Benoit Chevalier-Roignant, Lenos Trigeorgis, Avinash K. Dixit - Competitive Strategy - Options and Games-The MIT Press 2011 PDF

Competitive Strategy
Competitive Strategy
Options and Games
Benoît Chevalier-Roignant
Lenos Trigeorgis
The MIT Press

Cambridge, Massachusetts
London, England
© 2011 Massachusetts Institute of Technology
All rights reserved. No part of this book may be reproduced in any form by any electronic
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Library of Congress Cataloging-in-Publication Data
Chevalier-Roignant, Benoit, 1983–

Competitive strategy: options and games/Benoit Chevalier-Roignant and Lenos
Trigeorgis; foreword by Avinash K. Dixit.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-262-01599-8 (hardcover: alk. paper)
1. Options (Finance) 2. Investment analysis. 3. Game theory. I. Trigeorgis, Lenos.
II. Title.
HG6024.A3C48535 2011
332.6—dc22
2010053619
10 9 8 7 6 5 4 3 2 1
Contents
Glossary xi
Symbols xix
Foreword by Avinash Dixit xxiii
Preface xxv
1 The Strategy Challenge 1

1.1 The Changing Corporate Environment 3
1.2 What Is Strategy? 10
1.3 Two Complementary Perspectives on Strategy 15
1.3.1 Corporate Finance and Strategy 15
1.3.2 Game Theory and Strategy 20
1.4 An Integrative Approach to Strategy 35
1.5 Overview and Organization of the Book 41
Conclusion 43
Selected References 43
I STRATEGY, GAMES, AND OPTIONS 45
2 Strategic Management and Competitive Advantage 47

2.1 Strategic Management Paradigms 48
2.1.1 External View of the Firm 48
2.1.2 Internal View of the Firm 50
2.2 Industry and Competitive Analysis 50
2.2.1 Macroeconomic Analysis 57
2.2.2 Industry Analysis: Structure–Conduct–Performance
Paradigm 58
2.2.3 Porter’s Industry and Competitive (Five-Forces)
Analysis 59
vi Contents
2.3 Creating and Sustaining Competitive Advantage 66

2.3.1 Value Creation 66
2.3.2 Generic Competitive Strategies 70
2.3.3 Sustaining Competitive Advantage 72
Conclusion 73
3 Market Structure Games: Static Approaches 75
3.1 Monopoly 76
3.2 Duopoly 81
3.2.1 Bertrand Price Competition 86
3.2.2 Cournot Quantity Competition 92
3.2.3 Strategic Substitutes versus Complements 97
3.3 Oligopoly and Perfect Quantity Competition 99
3.4 Market Structure under Incomplete Information 102
Conclusion 107
4 Market Structure Games: Dynamic Approaches 109
4.1 Commitment Strategy 110
4.1.1 Concept of Commitment 111
4.1.2 Taxonomy of Commitment Strategies 118
4.1.3 Sequential Stackelberg Game 131
4.2 Bargaining and Cooperation 135
4.2.1 Bargaining 135
4.2.2 Cooperation between Cournot Duopolists in
Repeated Games 138
4.2.3 Co-opetition: Sometimes Compete and Sometimes
Cooperate? 147
Conclusion 151
5 Uncertainty, Flexibility, and Real Options 153
5.1 Strategic Investment under Uncertainty—The Electricity
Sector 154
5.1.1 Need for New Investment in Europe 154
5.1.2 Sources of Uncertainty 156
5.1.3 Generation Technologies and Business Risk
Exposure 159
5.2 Common Real Options 162
Contents vii
5.3 Basic Option Valuation 169

5.3.1 Discrete-Time Option Valuation 176
5.3.2 Continuous-Time Options Analysis 184
Conclusion 189
Appendix 5A Multistep Cox–Ross–Rubinstein (CRR) Option
Pricing 190
II OPTION GAMES: DISCRETE-TIME ANALYSIS 193
6 An Integrative Approach to Strategy: Option Games 195

6.1 Key Managerial Issues: Optimal Timing and Flexibility
versus Commitment 196
6.1.1 Optimal Investment Timing under Uncertainty 196
6.1.2 The Trade-off between Flexibility and
Commitment 197
6.2 An Illustration of Option Games 197
6.3 Patent-Fight Strategies 206
6.4 An Application in the Mining/Chemicals Industry 209
Conclusion 217
7 Option to Invest 219
7.1 Deferral Option of a Monopolist 219
7.2 Quantity Competition under Uncertainty 224
7.2.1 Cournot Duopoly 224
7.2.2 Asymmetric Cournot Oligopoly 235
7.3 Differentiated Bertrand Price Competition 238
Conclusion 240
8 Innovation Investment in Two-Stage Games 243
8.1 Innovation and Spillover Effects 243
8.2 Innovation and Patent Licensing 253
8.2.1 Patent Licensing: Deterministic Case 253
8.2.2 Patent Licensing under Uncertainty 261
8.3 Goodwill/Advertising Strategies 264
Conclusion 271
viii Contents
III OPTION GAMES: CONTINUOUS-TIME MODELS 275
9 Monopoly: Investment and Expansion Options 277

9.1 Option to Invest (Defer) by a Monopolist 278
9.1.1 Deterministic Case 281
9.1.2 Stochastic Case 284
9.2 Option to Expand Capacity 298
9.2.1 Additional (Lumpy) Capacity Investment 299
9.2.2 Incremental Capacity Investment 303
Conclusion 306
Appendix 9A Contingent-Claims Analysis of the Option to
Invest in Monopoly 308
10 Oligopoly: Simultaneous Investment 311
10.1 Oligopoly: Additional Capacity Investment 312
10.1.1 Existing Market Model: Expansion Option 312
10.1.2 New Market Model: Investment (Defer) Option 314
10.2 Oligopoly: Incremental Capacity Investment 317
10.3 Perfect Competition and Social Optimality 322
Conclusion 325
Appendix 10A Derivation Based on Dynamic
Programming 326
11 Leadership and Early-Mover Advantage 331
11.1 A Basic Framework for Sequential Investment in a
Duopoly 331
11.2 Duopoly with Sequential Investment under
Uncertainty 339
11.3 Oligopoly with Sequential Investment under
Uncertainty 348
11.4 Option to Expand Capacity 352
Conclusion 357
12 Preemption versus Collaboration in a Duopoly 359
12.1 Preemption versus Cooperation 360
12.1.1 Preemption 363
12.1.2 Cooperation in an Existing Market 370
12.2 Option to Invest in a New Market under Uncertainty 372
Contents ix
12.2.1 Symmetric Case 373

12.2.2 Asymmetric Case 379
12.2.3 Size of Competitive (Cost) Advantage 382
12.3 Option to Expand an Existing Market 389
12.3.1 Symmetric Case 389
12.3.2 Asymmetric Case 393
Conclusion 395
Appendix 12A Strategy Space and Solution Concept 397
Appendix 12B Perfect Equilibrium in Deterministic
Setting 398
Appendix 12C Perfect Equilibrium in Stochastic Setting 400
13 Extensions and Other Applications 403
13.1 Exogenous Competition and Random Entry 404
13.2 Real-Estate Development 405
13.3 R&D and Patenting Applications 407
13.4 Investment with Information Asymmetry 411
13.5 Exit Strategies 415
13.6 Optimal Capacity Utilization 417
13.7 Lumpy Capacity Expansion (Repeated) 419
13.8 Other Extensions and Applications 421
Conclusion 423
Appendix: Basics of Stochastic Processes 425
A.1 Continuous-Time Stochastic Processes 426
A.1.1 Brownian Motion 427
A.1.2 Mean-Reversion Process 438
A.1.3 General Itô Processes 440
A.2 Forward Net Present Value 441
A.3 First-Hitting Time and Expected Discount Factor 447
A.3.1 Exercise Timing and First-Hitting Time 447
A.3.2 Expected Discount Factor 448
A.3.3 Profit-Flow Stream with Stochastic Termination 452
A.4 Optimal Stopping 453
Conclusion 458
References 461
Index 473
Glossary
Accommodated entry Entry is accommodated if structural entry bar-

riers are low and entry-deterring strategies are ineffective or too costly.
An incumbent attempts to adopt strategies and build competitive advan-
tage early on to cushion the future negative effects of accommodated
competitive entry.
Action An action or move by one of the players in a simultaneous game
is a choice or decision she can make that affects the other player(s).
Barriers to entry Barriers or factors that allow an incumbent firm to
earn positive economic profits or excess rents by making it unprofitable
for newcomers to enter the industry. Competitive markets are character-
ized by low entry barriers.
Blockaded entry A condition where the incumbent need not undertake
any entry-deterring strategies to enjoy monopoly rents in the market-
place. Structural or administrative barriers are sufficient conditions for
blockaded market entry.
Call option A contract or situation that gives its holder the right, but
not the obligation, to buy or acquire an underlying asset at a predeter-
mined price over a specified period (maturity).
Chicken game See “war of attrition.”
Closed-form solution A solution that gives an analytical answer to a
mathematical formulation.
Closed-loop strategies In dynamic games, closed-loop strategies allow
players to condition their play on both the previous moves by the players
and on calendar time. All past actions of all players is common knowl-
edge at the beginning of each stage.
Closed-loop equilibrium The equilibrium forms a perfect equilibrium
in closed-loop strategies; that is, the closed-loop strategies form a Nash
xii Glossary
equilibrium in each and every subgame (on and off the equilibrium
path).
Commitment See “strategic commitment.”
Commitment value The incremental value (positive or negative) accru-
ing to a firm from making a strategic commitment.
Cost advantage One of the main strategies to achieve a competitive
advantage is to seek to attain lower costs, while maintaining a perceived
benefit comparable to that of competitors. A relative cost advantage
influences the optimal investment timing of competing firms.
Cost of capital The rate of return expected or required by an equally
risky asset or investment to induce investors to provide capital to the
firm. The cost of capital reflects the systematic (or market) risk of a
traded asset perfectly correlated with the investment or asset to be
valued.
Deterred entry A situation occurring when an incumbent can keep an
entrant out by employing an entry-deterring strategy.
Dominant strategy A strategy that is the best decision for a player
regardless of the action or strategy chosen by its opponent.
Early-mover advantage An advantage from moving early that enables
a firm to make a higher economic profit than its rivals. An early-mover
advantage can stem from the uncontested market presence of a leader
that enjoys monopoly rents for some time. Sources of sustainable early-
mover advantages include the learning-curve effect (economies of cumu-
lative production and learning), brand-name reputation—especially in
situations where buyers are uncertain about product quality (“experi-
ence goods”)—, or high customer switching costs.
Economic profit A profit concept that represents the difference
between the profits earned by investing resources in a particular activity
and the profits that would have been earned by investing the same
resources in the best alternative activity in the market. Opportunity costs
are subsumed in economic profits.
Economies of scale Cost savings achieved when the unit production
cost of a product decreases with the number of units produced.
Economies of scope These involve cost savings externalities among
product lines or production activities.
Elasticity The elasticity of a variable with respect to a given parameter
is the percentage change in the value of the variable resulting from a one
Glossary xiii
percent change in the value of the parameter, all other factors remaining
constant.
European option An option that can only be exercised at maturity, not
earlier.
Extended (or expanded) net present value (E-NPV) The total value of
a project including the option or flexibility value and the impact of any
strategic commitment or interaction effects.
Fixed costs Costs that are independent of the scale of production and
are locked in for a given period of time. Some distinguish among fixed
and sunk costs though the difference is subtle: “fixed” often refers to
short-term commitments, while “sunk” or nonrecoverable costs generally
involve a longer planning horizon.
Focal-point argument In the event of multiple equilibria, the focal-
point argument suggests that an equilibrium that appears “natural” or
logically compelling is the one more likely to arise.
Games of incomplete information Games where players do not know
some relevant characteristics of their opponents (e.g., their payoffs, avail-
able action sets or their beliefs).
Games of perfect information Games where all players possess all
relevant information. Extensive-form games of perfect information have
the property that there is exactly one node or decision point in each
information set.
Game theory A branch of mathematics and economic sciences con-
cerned with the analysis of optimal decision-making in multiplayer set-
tings. Chess is a well-known example. Solution concepts meant to provide
predictions on the likely outcomes impose certain behavioral restrictions
on players.
Information set The information a decision maker has at the moment
she makes a decision.
Isolating mechanisms Economic forces put in place by a firm to limit
the extent to which its competitive advantage can be duplicated, eroded,
or neutralized through the resource-creation activities of competitors.
Learning-curve effect Learning-based cost advantage that results from
accumulating experience and know-how in productive activities over
time.
Market structure Characteristic of a market in terms of number and
size (power) distribution of firms. Monopoly, duopoly, and perfect com-
petition are classic examples of market structure.
xiv Glossary
Markov property This property asserts that for certain stochastic pro-
cesses or dynamic problems, all the past relevant information is sum-
marized into the latest value of a variable or price. One cannot therefore
use past information to predict the future state of the variable. Efficient
markets and Itô processes have this Markov property.
Maturity The period or last moment at which an option can be exer-
cised. If the option can be exercised before this date, it is called an
American option; if only at maturity, a European option.
Myopic strategy A strategy that does not take into account or is inde-
pendent of the investment decisions of rivals.
Nash equilibrium A classic equilibrium solution concept used in the
analysis of multiplayer games: each player pursues its individual optimiz-
ing actions given the best actions of the other players. In equilibrium, no
player has an incentive to unilaterally deviate.
Nature Acts of nature are treated as the actions of a quasi-player that
makes random choices at specified points in a game.
Net present value (NPV) The NPV paradigm is well established in
corporate finance. The net present value of a project is the present value
of the expected cash flows minus the (present value of) required invest-
ment costs. In the absence of managerial flexibility, a stand-alone invest-
ment is deemed acceptable if its net present value is positive.
Node A decision point in a game at which a player (or nature) can take
an action.
Open-loop strategies Strategies where players cannot observe the pre-
vious play of the opponents and therefore condition their play on calen-
dar time only. Such strategies are also called “precommitment
strategies.”
Open-loop equilibrium A Nash equilibrium solution that is obtained
when firms adopt open-loop strategies ignoring their rivals’ actions over
the history of the game.
Option A contract or situation that gives its holder the right but not
the obligation to buy or acquire (if a call) or sell (if a put) a specified
asset (e.g., common stock or project) by paying a specified cost (the
exercise or strike price) on or before a specified date (the expiration or
maturity date). If the option can be exercised before maturity, it is an
American option; if only at maturity, a European option.
Option to invest or option to defer An American-type call option
embedded in projects where management has the right (but no obliga-
Glossary xv
tion) to delay the project start for a certain time period. The exercise
price is the cost needed to initiate the project.
Option valuation Valuation process by which the total value or
“expanded net present value” (E-NPV) of an investment opportunity
is determined. The valuation approach is meant to capture manage-
ment’s flexibility to adapt its decisions to the evolving uncertain
circumstances.
Path dependence A situation occurring when past circumstances or
history condition the current outcome and can preclude or favor certain
path evolutions in the future.
Payoff The utility, reward, or value a player receives when the game is
played out. In the option games context, the payoff can be the real option
value (e.g., the value of a plant with the option to expand production).
Perfect Nash equilibrium See “subgame perfect Nash equilibrium.”
Players The individuals, firms, or actors that make decisions in a game
situation. Each player’s goal is to maximize her payoff or value by choos-
ing the best action or sequence of actions (strategy).
Precommitment strategies See “open-loop strategies.”
Preemption A situation whereby a firm invests ahead of its rivals to
hinder their entry or profitable operation. Such a situation is often
related to the presence of some first-mover advantage.
Proprietary option An option held by a firm that entitles it to the full
exclusive benefits resulting from exploiting the option. A monopolist
firm has a proprietary investment option.
Real option The flexibility arising when a decision maker has the
opportunity to adapt or tailor a future decision to information and devel-
opments that will be revealed in the future. A real option conveys the
right, but not the obligation, to take an action (e.g., defer, expand, con-
tract, or abandon a project) at a specified cost (the exercise price) for a
certain period of time, contingent on the resolution of some exogenous
(e.g., demand) uncertainty.
Real options analysis The field of application of option-pricing theory
to valuing real investment decisions.
Risk-neutral valuation A valuation method underlying option pricing
analysis that adjusts for risk in the expectation of cash flows (certainty-
equivalent), enabling discounting of future values at the risk-free interest
rate. This contrasts to the standard valuation approach (NPV) consisting
xvi Glossary
in discounting the (actual) expected cash flows at a (higher) risk-adjusted

