 4 ments for the certainty-equivalence extend these results. of investmentsby In a related paper, Hirshleifer(1972) measuresthe "illiquidity" irreversible the time requiredto complete a technologically process(i.e. the time for the investmentto mature),and showsthat the prospectof emerginginformationcan explain the lower equilibrium yield on shorterterm assets. Baldwinand Meyer (1979), who cast
26
their analysisin terms of the sequentialarrivalof potentiallyattractivenew investment opportunitiesratherthan new informationabout fixed existing opportunities,similarly derive a positiverelationbetween the durationof investmentsand the liquiditypremium needed to induce their acceptance. l3ernanke's(1979) study of the optimal timing of the postponingof projectsduringperiodswhen investment,by rationalizing irreversible of aggregate suggeststhatthe observedinstability muchcanbe learnedby waiting,strongly value investmentover the businesscycle can best be explainedin termsof the fluctuating of flexibility. when a is real Recent work by Epstein (1980) relatesthe choice of a to uncertainty valued and the derivative
va(a,
T)
limh +o (v(a +h)-v(a))/h
he shows that when Va is convex (concave)in 7r,the optimala rises exists. In particular, of (II, q). This is similarto our Proposition0 with the natural (falls)with the uncertainty orderingof the real numbersreplacingoF. Epstein illustratesthis result with examples having a flexibilityinterpretation. Freixas and Laffont (1979) examine the situation where the firstperiod choice imposes an inequalityconstrainton second period choices, a case of nested switching costs, demonstrating(in their Theorem 1) the corollary describedin Remark5. and liquidity Flexibility has been used to referboth to an asset'scertaintyof yield, including The term "liquidity" capital gains, and to the differencebetween its purchaseand sale price, includingall transactioncosts. Keynes (1930, p. 67) leaves some ambiguitywhen he introducesthe term by callingone asset more liquid than anotherif it is "more certaintyrealizableat short notice without loss". Makowerand Marschak(1938) take care to distinguishan or futuresaleability,using liquidityto describethe asset's "safety"from its "plasticity", latterproperty. Certaintyof yield is singled out in the Tobin (1958)-Markowitz(1957) approach to money demand. The title of Tobin'spaper aptly expressesthe viewpoint:"Liquidity Preferenceas BehaviourTowardRisk".Flexibilityis not an issue since choice is confined to assets free of switchingcosts. In his recent contributionto monetary theory, Hicks (1974) outlines another approach,encompassinga broaderclass of assets that differ in terms of saleability. It representsthe applicationto monetarytheory of Hart'sframework,and, in comparison Preferenceas BehaviourTowardUncertainty". withTobin,couldbe entitled:"Liquidity sketchedby Hicks. The example of Section 5 fills in the formaldetails of an illustration andthe demandfor liquid(saleable) A similarconnectionbetweenemerginginformation assets is suggestedby Marschak(1949), Goldman(1974, 1978) and Cropper(1976). Hick's essay, even more than Hart's, indicates the range of macroeconomic phenomenathat may be treatedwith this approachto liquiditypreference. He remarks that the separation of determinantsof financialand real asset equilibrium,the twin and that with this more cuttingedges of his earlierIS-LM analysis,may need reworking; recent approach,in which "the balance sheet must be consideredmore generally,... it is desirablefor the marginalefficiencyof capital and the theory of money to be taken together". We thus have a sixty year traditionof isolated recognitionthat flexibilitychoice is of definingflexibility a componentof a wide rangeof economicdecisions. The difficulty in such a way as to have universalapplication,and the difficultyof obtainingformal may accountfor its limitedrole in convenresultswithoutmodel-specificqualifications, perspective,however,the tantaltional microeconomic theory. From a macroeconomic the connectionbetweenbusinesscyclesandpublicconfidence izingprospectof portraying
JONES & OSTROY
27
as a relation between flexibility induced shifts in asset demands (away from capital investment and towards more liquid assets, especially money) and uncertaintyis too compellingto be ignored.
APPENDIX
Proofs of Propositions0-6 - v (a', 7r) is convex on As for all a, a' E A such that Proposition 0. (a) v (a, 7r) a Fa' implies a'Fa' for all a, a'eA such that (i) (H,q)-(H',q') (ii) aEA(H,q),
a' EA(H', q') (iii) a 0 A(H', q') or a'i A (17,q) (iv) a, a' are-F-comparable.
Proof. Suppose - does not inducean orderpreservingrelationon zF. Then there exists (H, q), (H',q'), a, a' satisfying (i)-(iv) and a''Fa. The hypothesis asserts that v(a', Ir)-v(a, ir) is convex in ir. Hence, from definition(1) of-,
V(a'; II, q) - V(a; H, q) =
Zqy[v(a',
ir(y)) - v(a, 7r(y))] (A.1)
_ q y[v (a ', 7'(y )) - v (a, r'(y ))]

