Investment in new activities and the welfare cost of uncertainty

Recent Literature has shown that trade distortions are associated with first-order costs stemming from the induced drop in the formation of new activities. We demonstrate that uncertainty may induce similar welfare costs, and that these costs apply also to a closed economy. This argument is illustrated in Romer's model of a dependent economy, where foreign direct investment is needed to enable the importation of capital goods and intermediate products used in domestic production. We show that Knightian uncertainty inhibits the formation of new activities, leading to first-order losses, whereas risk aversion alone leads to second-order losses. (C) 1997 Elsevier Science B.V.