discount rate.
Risk neutral Situations where investors are indifferent between a sure
payoff (certainty-equivalent) and a risky outcome of equal expected
value. By extension, the same description is used for the corresponding
valuation method.
Shared option An option simultaneously held or shared by several
firms in the industry. Shared options characterize competitive industries
where incumbent firms share the same investment opportunities. Shared
options are more involved to analyze as they must account for rival reac-
tions or interactions. Option holders’ investment behavior and project
values are affected by the proprietary or shared nature of real options.
Soft commitment (or accommodating stance) A strategic investment
commitment that makes the rival firm better off in the (later) competi-
tion stage. In Cournot quantity competition, a soft commitment leads
the committing firm to produce relatively less, while in Bertrand price
competition a soft commitment induces the firm to maintain a higher
price.
Stochastic processes A set or collection of random variables such that
the value of the process at any future time t is random though specified
by a given probability distribution.
Strategic commitment A strategic decision or move intended to alter
the competitors’ behavior or beliefs about future market competition.
Such commitments are generally difficult or costly to reverse.
Strategic complements (or reciprocating actions) These characterize
actions in situations where firms react (in equilibrium) in a reciprocating
or complementary manner (i.e., reaction functions are upward sloping).
For example, I will be nice to you if you are nice to me. In case of price
competition, price-setting actions are strategic complements.
Strategic substitutes (or contrarian actions) These characterize actions
in situations where firms react (in equilibrium) in a contrarian or oppo-
site manner (i.e., reaction functions are downward sloping). For example,
you take advantage of me if I am nice to you. In case of quantity com-
petition, capacity-setting actions are strategic substitutes.
Strategy A behavioral rule adopted by a player that prescribes which
contingent action(s) to choose at each stage in a game. A strategy speci-
fies for each decision node or information set which action to pursue.
Open-loop and closed-loop strategies refer to different strategy types:
Glossary xvii
open-loop strategies make more restrictive assumptions on the informa-

tion the players possess over the game play.
Subgame perfect Nash equilibrium Solution concept used in dynamic
games under complete information: (continuation) strategies form a
Nash equilibrium at each and every stage of the game—even those stages
that will not be actually played in equilibrium (“off the equilibrium
path”).
Sunk costs Investment costs that cannot be recouped. Once incurred,
sunk costs are irrelevant for future decision-making.
Tough commitment (or aggressive stance) A strategic commitment
intended to hurt the rival. In Cournot quantity competition, tough com-
mitment induces the committing firm to produce more, while in Bertrand
price competition the firm will cut its price and enter a price war.
Variable costs Costs, such as direct labor or commissions to sales
people, that vary as the output level rises.
War of attrition (or chicken game) In a duopoly involving a second-
mover (follower) advantage, both firms have an incentive to be a fol-
lower or wait to be the last to move, leading to a “war of attrition.”
Symbols
i, j Competing firms (in a duopoly)

−i All other firms except firm i (in oligopoly)
n Number of firms (in a competitive industry or market)
π i (⋅) Firm i ’s certain (deterministic) profit function
π i (⋅) Firm i ’s uncertain (stochastic) profit function
p (⋅) Deterministic (inverse) demand function
p (⋅) Uncertain (inverse) demand function
a, b Known constant parameters in the (inverse) demand function
qi Quantity produced by firm i
Q Total quantity produced by all firms in the industry
ci Firm i ’s variable (unit) cost
Ki Up-front strategic investment outlay by firm i (in commitment
games)
s Degree of substitution (in differentiated Bertrand price
competition)
x R&D effort (in R&D investment games)
γ Degree of R&D spillover (sharing) effects
k Risk-adjusted discount rate (cost of capital)
r (Instantaneous) risk-free interest rate
δ Asset cash flow or dividend yield, convenience yield (for com-
modities), competitive erosion, or opportunity cost of waiting
g Actual growth rate (drift parameter) for geometric Brownian
motion
ĝ Risk-neutral growth rate (for geometric Brownian motion)
xx Symbols
α Actual growth rate for arithmetic Brownian motion

α̂ Risk-neutral growth rate for arithmetic Brownian motion
σ Volatility (for the arithmetic or geometric Brownian motion)
h Small time interval
dt Infinitesimal time interval (h → dt )
q Actual (empirically observed) probability (of up move)
p Risk-neutral probability (of up move)
u Up-move multiplicative factor in a binomial tree (process)
d Down-move multiplicative factor in a binomial tree (process)
Ii Investment outlay (cost) for firm i
e Expansion factor (base value V expanded by e percent upon
paying investment cost I , giving eV − I)
λ Poisson jump arrival rate (frequency)
ρ Correlation coefficient
E0 [⋅] Expectation based on actual probabilities (conditional on
time- 0 information)
Ê0 [⋅] Risk-adjusted expectation based on risk-neutral probabilities
(conditional on time-0 information)
var ( ) Variance (or σ 2 )
t0 Starting time
t Current time
T Time (years) to maturity of the option (in discrete-time models)
T random first-hitting time (i.e., the random time at which the
pre-set investment trigger XT is first reached)
T * Optimal random first-hitting time (i.e., the random time the
optimal investment trigger X * is first reached)
Bt (T ) Value (at time t ) of a bond paying 1 euro at random future time
T . It also represents the expected discount factor.
zt A standard Brownian motion or Wiener process
εp Price elasticity of demand (ε p (Q) ≡ −[∂Q ∂p] × ( p Q))
β (β̂ ) Dummy variable of the fundamental quadratic function (^ for
the risk-neutral version)
β1 (β̂1) Positive root of the fundamental quadratic function (elasticity
of the option to invest)
Symbols xxi
β 2 (β̂ 2 ) Negative root of the fundamental quadratic function (elasticity

of the option to exit)
x0 Time-0 value of the stochastic process in the case of arithmetic
Brownian motion
x t Stochastic process value at time t in the case of arithmetic
Brownian motion ( x t ≡ ln ( X t ))
X0 Time-0 value of the stochastic process in the case of geometric
Brownian motion
X t Time-t value of the process in the case of geometric Brownian
motion
XT Value of the stochastic process at maturity T in discrete-time
option games, or the preset investment trigger—not necessarily
the optimal one—in continuous-time option games
X* Optimal investment trigger (*)
M Monopolist firm’s total value (with investment timing or expan-
sion option)
S Total firm value (with investment timing or expansion option)
in an oligopoly characterized by simultaneous investment
L Leader’s value (with investment timing or expansion option) in
sequential investment option games
F Follower’s value (with investment or expansion option) in
sequential investment option games
* (Superscript) denotes optimal or equilibrium value
^ (Superscript) denotes risk-neutral or risk-adjusted expectation,
variable or parameter
Euro
M Million
Bn Billion
≡ Means “is defined to be”
Foreword
President Truman once said: “Give me a one-handed economist. All of

my economic advisers say ‘On the one hand this, on the other hand that.’”
Economists do indeed recognize that there are multiple forces at work
in most situations, and it takes quite subtle analysis to understand their
interaction and balance. This book is an admirable effort at such an
economic analysis.
When facing an uncertain future, remaining flexible until more infor-
mation arrives has value, because one can cherry-pick to make invest-
ments only when the prospects are relatively favorable. This is the starting
intuition of real option theory. But in game theory, the strategy of making
irreversible commitments to seize first-mover advantage and present
rival players with a fait accompli to which they must adapt can have its
own value. So what does one do when facing an uncertain future in the
company of rivals? This is a difficult problem, conceptually as well as
mathematically. The last two decades have brought a trickle of research
contributions that address some aspect of this dilemma. In this book,
Benoît Chevalier-Roignant and Lenos Trigeorgis synthesize and consoli-
date much of this literature and skillfully extend it. Generations of stu-
dents and researchers over the next decade or two will find the book an
invaluable starting point for their own work.
The authors also deserve congratulations for their excellent exposi-
tion. They begin with very simple and clear overviews of the issues,
concepts and models from the separate areas of real options and game
theory. They focus on applications to industrial organization and busi-
ness. For students in any of these areas, this book can serve as a hyper-
market for one-stop intellectual shopping.
I will endeavor a personal remark. I was involved in some of the early
research on real option theory. I also contributed to popularizing game
theory. But I seem to suffer from a kind of attention-deficit disorder in
xxiv Foreword
research; therefore I got interested in, and diverted to, other fields like
political economy and governance institutions. I am happy that my con-
tributions to real option theory are still remembered, and feel honored
to be asked to write a preface to this book. But, returning to the real
options literature after many years to read this book, I also feel like Rip
Van Winkle, amazed at how much has changed in the intervening years.
Although I have enjoyed my excursions into other fields, perhaps I
should have stayed and contributed to these equally exciting develop-
ments that have combined options and games to produce better two-
handed economists.
Avinash Dixit
Princeton, NJ
June 2010
Preface
In real life most situations corporate managers face are characterized by

both strategic and market uncertainties with respect to the economic
environment. Following the liberalization and deregulation of Western
economies, very few industries remain protected, whereas most compa-
nies face fierce competition in their respective economic sectors. Certain
European governments used to favor high administrative barriers shield-
ing certain “natural monopolies” from competitive entry. Such protected
monopolies included the telecommunications, electricity, and gas sectors.
European governments recently had to enforce deregulation schemes,
opening up many economic activities to new, potentially foreign market
participants. At the same time sectors traditionally populated by many
firms have undergone significant consolidation, yielding oligopolistic
situations with a reduced number of players. These two ongoing
concurrent phenomena—liberalization and continuing consolidation—
highlight the emphasis corporate managers increasingly put on strategic
uncertainty and market structure.
Besides strategic uncertainty, managers face increasing market uncer-
tainty. With a reduced life cycle for many products, firms can no longer
rely on a given offering but have to renew their product portfolio fre-
quently to sustain or enhance their revenue stream in light of competi-
tive pressures. The IT industry has evolved most rapidly, putting
companies unable to respond to market developments and technological
uncertainty at a severe disadvantage.
At the core of this dilemma lies a classic trade-off between commit-
ment and flexibility. Managers can stake a claim by making large capital
investments today influencing their rivals’ behavior or take a “wait-and-
see” or step-by-step approach to avoid possible adverse market conse-
quences tomorrow. The assessment and optimal management of strategic
options is critical for firms to succeed in today´s constantly changing
xxvi Preface
business environment. Whether to invest in a new product or enter a new

market is a critical decision management should address with proper
analytical tools in assessing options and deciding whether to make this
or that strategic move.
This book aims to make accessible to a wide audience recent results
on how to achieve and quantify balance between flexibility and commit-
ment through the new approach of “option games.” We believe that this
approach can play an important role in managing modern business in a
changing global marketplace. Option games help model situations where
a firm that has a real option to (dis)invest in specific projects faces com-
petition. Such situations lead to two, sometimes conflicting, main sources
of value for the firm. First, there is a value of waiting or flexibility related
to the real option that the firm holds to make future better-informed
decisions. Second, there is a value of commitment in light of the strategic
interaction with competitors. The trade-off between these two forces
calls for a careful balancing act. From a modeling perspective, the exami-
nation of such a trade-off calls for a combination of the real options and
game theory approaches to decision-making.
In the first part of the book, we discuss prerequisite concepts and tools
concerning basic game theory, industrial organization, and real options
analysis. We are then in a position to amalgamate these diverse fields
into a unified framework for option games. This makes the task at hand
very ambitious because these fields of research normally require differ-
ent tool kits and needed results are scattered around in disparate parts
of the literature. We aim to fill this gap here by synthesizing the existing
literatures to provide a consistent and accessible account of options and
games. We combine some of the best materials, tools, and ideas found in
diverse books and research works on game theory (e.g., Fudenberg and
Tirole 1991; Osborne 2004), industrial organization (Tirole 1988), and
real options analysis (Dixit and Pindyck 1994; Trigeorgis 1996) and go
beyond current knowledge to chart new territory. The current book
brings important materials and ideas together in a unified framework,
which makes it much easier for managers and academics to enter and
understand this new field. The second part of the book presents the new
approach in discrete time, while the last part on continuous-time option
games is not covered in any systematic way anywhere and is an important
addition. For pedagogical convenience and for the sake of simpler and
clearer exposition and buildup of the basic ideas, we first present each
of the building blocks step by step to form the supporting foundation
and columns of the structure, with the richer theory coming later
Preface xxvii
(culminating toward chapter 12) as the keystone that will complete the
arch.1
The book should be especially appealing to the academic community,
particularly in the areas of strategy, economics, and finance. It is the first
book that combines the aforementioned fields in such a way that it is
accessible to an audience that is not necessarily expert in all fields
involved. The book should also be of interest to (academically trained)
practicing managers who are interested in applying these ideas. It pro-
vides many strategic insights and a ready-to-use tool kit offering quan-
titative guidance for important competitive trade-offs faced by the
modern firm. We attempted to strike a balance between making the book
accessible to a wider audience while simultaneously making it challeng-
ing and rigorous, subjecting the art of strategy to a scientific inquiry. The
book provides a very pragmatic and intuitive, yet rigorous approach to
strategy formulation.
We owe an intellectual debt to the many scholars who made significant
contributions to the related literatures and to the many individuals who
provided us with generous comments, criticism, ideas, and suggestions.
We thank Avinash Dixit for his feedback, prologue, and encouragement.
Marcel Boyer, Marco Días, Kuno Huisman, Grzegorz Pawlina, Sigbjørn
Sødal, and Jacco Thijssen made invaluable detailed comments and pro-
vided suggestions for improvement on the entire manuscript. Several
other colleagues offered valuable comments on select parts of the book
or on specific chapters: Christoph Flath, John Khawam, Bart Lambrecht,
Richard Ruble, and Bruno Versaevel. We also thank Stefan Hirth, Helena
Pinto, Artur Rodrigues, and Han Smit for useful comments. We thank
Robert J. Aumann, Rainer Brosch, Peter Damisch, Marco Días, Avinash
Dixit, Eric Lamarre, Scott Mathews, Robert C. Merton, Reinhard Selten,
and Jean Tirole for enhancing the relevance of this book with their valu-
able interviews and comments. The authors would like to thank Arnd
Huchzermeier for his support. Jane MacDonald from the MIT Press has
been most enthusiastic, efficient, and supportive. Last but not least, we
would like to thank our families, alive or departed, for their love and
support.
1. Chapter 12 can be thought of as the climax of the book, but we need to introduce various
key notions (e.g., investment trigger, open-loop vs. closed-loop equilibrium) in a step-by-
step fashion to facilitate and smooth out the exposition. Several of the issues left unre-
solved in the earlier parts of the book are addressed in chapter 12.
The Strategy Challenge
1
At a time when national monopolies have been losing their secular well-
protected positions owing to market liberalization in the European
Union and elsewhere across the globe, strategic interdependencies and
interactions have become a key challenge for managers in many corpora-
tions. Strategic questions abound: How should a firm sustain or gain
market share? How to differentiate oneself from others in the grueling
global marketplace? When precisely should a firm enter or exit an indus-
try when it faces uncertainty and significant entry and exit costs?
Recent developments in economics, finance, and strategy equip man-
agement facing such challenges with a concrete framework and tool kit
on how to behave strategically in such a complex and changing business
environment. Corporate finance and game theory provide complemen-
tary perspectives and insights regarding strategic decision-making in
business and daily life. Box 1.1 motivates the relevance of game theory
to the understanding of daily life situations. The option games approach
followed in this book paves the way for a more rigorous approach to
strategy formulation in many contexts. It helps integrate in a common,
consistent framework the recent advances made in these diverse disci-
plines, providing powerful insights into how firms should behave in a
dynamic, competitive and uncertain marketplace.
We first highlight in section 1.1 several environmental factors that
justify why firms should be careful when formulating their corporate
strategies in an uncertain, competitive business environment. In section
1.2 we discuss how an understanding of competitive strategy in terms of
sound economic principles is useful to managers. Two complementary
but separate perspectives on strategy (corporate finance and game
theory) are discussed in section 1.3. We address the need for an integra-
tive approach to corporate strategy in section 1.4. We provide an over-
view of the book organization in section 1.5.
2 Chapter 1
Box 1.1
Game theory in daily life
All Is Fair in Love, War, and Poker