=
V(a'; H', q')- V(a; HI', q').
But a EA(H, q) implies 7(a) + V(a; H, q) - F(a') + V(a'; H, q), by definition, and a' E A (HI', q') implies F(a') + V(a'; H', q') ?_r(a) + V(a; H1', q'), with condition (iii) requiring strictinequalityin at least one case. Therefore V(a'; HI, q) - V(a; HI, q) < V(a'; HI', q')- V(a; HI', q'), contradicting (A. 1). 11
(A.2)
(b) Existence of a, a'eA such that a Fa', a';Fa and v(a, -7r)-v(a',7r) is not convex on As implies existence of (H, q), (EL', q') and r: A x S - R such that {a'} = A(HI, q) and {a} = A(fl', q'). (Le. - does not induce an order-preserving relation on zF.)
Proof. Define d(7r)= v(a, 7r)- v(a', 7r). d(7r) is not convex implies there exists IrT,ITr2EAs andA E[0, l]suchthat Ad(I7r)+ (1-A) d(7r ) < d(Air'+ (1 -A Define (H1, q)=
([Tt )7r 2).
(A.3)
(1-A)) .]'
ir-Hq,
and
(H', q')=
([ -r, ii]
(11-A))
Clearly (H, q) - (H',q') by (4) since [TM = H' and Mq' = q with
M=-A Finally,define r:A x S -> R as follows:

F(a) = r(a, s) = 0,
1-Al
Vs E S
+ (1 -A)d(,7r2)]/2, f(a') = r(a', s) = [d(#r) +Ad(i7r1)
Vs E S
Vs ES and a" E A\{a, a'}
r(a") = r(a", s) < -k
where k is sufficiently large to make all other positions a" non-optimal for (H, q) or
28
(11', q'). I.e. A(HI, q) c {a, a'} and A(JI',q') c {a, a'}. Now, (F(a)+ V(a; [I, q))-(F(a')+ V(a'; [I, q))= F(a)-F(a')+Ad(irT)+(1-A)d(i,-2)
-
-(d(#) -Ad(irT)-(1 -A)d(r2))/2
< 0 by (A.3). Hence a'eA( H, q) and aiA( H, q).

Similarly, (r(a) + V(a; LI', q'))- (F(a') + V(a'; LI',q')) = f(a)-f(a') +Ad(#) + (1-A)d(#) = (d(#) -Ad(IT1)-(1 -A)d(1T2))/2
>0
by(A.3).
Hence a EA(H', q') and a'o A(H', q'). Thus A(H, q) = {a'} and A(H', q') = {a}. 1
Inequalitiesused in provingthe next four propositionsare collectedin the following Lemma. Lemma. For all (11,q)-(11', q'),
(L.1) (L.2) V(a*;L, q) V(a;HI,q) V(a;Lt,q) V(a;HI',q') for all a, a*eA for allaEA for all a*
EA
(L.3)
(L.4)
V(a*; I, q)= V(a*; HI',q') V(a*; HI,q) =V(a*'; HI,q)
for all a*, a*'eA.
Proof. (L.1) follows immediatelyfrom the definitionof V, the non-negativityof switchingcosts, and the definitionof perfectflexibilityin Section 3. (L.2) follows from the definition of V, the convexity of v (a; 7r) in 7r (it is the maximumof a finite collectionof boundedlinearfunctions),and the definitionof>. (L.3) follows from the fact that economic irreversibility means that c (a*, b, s)
u(b, s) - u(g(a*), s) for all b, s. Hence v(a*; 7r) = Z,s 7rsu(g(a*), s), implying V(a*; [I,q)=EZs isu(g(a*),s). Since (1,q)_ (11',q') implies 4r=4r', it follows that V(a*; [I, q) = V(a*; HI', q').
(L.4) is obtainedby applying(L.1) to both a* and a*' in turn. Proposition 1. F(a*)-F(a*')

