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 Itô 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 l(t), i.e., the unique solution of a representation problem in the spirit of Bank and El Karoui [P. Bank and N. El Karoui, Ann. Probab., 32(2004), pp. 1030-1067]. We show that the base capacity is deterministic and it is identified with the free boundary ŷ(t) 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. © 2014 Society for Industrial and Applied Mathematics.
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