Tim Harford, BBC News Online
What Do Love, War, and Poker Have in Common?
High stakes, perhaps. Certainly, in all three you spend a lot of effort trying
to work out what the other side is really thinking. There is another similar-
ity: economists think they understand all three of them, using a method
called “game theory.”
Threats and Counterthreats
Game theory has been used by world champion poker players and by
military strategists during the cold war. Real enthusiasts think it can be
used to understand dating, too. The theory was developed during the
Second World War by John von Neumann, a mathematician, and Oskar
Morgenstern, an economist. Mr. von Neumann was renowned as the
smartest man on the planet—no small feat, given that he shared a campus
with Albert Einstein—and he believed that the theory could be used to
understand cold war problems such as deterrence. His followers tried to
understand how a nuclear war would work without having to fight one,
and what sort of threats and counterthreats would prevent the US and the
Soviets bombing us all into oblivion. Since the cold war ended without a
nuclear exchange, they can claim some success.
Understand the World
Another success for game theory came in 2000, when a keen game theorist
called Chris “Jesus” Ferguson combined modern computing power with
Mr. von Neumann’s ideas on how to play poker. Mr. Ferguson worked out
strategies for every occasion on the table. He beat the best players in the
world and walked away with the title of world champion, and has since
become one of the most successful players in the game’s history. Game
theory is a versatile tool. It can be used to analyze any situation where
more than one person is involved, and where each side’s actions influence
and are influenced by the other side’s actions. Politics, finding a job, nego-
tiating rent, or deciding to go on strike are all situations that economists
try to understand using game theory. So, too, are corporate takeovers, auc-
tions, and pricing strategies on the high street.
Financial Commitment
But of all human interactions, what could be more important than love?
The economist using game theory cannot pretend to hand out advice on
The Strategy Challenge 3
Box 1.1
(continued)
snappy dressing or how to satisfy your lover in the bedroom, but he can
fill some important gaps in many people’s love lives: how to signal confi-
dence on a date, or how to persuade someone that you are serious about
them, and just as importantly, how to work out whether someone is serious
about you. The custom of giving engagement rings, for instance, arose in
the United States in the 1930s when men were having trouble proving they
could be trusted. It was not uncommon even then for couples to sleep
together after they became engaged but before marriage, but that was a
big risk for the woman. If her fiancé broke off the engagement she could
be left without prospects of another marriage.
For a long time the courts used to allow women to sue for “breach of
promise” and that gave them some security, but when the courts stopped
doing so, both men and women had a problem. They did not want to wait
until they got married, but unless the man could reassure his future wife,
then sleeping together was a no-no. The solution was the engagement ring,
which the girl kept if the engagement was broken off. An expensive
engagement ring was a strong incentive for the man to stick around—and
financial compensation if he did not.
Not Committed
Modern lovers might think the idea of engagement ring as guarantee is a

thing of the past, but they can still use game theory to size up their part-
ners. When a couple with separate homes move in together, selling the
second home is an important signal of commitment. That second home is
an escape route—valuable only if the relationship is shaky. If your partner
wants to hang on to his bachelor pad, do not let him tell you it is merely
a financial investment. Game theory tells you that he is up to something.
Reprinted with permission of BBC News, bbc.co.uk/news. Publication

date: August 17, 2006.
1.1 The Changing Corporate Environment
The competitive environment around the globe is becoming increasingly

challenging for managers as modern economies have witnessed tremen-
dous changes over the last three decades. In this constantly evolving
environment, where firms must often make quick decisions that have
long-term impact, it is anybody’s guess what might happen in the future—
market developments often prove expectations wrong. Firms must care-
fully commit to specific strategies while developing adaptive capabilities
4 Chapter 1
in an ever-changing marketplace. Globalization, deregulation, and the

emergence of new economies (e.g., Brazil, Russia, India, and China) have
created both threats and opportunities for incumbent firms who now
have to adapt more effectively to the rapidly changing global environ-
ment or suffer damage by new entrants and risk extinction.
Following the liberalization and deregulation of European economies,
only a limited number of industries have remained secure, while most
companies across the board face serious competitive pressures. At the
same time other economic sectors traditionally characterized by a large
number of companies have undergone significant consolidation, result-
ing in oligopoly structures with a reduced number of players. The recent
economic crisis has amplified these consolidation pressures. The mining
giant Rio Tinto has recently merged with BHP Billiton, forming a virtual
duopoly together with Brazilian mining giant Vale. M&A deals have
similarly reshaped the automotive sector, with the recent acquisitions of
Chrysler by Fiat, of Porsche and Suzuki by Volkswagen, and of Mitsubi-
shi by PSA (Peugeot, Citroën). British Airways together with Iberia
claim the top two position in the fiercely competitive European airline
business. In the United States, the merger between United Airlines and
Continental Airlines created one of the world’s biggest airlines. A dra-
matic concentration has also taken place in the banking sector: out of
the top five investment banks worldwide, only two (Goldman Sachs and
Morgan Stanley) have remained independent. Notable banking deals
include the acquisition of Washington Mutual by JP Morgan Chase, of
Countrywide by Bank of America, and of the Belgian bank Fortis by
BNP Paribas.
These two concurrent phenomena—liberalization and consolidation—
have put higher on the corporate agenda the assessment of strategic
uncertainty. Italy’s dominant state electricity authority, Enel, is a good
case in point. Just a decade ago Enel was in a very comfortable position,
enjoying an established natural monopoly in the Italian electricity market
with the benediction of the national government. The main concern for
Enel during this period was to minimize or keep under control its mix
of input or production costs, as the output electricity price was regulated.
Several years later Enel lost its preferential monopoly position due to
the liberalization of the European markets, and the competitive environ-
ment facing Enel changed dramatically. Enel was forced to sell half of
its generating assets to half a dozen smaller local rivals, creating more
competition in its home base. Electricity price deregulation accompanied
by oil and other fuel price fluctuations have added considerable pressure
and uncertainty for Enel. With further deregulation other European

competitors (e.g., the dominant electricity producer of France, EDF) also
entered the Italian electricity market. Today Enel has to consider the
actions of local as well as international competitors on the national soil,
as well as contemplate investing itself in new or emerging markets, such
as Russia, to sustain or leverage its once dominant position in the area.
Just as its European and global counterparts, Enel now faces a broader
range of uncertainties and challenges: How to cope with increased energy
(input) and electricity demand (output) uncertainties? How to compete
with local and global rivals in an ever-changing local and global competi-
tive landscape? How to assure and diversify its energy portfolio mix in
a globalized marketplace? How to formulate and dynamically adjust its
strategy, knowing when to compete, threaten, bargain, or cooperate with
its rivals? These are the kind of questions we will be addressing in this
book.
Many situations corporate managers face today are characterized by
both market and strategic uncertainty with respect to the economic
environment. When one desires to address such complex issues, some
simplification of reality is useful to focus on the fundamental trade-offs.
Some simple models in management are being revised as they offer
rather simplistic approaches that no longer describe current economic
reality. The field of investment under uncertainty falls in this category.
Prevailing management approaches often lead to investment decisions
detrimental to the overall firm’s long-term well-being. In an increasingly
uncertain and competitive environment, corporate managers need
appropriate management tools that can provide long-term guidance. This
book describes a novel approach aimed to enable managers make ratio-
nal decisions in a competitive environment under uncertainty. It allows
managers to quantify and balance the conflicting impacts of managerial
flexibility and the strategic value of early investment commitment in
influencing rivals’ strategic behavior.
Real options analysis is widely considered to be more reflective of
reality than traditional financial methods (e.g., net present value) in that
it takes managerial flexibility into account.1 To avoid dealing with
complex models, however, standard real options analysis often ignores
1. Investment under uncertainty is part of the mainstream literature on finance, economics,
and strategic management. In the last decades financial theory has been supplemented with
real options analysis. Use of the financial options analogue can be insightful in assessing
flexibility embedded in real asset situations. The real options approach to investment has
reached a corporate finance textbook status and is currently applied in leading corpora-
tions for guiding real-world strategic investment decisions.
6 Chapter 1
the strategic interactions among option holders, analyzing investment

decisions as if the option holder has a proprietary right to exercise. This
simplifying perspective is far from being realistic in many situations
because firms generally compete with rivals. Several firms may share an
option in the industry and hence option exercise strategies cannot be
formulated in isolation. Rather, optimal investment behaviors must be
determined as part of an industry equilibrium. As a consequence of this
more pragmatic view of the nature of the competitive environment, a
new theory called “option games” has emerged. This theory combines
the concepts and tools offered by traditional real options analysis with
game theory principles designed to help figure out how players behave
in strategic conflict situations. The option games approach we elaborate
on herein provides powerful insights into understanding strategic inter-
actions and challenges traditional thinking that presumes that firms
pursue strategies in isolation. Game theory is for the most part deter-
ministic. Option games help management better intuit how uncertainty
can be modeled in a strategic setting. This approach helps improve pre-
diction and understanding of industry dynamics in highly uncertain
industries. It enhances previous industrial organization literature on stra-
tegic investment in a deterministic setting to better explain the strategic
investment behavior of firms under changing conditions. Box 1.2 pro-
vides an overview of the challenges commercial airframe manufacturers
Box 1.2
Evolving strategy in commercial aviation
Boeing Bets the House on Its 787 Dreamliner

Leslie Wayne
In recent years Boeing has stumbled badly, ceding its decades-long domi-
nance in commercial aviation to Airbus and becoming mired in a string of
scandals over Pentagon contracts. The terrorist attacks of 2001 depressed
demand at a time when the company’s product line paled against appeal-
ing new planes from Airbus. In one year alone, from 2001 to 2002, Boeing’s
profits dropped 80 percent.
But the view from Seattle, the headquarters of Boeing’s commercial jet
operations, has more of that Chinese pep-rally spirit than such gloomy talk
might indicate . . .. With revenue having grown for the second consecutive
year, to $54.8 billion in 2005, and a record number of orders on its books,
Boeing has had a huge gain in its stock price—to more than $80 a share,
more than three times its nadir of $25 in 2003. Boeing’s 1,002 orders last
Box 1.2
(continued)
year fell short of Airbus’s 1,055. But Boeing’s orders included more wide-
body planes, which analysts valued at $10 billion to $15 billion more than
Airbus’s.
But what is really driving the high spirits at Boeing—and the high stock
price—is a plane that has not yet taken to the skies: the 787. It is Boeing’s
first new commercial airplane in a decade. Even though it will not go into
service until 2008, its first three years of production are already sold out—
with 60 of the 345 planes on order going to China, a $7.2 billion deal. Other
big orders have come from Qantas Airways, All Nippon Airways, Japan
Airlines, and Northwest Airlines.
Big orders mean big money, of course—and that is good, because ana-
lysts estimate that Boeing and its partners will invest $8 billion to develop
the 787. Boeing is also risking a new way of doing business and a new way
of building airplanes: farming out production of most major components
to other companies, many outside the United States, and using a carbon-
fiber composite material in place of aluminum for about half of each plane.
If it works, Boeing could vault back in front of Airbus, perhaps deci-
sively. If it fails, Boeing could be relegated to the status of a permanent
also-ran, having badly miscalculated the future of commercial aviation and
unable to meet the changing needs of its customers.
“The entire company is riding on the wings of the 787 Dreamliner,” said
Loren B. Thompson, an aviation expert at the Lexington Institute, a
research and lobbying group in Arlington, Virginia, that focuses on the
aerospace and military industries. “It’s the most complicated plane ever.”
Boeing calls the 787 Dreamliner a “game changer,” with a radically dif-
ferent approach to aircraft design that it says will transform aviation. A
lightweight one-piece carbon-fiber fuselage, for instance, replaces 1,200
sheets of aluminum and 40,000 rivets, and is about 15 percent lighter. The
extensive use of composites, already used to a lesser extent in many other
jets, helps improve fuel efficiency.
To convince potential customers of the benefits of composite—similar
to the material used to make golf clubs and tennis rackets—Boeing gives
them hammers to bang against an aluminum panel, which dents, and
against a composite one, which does not. At the same time, the 787 has
new engines with bigger fans that are expected to let the plane sip 20
percent less fuel per mile than similarly sized twin-engine planes, like Boe-
ing’s own 767 and many from Airbus. This is no small sales point, with oil
fetching around $70 a barrel and many airlines struggling to make a profit
even as they pack more passengers into their planes.
“The 787 is the most successful new launch of a plane—ever,” said
Howard A. Rubel, an aerospace analyst at Jeffries & Company, an invest-
ment bank that has advised a Boeing subsidiary . . .. The 787 is designed
to carry 220 to 300 people on routes from North America to Europe and
Asia. Boeing is counting on it to replace the workhorse 767, which is being
8 Chapter 1
Box 1.2
(continued)
phased out, and, it hopes, a few Airbus models as well. Its advantages go
beyond fuel efficiency: Boeing designed the 787 to fly long distances while
keeping passengers relatively comfortable.
That approach grows out of another gamble by Boeing—that the future
of the airline business will be in point-to-point nonstop flights with
medium-size planes rather than the current hub-and-spoke model favored
by Airbus, which is developing the 550-seat A380 superjumbo as its
premier long-haul jetliner. Flying point to point eliminates the need for
most passengers to change planes, a competitive advantage so long as the
Dreamliner is as comfortable and as fast as a bigger aircraft.
And after talking with passengers around the world, Boeing designed
the 787 to have higher humidity and more headroom than other airplanes,
and to provide the largest windows of any commercial plane flying today.
“We are trying to reconnect passengers to the flying experience,” said
Kenneth G. Price, a Boeing fleet revenue analyst. With airlines squeezing
every last cent and cutting back service, “flying is not enjoyable,” Mr. Price
said. “Every culture fantasizes about flying,” he added. “All superheroes
fly. But we were taking a magical experience and beating the magic out.”
Even more innovative for Boeing is the way it makes the 787. Most of
the design and construction, along with up to 40 percent of the estimated
$8 billion in development costs, is being outsourced to subcontractors in
six other countries and hundreds of suppliers around the world. Mitsubishi
of Japan, for example, is making the wings, a particularly complex task that
Boeing always reserved for itself. Messier-Dowty of France is making the
landing gear and Latecoere the doors. Alenia Aeronautica of Italy was
given parts of the fuselage and tail.
Nor are these foreign suppliers simply building to Boeing specifications.
Instead, they are being given the freedom, and the responsibility, to design
the components and to raise billions of dollars in development costs that
are usually shouldered by Boeing.
This transformation did not come overnight, of course, nor did it begin
spontaneously. Boeing changed because it had to, analysts said. “Starting
in 2000, Airbus was doing well,” said Richard L. Aboulafia, an aerospace
analyst with the Teal Group, an aviation research firm in Fairfax, Va.
“Boeing had to reconsider how it did business. That led to the framework
for the 787—getting the development risk off the books of Boeing and
coming up with a killer application.”
Boeing plans to bring the 787 to market in four and a half years, which
is 16 to 18 months faster than most other models. All of that is good, Mr.
Aboulafia added, if it works. It is a tall order for a wholly new plane being
built with new materials, many from new suppliers and assembled in a new
way. “The 787 is operating on an aggressive timetable and with aggressive
performance goals,” he said. “It leaves no margin for error.”
Box 1.2
(continued)
Never before has Boeing farmed out so much work to so many

partners—and in so many countries. The outsourcing is so extensive that
Boeing acknowledges it has no idea how many people around the world
are working on the 787 project.
Airbus, Boeing’s sole rival in making big commercial airliners, is also
making a big bet on the future, but in a different direction. The companies
agree that in 20 years, the commercial aviation market may double, with
today’s big orders from China, India, and the Middle East to be followed
by increased sales to American and European carriers as they reorganize
and reduce costs.
By 2024, Boeing estimates, 35,000 commercial planes will be flying, more
than twice the number now aloft, and 26,000 new planes will be needed
to satisfy additional demand and replace aging ones. But how passengers
will get from place to place, and in what planes, will depend on whether
Boeing or Airbus has correctly forecast the future.
Boeing believes that passengers will want more frequent nonstop flights
between major destinations—what the industry calls “city pairs.” That is
what led to the big bet on the Dreamliner, a midsize wide-body plane that
can fly nonstop between almost any two global cities—say, Boston to
Athens, or Seattle to Osaka—and go such long distances at a lower cost
than other aircraft.
Airbus believes that airplane size is more important than frequent
nonstop flights and that passengers will stick with a hub-and-spoke system
in which a passenger in, say, Seattle, will fly to Los Angeles and transfer
to an Airbus 380 to go to Tokyo before catching a smaller plane to Osaka.
That view has led it to spend $12 billion to develop the double-deck A380,
the largest passenger jet ever—a bet that is as crucial to its future as the
787 is to Boeing’s.
“We have a fundamental difference with Airbus on how airlines will
accommodate growth,” said Randolph S. Baseler, Boeing’s vice president
for marketing. “They are predicting flat growth in city pairs. We are saying
that people want more frequent nonstop flights. They believe airplane size
will increase, and we believe that airplanes will not increase in size that
much. Those two different market scenarios lead to two different product
strategies.”
The market, of course, will determine the winner, but given the indus-
try’s long lead times, that may not be clear for 10 to 20 years. For now,
airlines have ordered 159 copies of the A380—which has a list price of
$295 million and is scheduled to enter service this year—and more than
twice as many 787s, which list for $130 million and are scheduled to enter
service in two years.
Publication date: May 7, 2006.