for all (H, q).
II
implies f(a*)+ V(a*; H q)>f-(a*')+ V(a*'; H, q)
Proof. Immediatefrom (L.4). || Proposition2. f(a*) + V(a*; H, q) > F(a*) + V(a*; HI, q) implies F(a*) + V(a*; II', q') _ F(a*) + V(a' ; 'q')
whenever Hq = H'q'. V(a*; H, q)= Z r,su(g(a*),s) in the proof of (L.3), it follows that f(a*)+ V(a*; H, q)= ',q'),where iir=Hq =H'q'. , ir,(r(a*,s)+u(g(a*),s))=F(a*)+V(a*;
Proof. From the definition r(a) E i7r-r(a,s) in (2), and the demonstrationthat
To shortenthe statementsof the remainingpropositions,we use the fact that the change in value of a position is the same as the change in V(a; H, q) when the prior belief #r
is fixed (i.e. when (H, q) > (H', q')).
JONES & OSTROY
29
Proposition3. (II,q) : (HI', q') implies V(a; II, q) - V(a l', q') >: V(a*; r, q) - V(a*; 11',q').
Proof. The left side of the inequality is non-negative by (L.2). The right side is 0
by (L.3). 1I Proposition4. (1L, q) > (Il*, q*) implies - V( a' II*, q*). V(a * R, q) - V(a* fl* q*) -i"V(a; 1, tq) Proof. (H*,q*) indicates no variabilityin beliefs, and (Il, q) ! (HI, q*) implies = q*) > V(d, Il*, q*). 171q IIq* = ir. Therefore lr*(y) =r for all y. By (LA1)V(a*; H,*, But
V(a; 11*,q*) =
Y q*yv(d, #)
*
= v (a.
r) maxaeA
v (a, r) q*).
>-v(a,
iY q*yv(a,
v)-(a*,f*
The first and last equalities follow from the definition of v and the fact that ir*(y) = X for all y; the second and fifth from Y,qy = 1 for any information structure, the third is the definition of a. Hence V(a*; H*, q*) = V(d, H*, q*). Applying (L.1) again, V(a* H, q) > V(a; 171, q). Subtracting (A.4) from (A.5) yields (A.5) (A.4)
V(a*; Hl,q)- V(a*; H*, q*~) > V(a; H, q)- V(d; 17I,q*).
Proposition S. c(a,bs)=c(a) V(a*; I,q)for all s and b #g(a), ', lq')-
II
and (H,Iq)>s (171', q') imply V(d; H',q')-
V(d; H,Iq) > V(a*
Proof. Define b- g(d). The definition of v(a; ir) and fact that c(a*, b, s) = 0 for all b, s imply the first equality in
v (a* ir) - v (d; ir) = maxb

- mi
,ir,u (b, s) -maXb

{c (a), maxb
ir.(u (b, s)- c (J, b, s)) EX (A.6)
X, 'ire(u (b, s) - u(1 s))}.
The second equality follows from c (d' b, s) = {0 for b = b, c (d) for b1 - b}. Since (H, q) os (H', q') requires that ir'(y) = Ayir(y)+ (1 -Ay)r, where 0 c Ayc1 for each y E Y, maxb Y., irT(y)(u (b, s) - u (b, s))cAY maxb Es Xr, (y)(u (b, s) - u(b, s)) + (1 -Ay ) maxE, ii (u(b, s) - i(b, s)) Es maXb (A.7) r. (y) (u (b, s) - u (b, s)).
The firstinequalityfollows from the convexityof maXbY,s7r (u(b,s) - u (b,s)) in ir, as it

