Intersectoral capital reallocation under price uncertainty

Abstract Consider a small open two-sector economy with costly capital mobility. The world price follows Brownian motion. The optimal reallocation policy is found using the theory of option pricing. The total value of each capital unit is its expected discounted marginal product in the current sector plus the option value of moving it to the other sector. A marginal unit is moved when its total value in the new sector exceeds that in the old sector, plus the adjustment cost. This yields ‘hysteresis’ — a zone of inaction and caution before reorienting capital in response to relative price shifts.