10 Chapter 1
have faced over the recent years, focusing on the changes in corporate
strategy of Boeing compared with Airbus. A manager from Boeing dis-
cusses in box 1.3 the use of real options to capture and assess the diverse
sources of uncertainty in his business; an analysis of the strategic inter-
play vis-à-vis Airbus is highlighted.
1.2 What Is Strategy?
Corporate strategy is high on the agenda of every major corporation.2

The strategy a firm formulates and how it implements that strategy will
determine to a large extent whether it will survive and be successful in
the marketplace or become extinct. Formulating the right strategy in the
right place at the right time is not an easy task. It requires deep analysis
and ready-to-implement, adaptable solution programs.
Our approach to strategy is based on the premise that strategic man-
agement is a structured, rational discipline relying on rigorous market
and competitive analysis. One can understand why firms succeed or
fail by analyzing their decision processes in terms of consistent princi-
ples of market economics and rational strategic actions. This is the
reason why a large literature in strategic management relies on eco-
nomic theory as it provides a reliable, rigorous foundation to under-
standing specific developments and reactions taking place in the
market place.
Good firm performance is considered the result of soundly formulated
and well-implemented strategies. Grant (2005) identifies the following
elements as key to a successful strategy: (1) simple, agreed-upon, long-
term objectives; (2) deep understanding of the competitive landscape;
(3) objective appraisal of the firm’s internal resources and capabilities;
and (4) effective implementation. There are no easy “recipes for success”
applicable to each firm in every industry.3 The pursuit of one-size-fits-all
2. Although it is commonly agreed that strategy is critical in today’s changing corporate
environment, there is no universally agreed-upon definition of business strategy. According
to Chandler (1962), strategy is “the determination of the basic long-term goals and objec-
tives of an enterprise and the adoption of courses of action and the allocation of resources
necessary for carrying out these goals.” According to Mintzberg et al. (2002), strategy is
“the pattern or plan that integrates an organization’s goals, policies and action sequences
into a cohesive whole.”
3. There are two main approaches to strategy formulation. The first approach looks at
specific firms or case studies examining why these firms are successful and tries to deduce
success factors that might be applicable to other firms. This is the “best-practices” approach.
Herein we take a different approach. We formulate a conceptual framework for strategic
management and assess if it provides prescriptive insights into real-world managerial
problems.
Box 1.3
Interview with Scott Matthews, Boeing
1. Do you believe real options is more suitable than other capital budgeting
approaches to provide managerial guidance? Where and to what extent is
real options analysis used at Boeing?
Real options provides a more informed decision for our strategic projects.
Of special significance are the scenarios that we build around the real
options analyses that help us understand both the risks and the opportuni-
ties of any venture. To date, real options analysis has been used mostly on
large-scale projects. Because of the higher investment amounts, these large
projects pose particular risks that require more careful analyses including
the use of real options techniques.
2. What are the sources of uncertainty you face at Boeing, and how do you
manage them with options, physical or contractual?
Boeing projects have many sources of uncertainty. We build models that

attempt to integrate technology development, design, manufacture, supply
chain, and market forces, including possible actions of our competitors.
These models have dozens, even hundreds, of variables modeled using
various Monte Carlo and discrete event simulation capabilities. Usually
there are just a handful of principal uncertainty drivers which are deter-
mined using sensitivity analysis. We then apply a series of targeted invest-
ments to investigate and better understand the true scale of these
uncertainties. Since the uncertainty landscape is in constant evolution, due
to both our risk mitigation efforts as well as exogenous events, we continue
to update the model and modify our investments as appropriate. These are
12 Chapter 1
Box 1.3
(continued)
often modeled as real option investments with a type of varying volatility,

as we are attempting to both reduce uncertainty while at the same time
increase the value of the subsequent project stage.
3. Do you see a usefulness for game theory and option games in Boeing’s
strategic thinking, for example, vis-à-vis Airbus?
We find that game-theoretical approaches provide additional insight to a

solution set as long as the number of actors is limited to just a few players.
At a certain point market considerations dominate and provide a better
approach to modeling the scenarios. We have managed to execute a few
plays against our competitors, the origin of which could be traced back to
strategic gaming scenarios and market timing. When we are successful,
these plays are often highly leveraged, and therefore take on the charac-
teristics of well-placed option investments. However, like other companies
in dynamic markets, we find our competitive response limited by timing
or technology and product availability considerations.
success factors has failed to provide a coherent direction to guide the

actions and decisions of firms.
Ghemawat (1991) criticizes the success factors approach and identifies
commitment as a main driver of corporate success or failure. He sees
commitment as a well-thought-out plan of action affecting the firm in
the long term. A successful strategy should exhibit consistent but adap-
tive behavior over time and involve certain strategic commitments that
might sometimes hinder managerial flexibility. This feature of strategy
implies that, in an uncertain environment, resolving the investment or
commitment timing issue is critical to a firm’s success. A firm should not
always invest or commit immediately, but should be prepared to decide
at the right moment to reap the benefits of a developing opportunity. As
suggested by Dixit and Pindyck (1994), investment situations where deci-
sions are costly or impossible to reverse compel corporate managers to
be cautious and careful to make decisions at the right time.
Strategy should also be dynamic in that it should be adaptable to
changing market circumstances or competitive dynamics. Following
Rumelt (1984, p. 569), the essence of competitive strategy is being in
“constant search for ways in which the firm’s unique resources can be
redeployed in changing circumstances.” The increasing cone of market
and strategic (competitive) uncertainty makes the dynamic formulation
of strategy key to survival and success in a changing marketplace. Box 1.4
Box 1.4
Flexible strategy and real options
Stay Loose: By Breaking Decisions into Stages, Executives Can Build

Flexibility into Their Plans
Lenos Trigeorgis, Rainer Brosch, and Han Smit, Wall Street Journal
In turbulent times adaptability is critical. That’s why today flexibility is

more valuable than ever in business strategy. Markets, technologies, and
competition are becoming more dynamic by the day. To succeed in this
environment, companies need to position themselves to capitalize on
opportunities as they emerge, while limiting the damage if adversity hits.
This requires a whole new level of flexibility.
Good managers have always been able to think on their feet. But many
widely applied tools of strategy development were designed for relatively
stable environments. As a result business strategy may too often lock
managers into decisions that turn out to be flawed because something
outside their control doesn’t go as planned. What is needed is a systematic
translation of managers’ flexibility into strategy—a plan that lays out a
series of options for managers to pursue or decline as developments
warrant.
That is the essence of what is known as “real options” analysis, an
approach that borrows from the workings of the financial markets. Just as
stock options, for instance, give the holder the right, but not the obligation,
to buy or sell shares at a given price at some time in the future, real options
give executives the right, but not the obligation, to pursue certain business
initiatives.
Start Small
Instead of making rock-hard plans and irreversible long-term commit-

ments, the idea is to create flexibility by breaking decisions down into
stages. When building a new plant, for example, it may be tempting to
realize the full economies of scale by building the biggest facility the
company can manage. But it may be wiser to first build a smaller plant
that can be easily expanded later on. That way, if the market for the prod-
ucts the plant produces should decline, a smaller investment has been put
at risk. At that point managers have the option to scale down or abandon
operations. On the other hand, if things turn out well, they have the option
to expand the plant.
As a mind-set this approach encourages managers to be flexible in their
planning. In more concrete terms it allows them to value investment deci-
sions and business initiatives in a new way. Instead of making a decision
based on a rigid financial analysis of a given project as a whole, managers
can analyze, from the start, the financial implications of each step along
the way and every potential variation—without committing to anything
14 Chapter 1
Box 1.4
(continued)
before they must. Once the project is under way, they also can account for
the changing value of each option as events unfold. All that information
gives them a clearer framework for decisions on whether to launch a
project and whether to proceed, hold back, or retreat at each stage.
What does this look like in practice? A leading European automaker
was considering two investment alternatives for the production of a new
vehicle. Under one alternative, production would be based entirely in one
country. Under the other, the company would set up plants around the
world, allowing it to switch production from site to site to take advantage
of fluctuations in exchange rates or labor costs. The cost of the flexible
system would be higher. But the company decided that the value of that
flexibility, with its promise of cost savings and increased profits, exceeded
the difference in cost between the two alternatives. So it chose the multi-
national plan.
Competitive Edge
Real options analysis can also be useful in helping strategic planners

address the challenges of competition. Many managers already incorpo-
rate game theory into their planning to help predict how competition will
play out. But with competition emerging and evolving more rapidly than
ever, supplementing game theory with real options analysis can help com-
panies be more flexible in how they react.
Consider, for example, the question of whether a company should aim
to preempt competition or choose to cooperate with other players in a
way that could expand the market. This is a question of growing relevance
as sometimes competing technologies are at the heart of more products.
In deciding whether to fight or cooperate, companies can use real options
analysis to better quantify the value of each contingency, including the
value of the options that would be lost or gained depending on what
competitive course is chosen.
What this all adds up to is a portfolio of corporate real options, each
with a value that will change along with the company’s developing markets.
Those who manage that portfolio most effectively will be in the best posi-
tion to realize their company’s growth potential.
Reprinted with permission of The Wall Street Journal, Copyright © 2007

Dow Jones & Company, Inc. Publication date: September 15, 2007.
discusses the need for strategic plans to be flexible and adaptable in a

changing environment. Since strategic decisions have long-term conse-
quences, one should look not only at today’s advantages or drawbacks
but also at the long-term consequences and value of such decisions. The
trade-off between the benefits of commitment (as part of a consistent
strategy over time) and remaining flexible and adaptive to changing
circumstances calls for an integrative approach weighing the merits of
flexibility against commitment.
1.3 Two Complementary Perspectives on Strategy
Two approaches to strategy are of particular interest as they provide

insights that help management deal with the flexibility or commitment
trade-off: corporate finance and game theory. These disciplines are gen-
erally considered separate but are in fact complementary. We discuss
each one next.
1.3.1 Corporate Finance and Strategy
At first sight the link between corporate finance and strategy may not
be that clear. Within corporations, finance is in charge of raising firm
resources, while the strategy department is concerned with how to allo-
cate these resources strategically. The two departments deal, however,
with two sides of the same coin. Financial managers are concerned with
how to finance a project at a reasonable cost. They are aware that
resource providers (e.g., shareholders or banks) will carefully scrutinize
what the firm plans to do with the resources they are asked to provide,
carefully assessing the firm’s strategic plans and the quality of its man-
agement. The formed opinion of the resource providers will influence
the cost of the resources the firm has access to. A good financial
manager cannot therefore ignore the firm’s strategy. Understanding
and communicating the firm’s strategy should be one of her primary
tasks.
Following a finance theory approach, the objective of the firm is to
maximize the wealth (utility) of shareholders. According to the Fisher
separation theorem, this objective is achieved when maximizing the
firm’s market value. A fundamental question in corporate finance is how
to attain this objective. As part of corporate finance, capital budgeting
considers this problem from an investment perspective, being concerned
with the optimal allocation of scarce resources among alternative
16 Chapter 1
projects.4 A key issue is how to address the intertemporal trade-off faced

by a firm between paying more dividends or cash distributions now and
investing in growth projects meant to generate future cash flows.
The established criterion in capital budgeting is the discounted cash-
flow (DCF) or net present value (NPV) method. The approach involves
a relatively easy-to-understand logic and methodology that consists in
assessing the current value of a project based on the expected future
cash flows it will generate, net of the related costs. Management esti-
mates the stream of future expected cash flows over the project’s life
and discounts them back to the present using a risk-adjusted discount
rate, obtaining the project’s present value V . It then subtracts the
(present value of) investment outlays, I , obtaining the current (t = 0) net
present value:5
NPV = V − I . (1.1)
Alternatively, the present value represents the discounted sum of eco-

nomic profits.6 The economic profit in a given period represents the firm’s
total revenue earned in that period minus all relevant opportunity costs,
including the cost of capital. Following the DCF or NPV paradigm, the
firm creates shareholder value by following the NPV rule, prescribing to
immediately undertake projects with positive NPV, meaning NPV > 0 or
V > I . In the absence of managerial flexibility, net present value is the
main valuation measure consistent with the firm’s objective to maximize
shareholders’ wealth.7 Other valuation measures, such as payback period,
accounting rate of return, or internal rate of return are considered infe-
rior to NPV and sometimes even inconsistent.
The above finance theory often appears rather technical and not so
relevant for strategic management practice. Already in Myers (1984), a
4. Corporate finance provides a useful frame to help managers make investment and
financing decisions. Two subfields of corporate finance are particularly relevant for corpo-
rate managers: capital budgeting, or how to make investment decisions, and financing, or
how to finance projects at the lowest cost available. It is commonly agreed that real invest-
ments are more important for creating shareholder value than financial engineering.
5. Consider a project generating over its lifetime (T years) expected cash inflows E [ Rt ] in
each future year t. Launching the project is costly, involving expected cash outflows
E [Ct ]. Let V ≡ ∑Tt =0 E [Rt ] (1 + k ) and I ≡ ∑Tt =0 E [Ct ] (1 + k ) denote the present value
t t
of the stream of cash inflows and outflows, respectively. k denotes the appropriate risk-
adjusted discount rate. The necessary cash outflow I might be a single investment outlay
incurred at the outset or the present value of a series of outflows.
6. The economic value added (EVA) approach is based on this notion.
7. Throughout the book, we ignore agency problems inside a firm that may invalidate the
NPV rule. Myers (1977) discusses the problem of “underinvestment.” Managers acting in
the shareholders’ interest may reject projects with positive NPV when the firm is close to
bankruptcy since investing in these projects would only benefit debt-holders.
gap between finance and strategy was identified. Myers offers three main
explanations for this gap:
• NPV is often mistakenly applied Firms in practice often pursue
financial objectives that are inconsistent with basic financial theory. They
may focus on short-term results rather than long-term value creation.
For instance, firms may worry about the impact of their strategic deci-
sions on today’s P&L and on today’s balance sheet.8 Financial theory in
fact stresses the importance of taking a long-term perspective to enhanc-
ing firm value over short-term creative accounting.9 The balance sheet
or income statement are accounting instruments presenting snapshots of
the moment or period and do not necessarily mirror real long-term value
creation. Another pitfall is that some managers may pursue corporate
diversification to reduce total risk for their own benefit.10 In addition
managers often treat available divisional resources as being limited. This
internally imposed constraint is in sharp contrast with the basic finance
assumption that firms have ready access to capital markets at the prevail-
ing cost of capital. Even if acquiring new financial resources may be more
costly, the project should be adopted if the project brings more value
than it costs to undertake it.
• Finance and strategy mind-sets differ They represent two cultures
looking at the same problem. In perfect competition the firm presumably
makes no excess economic profit. Strategists are thus looking for devia-
tions from perfect competition to generate excess profits. Such deviations
result from distinctive sustainable competitive advantages. Given the
linkage between competitive advantage and excess economic profits,
strategists often find it superfluous to determine the net present value
(as the discounted sum of economic profits) once they have identified
the source of competitive advantages.
• NPV has limited applicability The DCF approach involves the esti-
mation of a risk-adjusted discount rate, a forecast of expected cash
flows, and an assessment of potential side effects (e.g., erosion or syner-
gies between projects) or time-series links between projects. The last
aspect is most difficult to handle with traditional techniques because
8. Other common mistakes include the inconsistent treatment of inflation (deflated cash
flows discounted back at a discount rate assuming inflation) and unrealistic hurdle rates
(use of discount rates that take into account both systematic and diversifiable risk).
9. Short-term orientation is allegedly rampant in countries relying heavily on the capital
markets.
10. Risk reduction through portfolio diversification had better be undertaken by investors
directly in the capital markets; corporate diversification undertaken by managers is a less
efficient means to diversify risk.
18 Chapter 1
today’s investment decisions may constrain or open up new future