is the maximum of a finite collection of linear functions of ir. The definition of a implies
maxb
maxb
2; #r(u (
E3
rTs(y)(u
s)
(b,
u(b,
s))
s) - u (b, s))v(a*-
Substituting
ir = ir(y)
since a* was available; with Ay this, together 0, gives the second inequality. and ir'(y) in turn into (A.6), and utilizing (A.7), gives =0 ir()):-:v(-
1 and
1r(y))-v('-
a * 7r'(y))-v(a'-, srfv))
30
for each y E Y. Since 's requires that qy = q ' for each y, this means that
V(a*;fl,q)-V(a;fl,q)
' V(a*;W',q')- V(a;W,q')
||
Proposition 6. Condition 1. For each a e A, G(a, s, a) = BaC B for all s e S, a-' ?; the ordering ZF on A is complete (nested switching costs). Condition 2. For each (a, b) e A x B, there exists b E Ba such that for all 7r either
maXb' EBa
EsVsU(b
Xs ) _E
(b, s) s Tsu
or
maXb'eBa
Es VsU(b s) = s IT5U(b, s). induces an orderpreserving relation an

oZF-
Condition 1 and Condition 2 implies '
Proof. Condition 1 implies that v (a, ir) = maxbeBa Es isu (b,s) for all a and Vr.The definition of ZF and Condition 1 require that Ba DBa' for all a 'F a'. Hence, for all
a
'Fa'
and Ir,
v (a; ix) - v (a'; rr) -maxbEBa

=maxdEBa
EsTsu
(b, s)
- maxb'eBa'Es
(b', s) 7rsu
{maX bE{Ba, d} Es Tsu (b, s)-maxb'EBa
Es
su (b',
s)} (A.8)
= maxdEBa {max {0, Es 7rsu(d, s) - Es srSu (b, s)}}.
The position b in the last expression is the fixed b EBa asserted to exist for each (a, d) E A x B in Condition 2, i.e. b (a, d) does not vary with r. The second and third expressions are equal since Ba D Ba'; the last equality follows from Condition 2. Since the innermost maximum in the last expression in (A.8) is between two linear functions of r, it is a convex function of r. The outer maximum is thus a maximum of convex functions, and hence v (a, r)- v (a', vr) is convex in r. Proposition 0 then allow us to assert that - induces an order preserving relation on !F. Requiring that the flexibility ordering on A be complete (i.e. nested switching costs) allows one to strengthen the implication of increased variability of (fl, q) from "the optimal position is not less flexible" to "the optimal position is at least as flexible". |
First version received July 1981; final version accepted September 1982 (Eds.). An earlier version of this paper entitled "Liquidity as Flexibility" was presented at the Third World Congress of the Econometric Society, Toronto, August 1975. REFERENCES ARROW, K. J. (1968), "Optimal Capital Policy with Irreversible Investment", in Wolfe, J. N. (ed.) Value Capital and Growth (Chicago: Aldine). ARROW, K. J., BECKMANN, M and KARLIN, S. (1958), "Optimal Expansion of the Capacity of the Firm", in Arrow, K. J., Karlin, S. and Scarf, H. (eds.) Studies in the Mathematical Theory of Inventory and Production (Stanford). ARROW, K. J. and FISHER, A. C. (1974), "Preservation, Uncertainty and Irreversibility", QuarterlyJournal of Economics, 89, 312-319. BALDWIN, C. Y. and MEYER, R. F. (1979), "Liquidity Preference Under Uncertainty", Journal of Financial Economics, 7, 347-374. BAUMOL, W. J. (1952), "The Transactions Demand for Cash: An Inventory Theoretic Approach", Quarterly Journal of Economics, 66, 545-566. BERNANKE, B. (1979), "Irreversibility, Uncertainty, and Cyclical Investment" (Unpublished Manuscript, Stanford University). BLACKWELL, D. (1951), "The Composition of Experiments", in Proceedings of the Second Berkeley Symposium on Mathematical Statistics and Probability (University of California Press). BLACKWELL, D. (1953), "Equivalent Comparison of Experiments", Annals of Mathematics and Statistics, 24, 265-272. BOHNENBLUST, H. F., SHAPLEY, L. S. and SHERMAN, S. (1949), "Reconnaisance in Game Theory" (RM-208. The RAND Corporation).
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The Review of Economic Studies, Ltd.

Review of EconomicStudies(1984) LI, 13-32 ? 1984 The Societyfor EconomicAnalysisLimited

REVIEW OF ECONOMIC STUDIES

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REVIEW OF ECONOMIC STUDIES

JONES & OSTROY