opportunities.
NPV has other drawbacks. First, the NPV paradigm views investment
opportunities as now-or-never decisions under passive management. This
precludes the possibility to adjust future decisions to unexpected future
developments in industry cycles, demand, or prices. Firms need to posi-
tion themselves to capitalize on opportunities as they emerge while
limiting the damage arising from adverse circumstances. If market devel-
opments deviate significantly from the expected future scenario, manag-
ers can generally revise their future decisions to protect themselves from
adverse downward movements or tap on favorable developments and
further growth potential. Applying the NPV rule strictly is ill-advised
when managers can adjust their planned investment programs or delay
and stage their investment decisions. Managers following the prescrip-
tions offered by NPV may find themselves locked into decisions that are
flawed when something outside their control does not go as planned.
Second, NPV typically assumes a constant discount rate for each future
time and state scenario regardless of whether the situation is favorable.
Table 1.1 summarizes situations where NPV might give a good approxi-
mation of reality and when it might be misleading. Finally, NPV typically
overlooks the consequences of competitive actions.
Strategy is in need of a quantitative tool that allows for dynamic con-
sideration of changing circumstances. Academics have attempted early
on to use alternative approaches to overcome the problems inherent in
NPV, particularly to deal with uncertainty and the dynamic nature of
investment decision-making. Such methods include sensitivity analysis,
Table 1.1
Use of NPV for financial and corporate real assets
Financial assets Corporate real assets
Appropriate Valuation of bonds, preferred Valuation of flows from

stocks, and fixed-income financial leases
securities
Valuation of relatively safe Valuation of “cash cows”
stocks paying regular dividends
Inappropriate Valuation of companies with Valuation of projects with
significant growth opportunities substantial growth
opportunities
Valuation of call and put options Valuation of R&D projects
Source: Myers (1984, p. 135).

simulation, and decision-tree analysis. Each has had, however, known

drawbacks. Sensitivity analysis considers each variable in isolation,
thereby ignoring correlations among them. Simulation (e.g., Monte
Carlo) faces the same risk-adjustment (discount rate) problem as NPV
and generally requires additional adjustment to handle certain recursive
problems (e.g., American options) because it is a forward-looking process.
Sensitivity analysis and standard simulation are static approaches in that
they assume that management is precommitted to a previously agreed-
upon course of action. In real life this hardly holds. Managers have valu-
able flexibility and can adapt to the actual market developments
once uncertainty gets resolved. They may, for example, abandon a once-
undertaken project if the prospects prove gloomy. Managers may also
have other options to alter project features in view of the actual market
development.
Decision-tree analysis (DTA) can be seen as a refined version of NPV
aimed to take into consideration the dynamic nature and across-time
linkages of decision-making. DTA attributes probabilities to different
states of the world and determines in each case the strategy management
should optimally formulate (e.g., increase the production scale, switch off
the plant, exit the market). In this respect DTA considers the options
management has and provides better insights on the dynamic structure
of the problem. Trigeorgis and Mason (1987) point out that DTA fails,
however, to be economically sound. The discount rate might not be con-
stant over time or across states as typically assumed. Determining the
real probabilities of occurrence of each state is often quite involved. Real
options analysis (ROA) is an enhanced version of decision-tree analysis
that provides improvement in terms of risk-adjustment and determina-
tion of probabilities.11 This enhancement is the result of using insights
from option-pricing theory.12 Just as stock options give the holder the
right, but not the obligation, to buy or sell shares at a given price at some
time in the future, real options gives executives the right, but not the
obligation, to pursue certain business initiatives. ROA is operationally
similar to DTA, with the key difference that the probabilities are risk-
adjusted, which allows the use of the risk-free discount rate. Real options
11. Several corporate-finance textbooks subsume DTA into real options analysis. We dis-
agree. Real options is the application of option-pricing theory (contingent claims analysis)
and risk-neutral pricing to real investment situations (Myers 1977).
12. An alternative to NPV for risk-adjusting risky future cash flows is to consider the
certainty equivalents of the uncertain future cash flows and discount them at the risk-free
rate. This alternative approach for risk adjustment is a cornerstone of risk-neutral pricing
and real options analysis.
20 Chapter 1
analysis is an innovative capital-budgeting tool suitable for the analysis

of dynamic decision making under exogenous uncertainty. It enables
quantifying strategic considerations that justify sometimes undertaking
projects with negative (static) net present value or delaying projects with
positive NPV. Box 1.5 highlights the challenges managers face under
uncertainty, the inability of NPV to cope with them, and the usefulness
of real options in practice.
1.3.2 Game Theory and Strategy
Corporate life would be rather comfortable if a single firm were the only
one operating in the marketplace. As a monopolist the firm could
Box 1.5
Uncertainty, NPV, and real options in practice
Getting Real: Want to Take More Uncertainty out of Capital Investment

Decisions? Try Real Options
S. L. Mintz, CFO Magazine
“The Edsel is here to stay.” That’s what Ford Motor Co. chairman Henry
Ford II told Ford dealers in 1957. “There is no reason why anyone would
want a computer in their home.” Thus intoned Digital Equipment Corp.
founder Kenneth Olsen in 1977. Even for business leaders with vision, the
future is difficult to predict. So where does that leave less-than-legendary
executives come budget-planning season? Stuck, largely, with the same
venerable tools that guided their predecessors and their predecessors: net
present value and gut instinct.
Short of denigrating tools that account for many great successes (along
with memorable flubs), many executives are wondering if that’s all there
is. “There is definitely room for improvement,” concedes Rens Buchwaldt,
CFO of Bell & Howell Publishing Services, in Cleveland. Large capital-
investment decisions—whether it’s launching a new automobile, or build-
ing a chip-fabrication plant, or installing an ERP system, or making any
number of other very pricey investments—hurl companies toward uncer-
tain outcomes. Huge sums are at risk, in a competitive climate that demands
ever-faster decisions. Is there a better way to evaluate capital investments?
A growing and vocal cadre of academics, consultants, and CFOs say there
is one: real options.
Fans insist that real options analysis extends quantitative rigor beyond
discount rates and expected cash flows. “Everybody knew there was some
kind of embedded value” in strategic options, says an oil industry finance
Box 1.5
(continued)
executive. Real options analysis, he says, brings that embedded value to

light.
By quantifying the fuzzy realm of strategic judgment, where leaps of
faith govern decisions, real options analysis fosters the union of finance
and strategy. “It’s a way to be a little more precise about intuitive feelings,”
says Tom Unterman, CFO of $3 billion Times Mirror Co., the Los Angeles
based news and information company. A real options analysis recently
bolstered the company’s decision to back away from an acquisition, says
Unterman, and wider use of the approach is foreseeable. “We are quite
actively looking for ways to apply it,” he says.
Casting investment opportunities as real options increased both the top
and bottom lines at Cadence Design Systems Inc., a San Jose, California,
based provider of electronic design products and services. “We have closed
a number of transactions that we would not have closed before,” CEO
Ray Bingham declares . . ..
The Value of Flexibility
Unlike net present value measurements, real options analysis recognizes

the flexibility inherent in most capital projects—and the value of that
flexibility. To executives familiar with stock options, real options should
look familiar. A stock option captures the value of an investor’s oppor-
tunity to purchase stock at a later date at a set price. Similarly a real
option captures the value of a company’s opportunity to start, expand,
constrain, defer, or scrap a capital investment depending on the invest-
ment’s prospects. When the outcome of an investment is least certain,
real options analysis has the highest value. As time goes by and pros-
pects for an underlying investment become clearer, the value of an
option adjusts.
Sweep away the rocket science, and real options analysis presents a
more realistic view of an uncertain world beset by constant shifts in prices,
interest rates, consumer tastes, and technology. To focus strictly on numeri-
cal value misses the depth and complexity of real options discipline,
observes Nalin Kulatilaka, a professor of finance at Boston University
School of Management. Kulatilaka is an evangelist for a methodology that
obliges managers to weigh equally all imaginable alternatives, good and
bad.
Real options analysis liberates managers from notions of accountability
that mete out blame when plans don’t go as expected. That’s not a healthy
environment for workers or companies that need to be nimble all the time,
if not right all the time. “The best decision may lead to a bad outcome,”
says Soussan Faiz, manager of global valuation services at oil giant Texaco
Inc. “If you are judged on a bad outcome, guess what? People will say,
22 Chapter 1
Box 1.5
(continued)
‘Why go through that?’” To succeed today, companies must create new

options. But unless managers are rewarded for creating them, Faiz warns,
“it ain’t gonna happen.”
Certainty Is a Narrow Path
By taking uncertainty into account, real options analysis fosters a more

dynamic view of the world than net present value does. Net present value
ultimately boils down to one of two decisions: go or no-go. When the net
present value of expected cash flows is positive, companies usually proceed.
As a practical consequence managers concentrate on prospects for favor-
able outcomes. Prospects for unfavorable outcomes get short shrift. In this
analysis certainty enjoys a premium—and that’s a narrow path. Even
without gaming the numbers to justify projects, this upside bias invites
unpleasant surprises.
“Unfortunately, discounted cash flow collapses to a single path,” says
Texaco’s Faiz. Management and measurement are intertwined, she explains,
yet companies manage with an eye to options, but measure performance
as if options don’t exist. In the oil business, oil prices don’t remain low for
the life of a project; they bounce back. “The likelihood of prices being low
for the rest of the project is zero or nearly zero,” says Faiz. But even if
prices do remain stagnant, defying the odds, managers don’t snooze the
whole time. They wake up and react. Net present value, however, treats
investments as if outcomes are cast in stone. This, needless to say, is not
realistic. “Net present value makes a lot of heroic assumptions,” warns Tom
Copeland, chief corporate finance officer of Monitor, a strategy consul-
tancy in Cambridge, Massachusetts. Typically a multiyear project is plotted
along a single trajectory worth pursuing only if the net present value
exceeds zero or some hurdle rate. This type of reasoning may satisfy
requirements for a midterm exam, says Copeland, but situations in the real
world change constantly as new information surfaces. Most managers
realize that flexibility ought to be included in valuations, Copeland says.
“The bridge they have to cross is understanding the methodology to
capture the value of flexibility.”
Out of the Ivory Tower
Experts have touted the merits of real options for at least a decade, but
the sophisticated mathematics required to explain them has penned up
those merits in ivory towers. That’s changing, as proponents tout the
virtues of real options as a mind-set for decision-making . . .
“The kinds of businesses companies go into today are difficult to go into
with NPV,” says John Vaughan, vice president for business development
Box 1.5
(continued)
at M/A-COM, the Lowell, Massachusetts, based wireless products group

of AMP Inc . . .. Net present value would have derailed this project long
ago, Vaughan insists. “It would have been difficult to sell this business case,
because of the high level of uncertainty,” he says. Real options analysis
assembles diverse risks in a coherent fashion, Vaughan says, layer upon
layer, like a papier-mâché creation. “It very much mimics the venture
capitalist approach,” he says, “by timing expenditures to the maturity of
the opportunity.”
Handle with Care
Real options “add richness and perspective I can’t get elsewhere,” says the
oil industry executive. But like any metric that relies on judgment, he
warns, real options must be used carefully. They are not tamper-proof.
“Given enough volatility and time,” he says, “I can make an option a very
big number.” Without solid, accurate measures of volatility, real options
can lead companies astray. For evaluating an offshore oil lease, look at the
history of oil-futures prices; for a petrochemical plant, look at historical
futures and options contracts on margins . . .
“I don’t think the value of great judgment or intuition is any less in using
a more sophisticated model,” Bingham says. To the extent that real options
analysis sheds more light on uncertainty, in his view, it provides a critical
link between strategy and finance. Says Bingham: “Getting hold of real
options will make a CFO more and more relevant and a valuable part of
leadership.”
In an uncertain world, that’s the sort of vision CFOs rely on.
Reprinted with permission from CFO Magazine, website www.cfo.com

© CFO Publishing LLC. Publication date: November 1999.
sometimes make wrong decisions with limited adverse consequences. In

contrast, when several firms are active in the market, managers are under
constant competitive pressure to make the right decisions all the time.
Otherwise, the firm might go belly-up. In perfect competition the deci-
sions of a single firm do not have a significant impact on others, and
strategic interactions are again inconsequential. In reality, however,
industries are rarely either purely monopolistic or perfectly competitive.
In the real marketplace that is closer to oligopoly, firms typically respond
to their rivals’ actions. This calls for an appropriate methodology, namely
game theory.
24 Chapter 1
Over the last half century game theory has developed into a rigorous
framework for assessing strategic alternatives.13 It helps managers for-
mulate the right strategies and make the right decisions under competi-
tion. A recent article in CFO magazine epitomizes a renewed interest by
companies in using game theory to aid decision-making (see box 1.6).
The origins of game theory trace back to the 1900s when mathematicians
got interested in studying various interactive games, such as chess and
poker. The first comprehensive formulation of the concept of optimal
Box 1.6
Game theory in business practice
More Companies Are Using Game Theory to Aid Decision-Making: How

Well Does It Work in the Real World?
Alan Rappeport, CFO Magazine
When Microsoft announced its intention to acquire Yahoo last February,

the software giant knew the struggling search firm would not come easily
into the fold. But Microsoft had anticipated the eventual minuet of offer
and counteroffer five months before its announcement, thanks to the
powers of game theory.
A mathematical method of analyzing game-playing strategies, game
theory is catching on with corporate planners, enabling them to test their
moves against the possible responses of their competitors. Its origins trace
as far back as The Art of War, the unlikely management best seller penned
2,500 years ago by the Chinese general Sun Tzu. Mathematicians John von
Neumann and Oskar Morgenstern adapted the method for economics in
the 1940s, and game theory entered the academic mainstream in the 1970s,
when economists like Thomas Schelling and Robert Aumann used it
to study adverse selection and problems of asymmetric information.
(Schelling and Aumann won Nobel Prizes in 2005 for their work.)
Game theory can take many forms, but most companies use a simplified
version that focuses executives on the mind-set of the competition. “The
formal stuff quickly becomes very technical and less useful,” says Louis
Thomas, a professor at the Wharton School of Business who teaches game
theory. “It’s a matter of peeling it back to its bare essentials.” One popular
way to teach the theory hinges on a situation called the “prisoner’s
13. Game theory is concerned with the actions of decision makers conscious that their
actions affect those of rivals and that the actions of competitors, in turn, impact their own
decisions. When many players can disregard strategic interactions as being inconsequential
(perfect competition) or when a firm can reasonably ignore other parties’ actions (monop-
oly), standard optimization techniques suffice. Under imperfect competition such as in
oligopoly, a limited number of firms with conflicting interests interact such that the actions
of each can materially influence firm individual profits and values.
Box 1.6
(continued)
dilemma,” where the fate of two detainees depends on whether each

snitches or stays silent about an alleged crime.
Many companies are reluctant to talk about the specifics of how they
use game theory, or even to admit whether they use it at all. But oil giant
Chevron makes no bones about it. “Game theory is our secret strategic
weapon,” says Frank Koch, a Chevron decision analyst. Koch has publicly
discussed Chevron’s use of game theory to predict how foreign govern-
ments and competitors will react when the company embarks on interna-
tional projects. “It reveals the win-win and gives you the ability to more
easily play out where things might lead,” he says.
Enter the Matrix
Microsoft’s interest in game theory was piqued by the disclosure that IBM
was using the method to better understand the motivations of its compet-
itors—including Microsoft—when Linux, the open-source computer oper-
ating system, began to catch on. (Consultants note that companies often
bone up on game theory when they find out that competitors are already
using it.)
For its Yahoo bid, Microsoft hired Open Options, a consultancy, to
model the merger and plot a possible course for the transaction. Yahoo’s
trepidation became clear from the outset. “We knew that they would not
be particularly interested in the acquisition,” says Ken Headrick, product
and marketing director of Microsoft’s Canadian online division, MSN.
And indeed they weren’t; the bid ultimately failed and a subsequent
partial acquisition offer was abandoned in June.
Open Options wouldn’t disclose specifics of its work for Microsoft,
but in client workshops it asks attendees to answer detailed questions
about their goals for a project—for example, “Should we enter this
market?” “Will we need to eat costs to establish market share?” “Will a
price war ensue?” Then assumptions about the motives of other players,
such as competitors and government regulators, are ranked and differ-
ent scenarios developed. The goals of all players are given numerical
values and charted on a matrix. The exercise is intended to show that
there are more outcomes to a situation than most minds can compre-
hend, and to get managers thinking about competition and customers
differently.
“If you have four or five players, with four actions each might or
might not take, that could lead to a million outcomes,” comments Tom
Mitchell, CEO of Open Options. “And that’s a simple situation.” To sim-
plify complex playing fields, Open Options uses algorithms to model
what action a company should take—considering the likely actions of
others—to attain its goals. The result replicates the so-called Nash
26 Chapter 1
Box 1.6
(continued)
equilibrium, first proposed by John Forbes Nash, the Nobel Prize

winning mathematician portrayed in the movie A Beautiful Mind. In this
optimal state, the theory goes, a player no longer has an incentive to
change his position.
As a tool, game theory can be useful in many areas of finance, particu-
larly when decisions require both economic and strategic considerations.
“CFOs welcome this because it takes into account financial inputs and
blends them with nonfinancial inputs,” says Mitchell.
Rational to a Fault?
Some experts, however, question game theory’s usefulness in the real

world. They say the theory is at odds with human nature because it assumes
that all participants in a game will behave rationally. But as research in
behavioral finance and economics has shown, common psychological
biases can easily produce irrational decisions.
Similarly John Horn, a consultant at McKinsey, argues that game theory
gives people too much credit. “Game theory assumes rationally maximiz-
ing competitors who understand everything that you’re doing and what
they can do,” says Horn. “That’s not how people actually behave.” (Activist
investor Carl Icahn said Yahoo’s board “acted irrationally” in rejecting
Microsoft’s bid.) McKinsey’s latest survey on competitive behavior found
that companies tend to neglect upcoming moves by competitors, relying
passively on sources such as the news and annual reports. And when they
learn of new threats, they tend to react in the most obvious way, focusing
on near-term metrics such as earnings and market share.
Moreover finance executives have their own sets of metrics, and when
favored indicators such as net present value clash with game theory
models, choices become more complicated. “Sometimes [game theory]
tells you things you don’t like,” says Koch.
Game theory is still finding its place as a tool for companies, and its
ultimate usefulness may depend on how quickly it moves from novelty to
accepted practice. Practice in fact may be key. McKinsey takes that to heart
with its “war game” scenarios, in which a company’s top managers play
the roles of different parties in a simulation. In effect this boils game
theory down to the schoolyard lesson that perfection comes through rep-
etition. “Discipline is not a dirty word,” as basketball coach Pat Riley once
said. Game theory is one way that companies can assess their options with
more discipline.
Reprinted with permission from CFO Magazine, website www.cfo.com

© CFO Publishing LLC. Publication date: July 15, 2008.
strategies in a multiple-player setup came with The Theory of Games and

Economic Behavior by John von Neumann and Oskar Morgenstern
(1944). More critical advancements were made in the early 1950s when
John F. Nash Jr. provided a broad mathematical basis for the study of
equilibria in strategic conflict situations (Nash 1950a, b, 1951).14 More
recently game theory has been applied in many fields, including political
science, international relations, military strategy, law, sociology, psychol-
ogy, and biology. Game theory has revolutionized microeconomics and
given a strong analytical basis for studying real market structures. As firm
competitiveness involves interactions among many players (firms, sup-
pliers, buyers, etc.), it also brought appealing insights into strategic man-
agement. Box 1.7 provides an overview of the basics of game theory by
Avinash Dixit. An interview with Professor Dixit concerning the inter-
connection between real options and game theory and his pedagogical
approach is given in box 1.8.
To perform strategic analysis, one needs to reduce a complex multi-
player problem into a simpler analytical structure that captures the
essence of the conflict situation. As discussed later, conducting such an
analysis involves a clear depiction of the “rules of the game,” namely (1)
identifying the players, (2) describing their available alternative choices,
(3) specifying the information structure of the game, (4) determining the
payoff values attached to each possible strategy choice, and (5) specify-
ing the order or sequence of the play.15 From a specified game structure,
one may derive useful predictions on how rivals are likely to react (equi-
librium strategies) in a given environment.
A key question commonly arises: how should managers view these
models? Should they interpret them in a literal or in a metaphorical
sense? There is no clear-cut answer, but the metaphorical interpretation
is generally accepted as more appropriate. One of the underlying prem-
ises of standard game theory is the presumed rationality of economic
agents.16 This assumption is not always consistent with real-world
behavioral phenomena, so excessive mathematical rigor may limit the
14. Before John F. Nash’s work, the focus of game theory was mostly on zero-sum games.
Nash’s (1950b) equilibrium concept applies to a large set of problems beyond zero-sum
games. Myerson (1999) provides a comprehensive analysis of how the Nash equilibrium
concept shaped economic theory.
15. The order of play may affect both the possible actions players can select from and the
information they possess at the time they make their decisions.
16. Defining rationality and optimality in a given strategic setting is one of the core objec-
tives of game theory. This has an impact on the choice of the game-theoretic solution
concept. Nash equilibrium makes behavioral assumptions beyond common knowledge of
rationality.
28 Chapter 1
Box 1.7
Overview of game theory basics
Avinash K. Dixit,
John J. K. Sherrerd ’52 University Professor of Economics, Princeton
University
Game theory studies interactive decision-making, where the outcome for

each participant or “player” depends on the actions of all. If you are a
player in such a game, when choosing your course of action or “strategy”
you must take into account the choices of others. But in thinking about
their choices, you must recognize that they are thinking about yours, and
in turn trying to take into account your thinking about their thinking, and
so on.
It would seem that such thinking about thinking must be so complex
and subtle that its successful practice must remain an arcane art. Indeed
some aspects such as figuring out the true motives of rivals and recognizing
complex patterns do often resist logical analysis. But many aspects of
strategy can be studied and systematized into a science—game theory.
The Nash Equilibrium
The theory constructs a notion of “equilibrium” to which the complex

chain of thinking about thinking could converge. Then the strategies of all
players would be mutually consistent in the sense that each would be
choosing his or her best response to the choices of the others. For such a
theory to be useful, the equilibrium it posits should exist. Nash used novel
mathematical techniques to prove the existence of equilibrium in a very
general class of games. This paved the way for applications. Biologists have
even used the notion of Nash equilibrium to formulate the idea of evolu-
tionary stability. Here are a few examples to convey some ideas of game
theory and the breadth of its scope.
The Prisoner’s Dilemma

In Joseph Heller’s novel Catch-22, allied victory in World War II is a
forgone conclusion, and Yossarian does not want to be among the last ones
to die. His commanding officer points out, “But suppose everyone on our
side felt that way?” Yossarian replies, “Then I’d certainly be a dammed
fool to feel any other way, wouldn’t I?”
Every general reader has heard of the prisoner’s dilemma. The police
interrogate two suspects separately, and suggest to each that he or she
should fink on the other and turn state’s evidence. “If the other does not
fink, then you can cut a good deal for yourself by giving evidence against
the other: if the other finks and you hold out, the court will treat you
especially harshly. Thus no matter what the other does, it is better for you
to fink than not to fink—finking is your uniformly best or ‘dominant’
strategy.” This is the case whether the two are actually guilty, as in some
Box 1.7
(continued)
episodes of NYPD Blue, or innocent, as in the firm L.A. Confidential. Of

course, when both fink, they both fare worse than they would have if both
had held out; but that outcome, though jointly desirable for them, collapses
in the face of their separate temptations to fink.
Yossarian’s dilemma is just a multi-person version of this. His death
is not going to make any significant difference to the prospects of victory,
and he is personally better off alive than dead. So avoiding death is his
dominant strategy.
John Nash played an important role in interpreting the first experimen-
tal study of the prisoner’s dilemma, which was conducted at the Rand
Corporation in 1950.
Real-World Dilemmas
Once you recognize the general idea, you will see such dilemmas every-
where. Competing stores who undercut each other’s prices when both
would have done better if both had kept their prices high are victims of
the dilemma. (But in this instance consumers benefit from the lower prices
when sellers fink on each other.) The same concept explains why it is dif-
ficult to raise voluntary contributions, or to get people to volunteer enough
time for worthwhile public causes.
How might such dilemmas be resolved? If the relationship of the player
is repeated over a long time horizon, then the prospect of future coopera-
tion may keep them from finking; this is the well-known tit-for-tat strategy.
A “large” player who suffers disproportionately more from complete
finking may act cooperatively even when the small is finking. Thus Saudi
Arabia acts as a swing producer in OPEC, cutting its output to keep prices
high when others produce more, and the United States bears a dispropor-
tionate share of the costs of its military alliances. Finally, if the group as a
whole will do better in its external relations if it enjoys internal coopera-
tion, then the process of biological or social selection may generate
instincts or social norms that support cooperation and punish cheating.
The innate sense of fairness and justice that is observed among human
subjects in many laboratory experiments on game theory may have such
an origin.
Mixing Moves
In football, when an offense faces a third down with a yard to go, a run
up the middle is the usual or “percentage” play. But an occasional long
pass in such a situation is important to keep the defense honest. Similarly
a penalty kicker in soccer who kicks exclusively to the goalie’s right, or a
server in tennis who goes exclusively to the receiver’s forehand, will fare
poorly because the opponent will anticipate and counter the action. In
such situations it is essential to mix one’s moves randomly so that on any
one occasion the action is unpredictable.
30 Chapter 1
Box 1.7
(continued)
Mixing is most important in games where the players’ interests are

strictly opposed, and this happens most frequently in sports. Indeed recent
empirical studies of serving in tennis grand slam finals, and penalty kicks
in European soccer leagues, have found the behavior consistent with the
theory.
Commitments
Greater freedom of action seems obviously desirable. But in games of
bargaining, that need not be true because freedom to act can simply
become freedom to concede to the other’s demands. Committing yourself
to a firm final offer leaves the other party the last chance to avoid a mutu-
ally disastrous breakdown, and this can get you a better deal. But a mere
verbal declaration of firmness may not be credible. Devising actions to
make one’s commitment credible is one of the finer acts in the realm of
strategic games. Members of a labor union send their leaders into wage-
bargaining with firm instructions or mandates that tie their hands, thereby
making it credible that they will not accept a lower offer. The executive
branch of the US government engaged in international negotiations on
trade or related matters can credibly take a firm stance by pointing out
that the Congress would not ratify anything less. And a child is more likely
to get the sweet or toy it wants if it is crying too loudly to hear your rea-
soned explanations of why it should not have it.
Thomas Schelling pioneered the study of credible commitments, and
other more complex “strategic moves” like threats and promises. This has
found many applications in diplomacy and war, which, as military strategist
Karl von Clausewitz told us long ago, are two sides of the same strategic
coin.
Information and Incentives

Suppose that you have just graduated with a major in computer science
and have an idea for a totally new “killer app” that will integrate PCs, call
phones, and TV sets to create a new medium. The profit potential is
immense. You go to venture capitalists for finance to develop and market
your idea. How do they know that the potential is as high as you claim it
to be? The idea is too new for them to judge it independently. You have
no track record, and you might be a complete charlatan who will use the
money to live high for a few years and then disappear. One way for them
to test your own belief in your idea is to see how much of your own money
you are willing to risk in the project. Anyone can talk a good game; if you
are willing to put enough of your money where your mouth is, that is a
credible signal of your own true valuation of your idea.
This is a game where the players have different information; you know
the true potential of your idea much better than does your prospective
Box 1.7
(continued)
financier. In such games, actions that reveal or conceal information play

crucial roles. The field of “information economics” has clarified many
previously puzzling features of corporate governance and industrial orga-
nization, and has proved equally useful in political science, studies of
contract and tort law, and even biology. The award of the Nobel Memorial
Prize in 2001 to its pioneers, George Akerlof, Michael Spence, and Joseph
Stiglitz, testifies to its importance. What has enabled information econom-
ics to burgeon in the last twenty years is the parallel development of
concepts and techniques in game theory.
Aligning Interests, Avoiding Enrons

A related application in business economics is the design of incentive
schemes. Modern corporations are owned by numerous shareholders who
do not personally supervise the operations of the companies. How can they
make sure that the workers and managers will make the appropriate
efforts to maximize shareholder value? They can hire supervisors to watch
over workers, and managers to watch over supervisors. But all such moni-
toring is imperfect: the time on the job is easily monitored, but the quality
of effort is very difficult to observe and judge. And there remains the
problem of who will watch over the upper-level management. Hence
the importance of compensation schemes that align the interests of the
workers and managers with those of the shareholders. Game theory and
information economics have given us valuable insights into these issues.
Of course, we do not have perfect solutions; for example, we are just dis-
covering how top management can manipulate and distort the perfor-
mance measures to increase their own compensation while hurting
shareholders and workers alike. This is a game where shareholders and
the government need to find and use better counterstrategies.
From Intuition to Prediction
While reading these examples, you probably thought that many of the
lessons of game theory are obvious. If you have had some experience of
playing similar games, you have probably intuited good strategies for
them. What game theory does is to unify and systemize such intuitions.
Then the general principles extend the intuitions across many related situ-
ations, and the calculation of good strategies for new games is simplified.
It is no bad thing if an idea seems obvious when it is properly formulated
and explained; on the contrary, a science or theory that takes simple ideas
and brings out their full power and scope is all the more valuable for that.
32 Chapter 1
Box 1.8
Interview with Avinash K. Dixit
1. You have helped establish and popularize both real options and game
theory as separate disciplines. How do you see the interconnection or inter-
play among the two?
The real options concept emphasizes the value of flexibility, whereas an

irreversible commitment has value in many situations of strategic competi-
tion. Analyzing the two together enables us to understand when one
prevails over the other, or more generally, the trade-off between the two.
This is clearly an important research program.
2. In your teaching of game theory at Princeton you rely a lot on stories,

movies, literature, sports, games, and other engaging tools to motivate your
students. Can you elaborate on your view or approach?
Undergraduate students are rightly skeptical of abstract theory, and

demand evidence of its relevance before they will spend their time and
effort on studying theory. Game theory is fortunate in having so many
compelling and entertaining examples readily available. Using examples
to bring out theoretical concepts is similar to the case method used in most
business schools. But MBA students are narrowly focused on business and
moneymaking. Undergraduates have richer and more varied lives; there-
fore examples from sports, games, literature, and movies appeal to them.
3. What other current or future areas of research in economic sciences do

you find interesting?
Connections between economics and other social sciences are enriching

them all. Economists are becoming aware of aspects of human behavior
Box 1.8
(continued)
that differ from selfish rationality assumed in most traditional economic

theory; sociologists, political scientists, and even psychologists and anthro-
pologists are learning the value of economists’ conceptual framework of
choice and equilibrium and of the issues of endogeneity and identification
in empirical work. I find this confluence of the social sciences interesting
and exciting. I don’t expect complete reintegration of fields that separated
more than a century ago; the benefits of specialization remain. But I do
expect much closer communication and collaboration that will benefit
research in all these fields.
applicability of game theory in certain real-world situations. A meta-

phorical interpretation of game-theoretic models can nonetheless hold
significant value. Game theory can generally be used to deduce principles
and insights from simplified models of reality. Simpler models are gener-
ally more prescriptive. Oftentimes, when game theory is applied in more
complex situations, it results in no outcome or in multiple equilibria. In
such cases complex modeling may lose its predictive ability.17 One objec-
tive of microeconomic modeling is to simulate qualitatively the type of
environment being studied. Useful insights into an issue or behavior of
practical relevance can be then deduced.
A simple game-theoretic framework has several advantages for stra-
tegic management.18 First, it provides an audit track that enables research-
ers and practitioners to go back to basic premises. Management should
formulate the basic assumptions explicitly and consider whether they are
of practical relevance. Second, it offers a methodology that is conducive
to rigorous analysis and can help derive novel insights, which might be
counterintuitive in some cases. Such insights may hardly stem from a
“boxes-and-arrows” conceptual framework.19 Finally, it helps bring dis-
cipline by enforcing a common language that enables researchers and
managers to compare results and refine earlier models.20 In view of such
potential extensions, game theory holds out considerable promise for
17. See Grant (2005, p. 111).
18. This discussion follows Saloner (1991, pp. 120–25, 127).
19. Saloner (1991) includes Porter’s (1980) five-forces framework among these conceptual
frameworks for strategic management. A game-theoretic refinement of Porter’s (1980)
framework is offered by Brandenburg and Nalebuff (1996).
20. Some microeconomic models are quite tractable for studying new problems. Cournot
and Bertrand duopoly models discussed in chapter 3 form the basis for many industrial
organization setups which are often much more complex. For instance, the commitment
theory addressed in chapter 4 can be understood in light of these two pillar models.
34 Chapter 1
studying human interactions. This explains the success of game theory

particularly in economics and strategic management. The following three
fields have greatly benefited from game-theoretic modeling:21
• Industrial organization This field focuses on strategic interactions
arising in the external environment of the firm, addressing issues such as
competitive interactions in oligopolies, first- and second-mover
advantages, firm entry and exit decisions, strategic commitment, reputa-
tion, signaling and information asymmetries among different players in
an industry.
• Organization theory This field focuses on the firm’s internal or orga-
nizational aspects such as vertical and horizontal scope and conflicting
incentives inside an organization (e.g., optimal compensation schemes).22
• Interaction between the internal and external environment of the
firm This area addresses issues at their interface like optimal incentive
schemes in oligopolistic market structures,23 organizational design to
achieve competitive advantage, cooperation versus competition in
R&D.24
A good understanding of the competitive environment will thus enable

managers to ascertain the strategic implications of their actions in the
marketplace and determine how they should behave. A normative role
for the strategic management literature is to provide a broad qualitative
understanding of such strategic interactions and give qualitative pre-
scriptions for managerial action.25 Although game theory has witnessed
rapid developments since the 1950s, its use for practical strategic man-
agement purposes has remained limited so far.26 Nevertheless, some
managers already incorporate game-theoretic thinking into their
planning.
21. This discussion follows Saloner (1991, pp. 119–20).
22. Theories of the firm attempt to explain why firms exist and operate as they do. They
include property-rights theory, incentive-system theory, rent-seeking theory, adaptation
theory, and contract theory.
23. Ferschtman and Judd (1987), for example, argue that in case of product market com-
petition, a firm has an incentive to design incentive schemes in a way that would not be
optimal for a stand-alone organization. In their model, managers have an incentive to
maximize output in a quantity competition setting, which makes the firm better off since
the rival interprets the incentive contract as a commitment. This exemplifies the possible
use of industrial organization thinking to better the understanding of firms’ organizational
design.
24. D’Apremont and Jacquemin (1988) analyze the effect of R&D spillovers on the incen-
tive to cooperate or compete during the R&D stage and the market competition stage.
25. See Saloner (1991, pp. 107–31).
26. In politics, game theory has been used to analyze the 1962 Cuban missile crisis, Presi-
dent Reagan’s 1982 tax cut, and certain public auctions.
1.4 An Integrative Approach to Strategy
Both corporate finance and game theory provide useful insights for
strategic management. As discussed by Jean Tirole in box 1.9, the inter-
face between finance and game theory enables attaining a better
understanding on a number of firm- or market-related issues. Viewed
separately, however, these approaches have limited applicability. Inte-
grating these approaches in a consistent manner is at the core of the
option games approach. Standard real options analysis overcomes
many of the drawbacks of the NPV approach but neglects other
aspects. When management assesses its real options, it must determine
whether the benefits resulting from the exercise of its options are fully
appropriable. Kester (1984) distinguishes two categories of real options
depending on whether the benefits are proprietary or shared. If man-
agement has an exclusive exercise right, retaining all potential benefits
for itself, the investment opportunity is a proprietary option.27 When
the firm is not in a position to appropriate all of the project’s benefits
for itself but rivals share the same opportunity, it is a shared option.28
In this case, the presence of market contenders introduces strategic
externalities (positive or negative) that can significantly affect the
value and optimal exercise strategy of the firms’ real options. The value
loss resulting from strategic interactions is seen as a competitive value
erosion. Standard or naïve real options analysis typically assumes a
proprietary or monopolistic mind-set, ignoring such shared options.29
A firm here formulates its investment decisions in isolation, disregard-
ing interactive competition.
27. Rivals’ investment decisions have no material impact on project values or optimal
strategies. For instance, a monopolist protected by significant entry barriers faces such a
situation. Proprietary options are also encountered when a firm is granted an infinitely
lived patent on a product that has no close substitutes or when it has unique know-how of
a technological process.
28. Shared options include the opportunity to launch a new product that is unprotected
from the entry of close substitutes, or the opportunity to penetrate a newly deregulated
market.
29. One reason why strategic interactions among option holders are not typically consid-
ered in standard real options analysis is that early on real options were seen as an extension
of standard option-pricing theory to real investment situations. In capital markets, except
in special cases like valuation of warrants, strategic interactions among option holders
rarely affect the asset or the option values. Certain continuous-time real option models
attempt to account for market and competitive uncertainty in an exogenous manner, such
as through a higher dividend yield or a jump process. These models represent an improve-
ment over standard models developed with a monopolistic mind-set, but fall short of
adequately accounting for the endogenous nature of strategic interactions in an oligopo-
listic setting. Trigeorgis (1991) discusses continuous-time real options models involving
strategic uncertainty exogenously.
36 Chapter 1
Box 1.9
Interview with Jean Tirole
1. You have contributed greatly to extending game theory for the analysis
of economic problems. What are the merits of this mathematical discipline
for economic analysis? Which other social sciences do you believe can
benefit from the use of game theory?
Game theory aims at describing and predicting behaviors in environments

in which actors are interdependent and have potentially conflicting objec-
tives. It deepens our understanding of when the quest for specific goals
may lead to inefficiencies and of how players choose actions with an eye
on changing other actors’ incentives. As such, game theory applies to all
social sciences and beyond. The most obvious applications, besides eco-
nomics, include political sciences, sociology, law, and psychology. Psychol-
ogy might look like an outlier as it usually focuses on the individual, but
it is not. Experimental evidence confirms the old notion that we “play
games with ourselves.” These can be represented as games among succes-
sive incarnations of the self. Biologists use game theory to understand
mutualism between species, inefficient signals, or fights. Computer scien-
tists also take a keen interest in game theory. Part of the appeal of game
theory is that it accommodates diverse objective functions, which enables
us to conceptualize the behavior of different actors, from consumers to
politicians, from firms to suborganisms. Game theory more and more
integrates behavioral approaches. Mainstream game theory focuses on
optimal strategies given the strategic interdependences and the actors’
limited information and various constraints. This rational choice approach
has served social sciences well by identifying the key strategic features
of conflict situations. At the same time, limited cognition and various
Box 1.9
(continued)
behavioral biases are being increasingly incorporated into our thinking

about strategic interactions, extending the reach of game theory beyond
purely rational choice. Finally, experimental economists have been testing
our equilibrium concepts and behavioral predictions, and empiricists use
game theory to put more structure on their estimation strategies.
2. Your work on industrial organization has helped popularize this impor-

tant discipline and extend its areas of application. Do you think industrial
organization will become increasingly more useful for managerial practice
and understanding or predicting of market developments?
Yes. Game theory and its applications to industrial organization have

made their way into business books and have affected managerial practice.
For example, concepts developed in industrial organization are used in
deliberations on how to design new platforms and get all sides on board.
Game theory is taught to MBAs and strategy textbooks now incorporate
game-theoretic thinking. Game-theoretic analyses have become a lan-
guage for antitrust practitioners to conceptualize impacts of behaviors on
market outcomes. Empirical work on estimating demand and strategic
choices of price and non–price competition also make substantial use of
game-theoretic industrial organization.
3. Do you see a connection between industrial organization and corporate

finance? In what ways? Can game theory help reshape corporate finance as
it has reshaped standard microeconomics?
There is indeed a strong connection between industrial organization and

finance. I am really happy that your book “cross-breeds” options theory
and industrial organization and connects it to business, as this is an area
of very fruitful cross-fertilization. Not only do finance and industrial orga-
nization share common tools (e.g., economics of incentives, game theory),
they also interface in many areas. For example, it is hard to fully under-
stand predation or entry into industries without understanding financial
constraints and therefore corporate finance. Conversely, the industrial
organization of finance and banking is a hot topic on our research agenda.
Game theory has already made its way into various subfields of corporate
finance: takeover strategies, liquidity hoarding, expectations of refinancing
and bailouts, bank runs, issues of securities under asymmetric information,
and conglomerate strategies are just a few examples. Many areas of cor-
porate finance have benefited significantly from importing ideas coming
from game theory.
38 Chapter 1
Table 1.2
Comparison of main advantages and drawbacks of standard stand-alone approaches
Approach Advantages Drawbacks
Standard NPV Easy to use; Assumes precommitment

convincing logic; to a given plan of action,
widely used; often treating investment as
easy to communicate a one-time decision (“invest
now or never”);
ignores flexibility to adapt
to unexpected market
developments or strategic
interactions
Real options Incorporates market uncertainty Typically applied to the
and managerial flexibility; valuation of a monopolist
recognizes that investment or proprietary option;
decisions can be delayed, staged, ignores (endogenous)
or adjusted under certain future competitive interactions
contingencies
Game theory Incorporates competitive Typically disregards market
reactions endogenously; uncertainty involving
considers different player payoffs stochastic variables
Game theory has been generally applied to studying strategic interac-

tions in settings involving steady or deterministically changing states,
where players could accurately predict the evolution of the external
environment. Standard game theory falls short of explaining the firm’s
incentive to stay flexible to react to unexpected developments. Under
uncertainty this prescription of standard game theory is inadequate.30
The main advantages and drawbacks of each stand-alone approach
(standard NPV, standard real options analysis, and game theory) are
summarized in table 1.2.
Many real-world problems, however, require a simultaneous assess-
ment of both market (exogenous) as well as competitive (endogenous)
uncertainty. Stand-alone NPV, real options analysis, and game theory
alone fail in providing the necessary tool kit. The NPV paradigm deals
with static situations where firms make now-or-never decisions or pre-
commit to a certain plan of action. Real options analysis allows for
30. Different forms of uncertainty are considered in game theory. For instance, some solu-
tion concepts (e.g., Bayesian and perfect Bayesian equilibrium) are designed to address
problems involving information uncertainty. This form of uncertainty is not equivalent to
what we consider here. In stochastic environments, payoffs may be affected by exogenous
factors or shocks, whose future values are not known with certainty but follow a known
probability law. The appendix of the book provides a discussion of such stochastic
processes.
Table 1.3
Classification of decision situations and relevant theories
Decision theory Game theory

(no strategic (strategic
interaction) interaction)
Static Net present value Static industrial

(DCF) organization
Chapter 1 Chapter 3
Dynamic Deterministic Resource extraction/ Dynamic industrial
forest economics organization
Chapter 9 Chapters 4, 11, 12
Stochastic Real options analysis Option games
Chapters 5, 9, Chapter 6 onward
appendix
dynamic decision-making in situations where firms face exogenous sto-

chastic uncertainty.31 Static industrial organization (IO) has limited appli-
cability to situations involving simultaneous games where firms are
ignorant of both past and future actions and payoffs.32 Dynamic indus-
trial organization analysis permits a long-term perspective but assumes
steady state or a deterministic evolution of the market environment.33 We
here discuss an integrated approach employed to help overcome the
shortcomings of stand-alone approaches, analyzing key value drivers
concurrently. Option games are meant to capture dynamic strategic
interactions in stochastic environments. Table 1.3 positions the option
games approach within the traditional decision and game-theory para-
digms.34 We indicate in which chapters each approach is most relevant in
the book.
The importance of incorporating options analysis and game theory is
confirmed by the number of Nobel Prizes awarded in related fields. A
31. Real options analysis provides many applications for dynamic programming. The
term “dynamic programming” was originally used by Bellman (1957) to describe a recur-
sive process for solving dynamic problems. This method can be extended to stochastic
environments. Stochastic dynamic programming or stochastic control is discussed by
Harrison (1985), Dixit (1993), and Stokey (2008), with applications in economics and
finance.
32. Static industrial organization rests on static game theory with the related notion of,
for example, Nash or Bayesian Nash equilibria. See Osborne (2004) for an introduction.
33. Fudenberg and Tirole (1986) present a number of dynamic models of oligopoly. This
field rests on dynamic game theory. It involves the use of “dynamic” solution concepts such
as subgame perfect Nash, perfect Bayesian, or sequential equilibrium. A subfield is dif-
ferential games that study dynamic strategic interactions in settings where an industry state
evolves according to a differential equation. See Dockner et al. (2000) for an introduction
to differential games.
34. Option games share some aspects with stochastic timing and differential games.
40 Chapter 1
Table 1.4
Selected Nobel Prizes awarded in Economic Sciences
Year Nobel Prize winner(s) Noted contribution
2007 L. Hurwicz, E. S. Maskin, R. B. For laying the foundations of

Myerson mechanism design and contract
theory
2005 R. J. Aumann, T. C. Schelling For enhancing our understanding of
conflict and cooperation through
game theory analysis
2001 G. A. Akerlof, A. M. Spence, J. E. For analyzing markets with
Stiglitz asymmetric information
1997 R. C. Merton, M. S. Scholes For developing the option pricing
method to value derivatives
(and thereby real options)
1994 J. C. Harsanyi, J. F. Nash Jr., R. For their analysis of equilibria
Selten in the theory of noncooperative
games
1990 H. M. Markowitz, M. H. Miller, For their pioneering work in the
W. F. Sharpe theory of financial economics
1982 G. J. Stigler For his studies of industrial
structures, functioning of markets,
and causes and effects of public
regulation
1981 J. Tobin For his analysis of financial markets,
expenditure decisions, employment,
production, and prices
1978 H. A. Simon For his research into the decision-
making process within economic
organizations
1975 L. V. Kantorovich, T. C. Koopmans For their contributions to the
theory of optimum allocation of
resources
1970 P. A. Samuelson For developing dynamic economic
theory and raising the rigor of
analysis in economics
Source: Nobel Prize committee website.
selected list of Nobel Prize awards in economic sciences is shown in table

1.4. Real options analysis is a natural extension of major breakthrough
developments in financial economics to real investments. It builds on the
seminal works of Paul Samuelson, Robert C. Merton, Fischer Black, and
Myron Scholes. Concurrently the analysis of industrial organization has
been greatly facilitated by developments in game theory. Von Neumann,
Morgenstern, and Nash have made significant early contributions to
game theory. Selten, Harsanyi, Schelling, and Aumann also earned Nobel
Prizes for refinements to the theory.35 Option games, being at the inter-
section of option and game theories, benefited from the cumulative
developments in these subfields of economic sciences. Today option
games represent a powerful strategic management tool that can guide
practical managerial decisions in a competitive context, as discussed by
Ferreira, Kar, and Trigeorgis (2009). It enables a more complete quanti-
fication of market opportunities while assessing the sensitivity of strate-
gic decisions to exogenous variables (e.g., demand volatility, costs) and
competitive interactions.
1.5 Overview and Organization of the Book
The book is organized in three parts. Part I, “Strategy, Games, and

Options,” presents the three building blocks or prerequisite fields for
the option games approach. Chapter 2, “Strategic Management and
Competitive Advantage,” reviews the main strategic management par-
adigms used to analyze or explain a firm’s performance in creating
value for shareholders. We describe industry and competitive analysis
and discuss how to create sustainable competitive advantage in an
industry utilizing generic competitive strategies. Chapters 3 and 4 on
“Market Structure Games” introduce game theory principles and
industrial organization concepts providing economic foundations for
strategic management. Chapter 3, focusing on “Static Approaches,” dis-
cusses benchmark cases where firms interact in one-time situations.
Quantity and price competition are discussed in detail. Chapter 4,
focusing on “Dynamic Approaches,” supplements the previous analysis
by allowing firms to interact in the marketplace over many periods,
attempting in the long term to shape the market in their own advan-
tage or collaborating with rivals for mutual benefit. Chapter 5 on
“Uncertainty, Flexibility, and Real Options” discusses the strategy-
formulation challenges facing the firm when the underlying market is
uncertain. Motivated by various sources of uncertainty electricity utili-
ties face today, we discuss how real options analysis can be used to
analyze such situations, value strategic options, and optimally chose
among them. We also briefly discuss discrete-time and continuous-time
tools for the pricing of embedded real options. We ignore here the fact
35. Akerlof, Spence, Stiglitz, Hurwicz, Maskin, and Myerson won the Nobel Prize for
insightful applications of game theory for the understanding of incentives in social groups
(e.g., industrial organization, contract theory).
42 Chapter 1
that many firms may face counteracting business opportunities affected

by rival behavior.
Part II, “Option Games: Discrete-Time Analysis,” fleshes out in more
detail in discrete time the integration of real options with game theory
and industrial organization and explains how to capture the flexibility
and strategic-interaction aspects of real investment situations. Chapter 6
presents core issues in option games analysis, namely optimal investment
timing under uncertainty and competition and the trade-off between
commitment and flexibility. We provide a number of examples to illus-
trate the discrete-time option games approach. Chapter 7, “Option to
Invest,” rigorously sets the premise for analyzing option games in dis-
crete time, building upon models developed in chapter 3. Chapter 8,
“Innovation Investment in Two-Stage Games,” discusses at length the
trade-off between commitment and flexibility in sequential investment
settings. The focus, here, is on two-stage competition models where real
options analysis tools are combined with industry organization insights.
The two-stage analysis provides guidance into how and when strategic
investments enhance value creation or are detrimental to the firm. We
examine appropriate investment strategy applications in different set-
tings, such as R&D and advertising.
Part III, entitled “Option Games: Continuous-Time Models,” extends
the analysis of option games by use of continuous-time modeling tech-
niques. Chapter 9, “Investment and Expansion Option: Monopoly,”
introduces the methodology employed throughout part III and sets the
benchmark case of a monopolist firm. Two categories of options are
discussed, the option to invest in a new market and the option to expand
an existing market. Chapter 10, “Oligopoly: Simultaneous Investment,”
extends the analysis to simultaneous investment oligopoly markets.
Chapter 11, “Leadership and Early-Mover Advantage,” discusses the
appeal of having a competitive advantage to turn the investment-timing
game into one’s own advantage. Chapter 12, “Preemption versus Coop-
eration in a Duopoly,” deals with preemptive investments and the pos-
sibility of tacit collusion among firms, delaying investment until a later
date. Chapter 13, “Extensions and Other Applications,” provides a short
overview of important contributions on various subjects and other appli-
cations discussed in the literature. The appendix that follows discusses
the basics of stochastic processes and provides a compendium of tools
in stochastic calculus and control for the more analytically minded
reader. To smooth out the exposition in the text, part III occasionally
refers to this appendix when a derivation is more involved.
Conclusion
In this introductory chapter we discussed key changes firms have faced

over the past decades. We discussed the development and changes in a
challenging business environment and the evolution of strategy, and
examined to which extent the two pillar approaches underlying this
book, namely game theory and real options analysis, can be rigorous and
relevant for analyzing and understanding business strategies. We con-
cluded with the need to combine both into an integrative option games
approach.
Selected References
Grant (2005) discusses the role of strategy in corporate performance,

stressing the need for sound strategy formulation based on consistent
principles. Myers (1984) discusses the gap between financial theory and
its practical implementation in corporate strategy, highlighting the dif-
ferential insights corporate finance can add to strategy. Saloner (1991)
and Rasmussen (2005) discuss the usefulness of game theory for strategic
management, emphasizing its prescriptive value in competitive settings
involving strategic interactions.
Grant, Robert M. 2005. Contemporary Strategy Analysis, 5th ed.

Malden, MA: Blackwell.
Myers, Stewart C. 1984. Finance theory and financial strategy. Interfaces
14 (1): 126–37.
Rasmussen, Eric. 2005. Games and Information: An Introduction to Game
Theory. Oxford: Blackwell.
Saloner, Garth. 1991. Modeling, game theory, and strategic management.
Strategic Management Journal 12 (Winter): 119–36.
I STRATEGY, GAMES, AND OPTIONS
2 Strategic Management and Competitive Advantage
Managing an enterprise in an uncertain competitive environment is not

an easy task. Strategic management attempts to explain why some firms
are more successful than others in the marketplace. At the core of strat-
egy is a dilemma between flexibility and commitment. Flexibility to adapt
strategy and operations is clearly valuable when the environment changes
unexpectedly. An early investment commitment may yet have strategic
value because it can influence the behavior of rivals in equilibrium,
potentially creating a future competitive advantage for the firm. The
flexibility perspective partly draws on the resource-based view of the
firm and core-competence arguments: a firm should invest in resources
and competencies that give it a distinctive ability to pursue a set of
market opportunities. During the 1990s this view became a dominant
paradigm in strategic management. It has also helped spark further
developments in what is referred to as the “knowledge-based” view of
the firm. The commitment view has been firmly anchored in industrial
organization.
In recent years competitive advantage has become rather temporary
because industries and competition within industries change continually.
Firms make tremendous efforts to sustain competitive advantage and
protect their future growth options from duplication efforts by rivals.
Whether competitive advantage can be sustained in the long term partly
depends on mechanisms put in place by the firm to renew and protect
its resource position and capabilities. In section 2.1 we provide an over-
view of some of the prevailing strategic management concepts and theo-
ries. We discuss in section 2.2 several approaches used in practice that
help provide a deeper understanding of a given industry. We then
examine, in section 2.3, the sources of competitive advantage and their
sustainability as an industry evolves.
48 Chapter 2
2.1 Strategic Management Paradigms
Various paradigms in strategic management approach the underlying

sources of firm value creation from distinct viewpoints. Categorized in
figure 2.1 are the main strategic management approaches. Many of these
managerial perspectives trace their roots to primary economic disci-
plines (microeconomics, organization theory, finance). Behind many of
them lies the notion that competitive advantage is a function of the firm’s
position, resources, and capabilities compared to those of its rivals, the
opportunities these resources and capabilities create in a dynamic envi-
ronment, and the firms’ adaptive capability to respond to market changes.
It is commonplace to distinguish between approaches with an external
perspective from those with an internal firm view. The former consider
competitive advantage and value creation through the eyes of an exter-
nal observer, focusing on external forces, opportunities, and threats in
the external environment. The latter focus on internal forces within the
firm, viewing value creation from in-house combinations of expertise,
resources, and capabilities. These perspectives consider competitive
advantage as dependent on unique, firm-specific resources and capabili-
ties that enable the firm to create and exploit advantaged opportunities.
Real options and option games lie at their intersection and can bring
together these complementary perspectives. Real options are created by
internal adaptive capabilities developed over time but may be affected
by the actions of external parties.
2.1.1 External View of the Firm
Outside forces, such as firm’s rivals, suppliers, and customers, continually

shape the external environment. External approaches view the sources
of value creation as lying in market imperfections, synergies, or econo-
mies of scale. The industry and competitive analysis framework popular-
ized by Michael Porter (1980) views strategy in terms of industry structure,
entry deterrence, and strategic positioning. Key competitive variables
include entry and exit barriers, as well as product differentiation and
availability of information. Porter proposes to look at rivalry situations
among suppliers of a product and analyze the impact of additional forces,
such as the threat from substitute products and technology disruption,
new market entry, and the bargaining power of suppliers and buyers. He
emphasizes actions the firm should take to protect itself from these
market forces and threats. Another external approach is that of strategic
Broad Microeconomic Organization Financial
field theory theory economics
Structure Game theory/

Economic Agency Property Transaction
conduct industrial Option pricing
theory theory rights costs
performance organization
Strategic Industry and Dynamic

Strategic Resource- capabilities/
management competitive Real options
conflict based view core
analysis competencies
Option games
Strategic Management and Competitive Advantage
Schelling (1960)
Rumelt (1984) Prahalad and
Representative Shapiro (1989) Dixit and Pindyck
Wernerfelt (1984) Hamel (1990)
Porter (1980) Ghemawat (1991) (1994)
authors Collins and Teece, Pisano, and
Dixit and Nalebuff Trigeorgis (1996) Grenadier (2000)
Montgomery (1995) Shuen (1997)
(1991) Huisman (2001)
Smit and Trigeorgis
(2004)
External view of the firm Internal view of the firm
Figure 2.1
Strategic management frameworks
49
Rows 2 and 3 are related: economic theory (row 2) supports notions developed in strategic management (row 3) via formal models.
50 Chapter 2
conflict (e.g., Shapiro 1989), which focuses on conflict behavior and views
value creation as the result of strategic moves in a competitive environ-
ment. Game theory ideas are used to help management understand
better the strategic interactions among rivals, predict rivals’ reactions,
and determine the optimal competitive strategy.
2.1.2 Internal View of the Firm
The internal view of the firm traces its roots to The Theory of the Growth
of the Firm by Edith Penrose (1959). This approach became known sub-
sequently as the resource-based view of the firm in articles by Wernerfelt
(1984), Rumelt (1984), Teece (1984), and others.1 Its distinguishing char-
acteristic is that competitive advantage arises from within the firm. A
firm becomes profitable not so much because it undertakes strategic
investments that may deter entry or raise prices above long-run cost, but
rather because it manages to achieve significantly lower costs or obtain
markedly higher quality or product performance through internal mech-
anisms. Excess economic profits stem from imperfect markets for firm-
specific intangible assets like distinctive competences, know-how, and
capabilities. A more recent variant rests on corporate capabilities to
adapt in environments of rapid technological change. The theory of
“dynamic capabilities” proposed by Teece, Pisano, and Shuen (1997)
views capabilities to adapt in a changing environment as resting on dis-
tinctive processes, shaped by the firm’s asset position and the evolution-
ary path it has adopted or inherited. Box 2.1 discusses the concept and
process of strategy and their evolution in a changing and rapidly trans-
formed competitive landscape.
2.2 Industry and Competitive Analysis
A key objective of strategic management is to help decision makers

understand what leads to a firm’s success. Strategic management pro-
vides both explanation and direction. A useful strategy framework
should address the following types of questions: Why are some firms
more successful than others? Are there different paths to success? Can
some firms be successful by adopting product innovation, and others by
enhancing operational efficiency via process innovation?
1. According to Wernerfelt (1984), the resource-based view aims to understand the rela-
tionship between profitability and the different ways of managing resources over time.
Resources are “those tangible and intangible assets which are tied semi-permanently to
the firm” (p. 172).
Strategic Management and Competitive Advantage 51
Box 2.1
Strategy in a changing competitive environment
Changes in the Competitive Battlefield

C. K. Prahalad, Financial Times
Many of the concepts used in strategy were developed during the late
1970s and 1980s when underlying competitive conditions evolved within
a well-understood model . . .. While the canvas available to today’s strate-
gists is large and new, companies will need to understand global forces,
react quickly, and innovate when defining their business models . . .. It is
hardly surprising that the conceptual models and administrative processes
used by managers often outlast their usefulness. It takes researchers time,
after all, to identify new problems and emerging solutions before they can
produce theories about them. Then there is the time lag between the
development of these theories and their conversion into common business
practice.
Where management concepts are concerned, this time lag—often a
decade—brings with it an interesting conundrum. In an era of rapid and
disruptive change in the economic, political, social, regulatory, and tech-
nological environment do managers have to discard established and tested
analytical tools equally as fast? How can they identify the ongoing rele-
vance of concepts and tools in a changing environment?
The Heritage of Strategy Concepts

The most prevalent and widely used tools of strategy analysis are: strength
weakness, opportunities, and threats (SWOT) analysis, industry structure
analysis (five forces), value chain analysis, generic strategies, strategic
group analysis, barriers to entry, and others of the genre . . .. The concepts
and tools—many of them the staples of economists—were adopted and
simplified for the use of managers. The formalization of these concepts
was instrumental in pushing strategy development from the realm of “the
intuitive genius of the founder or a top manager” to that of logical process.
However, most of these concepts were developed during the late 1970s
and the decade of the 1980s. During this period, underlying competitive
conditions evolved but within a well-understood paradigm. A major com-
petitive disruption during this period, certainly for US and European
companies, was the spectacular success of Japanese manufacturing in
industries as diverse as steel, consumer electronics, autos, and semiconduc-
tors. The sources of competitive advantage, during this decade, accrued to
those who could wrest major efficiencies in operations through focus on
quality, cycle time, reengineering, and team work. Operational efficiencies,
within a relatively stable industry structure paradigm, became the focus.
In fact this focus on wresting competitive advantage through operational
efficiencies led some managers to believe that strategy was unimportant
and management was all about implementation.
52 Chapter 2
Box 2.1
(continued)
The Emerging Competitive Landscape

The decade of the 1990s has witnessed significant and discontinuous
change in the competitive environment and an accelerating global trend
to deregulate and privatize. Large and key industries like telecoms, power,
water, health care, and financial services are being deregulated. Countries
as diverse as India, Russia, Brazil, and China are at various stages of
privatizing their public sectors. Technological convergence—such as that
between chemical and electronic companies; computing, communications,
components, and consumer electronics; food and pharmaceuticals; and
cosmetics and pharmaceuticals—is disrupting traditional industry struc-
tures . . .. Ecological sensitivities and the emergence of nongovernmental
organizations such as the green movement are also new dimensions of the
competitive landscape. Are these discontinuities changing the very nature
of the industry structure—the relationships between consumers, competi-
tors, collaborators, and investors? Are they challenging the established
competitive positions of incumbents and allowing new types of competi-
tors and new bases for competition to emerge?
We can identify a long list of discontinuities and examples to illustrate
each one of them . . .. We need to acknowledge the signals (weak as they
may be) of the emergence of a new competitive landscape where the rules
of engagement may not be the same as they were during the decade of
the 1980s. Strategists have to make the transition from asking the question:
How do I position my company and gain advantage in a known game (a
known industry structure)? Increasingly the relevant question is: How do
I divine the contours of an evolving and changing industry structure and
therefore the rules of engagement in a new and evolving game? Industries
represent such a diversity of new, emerging, and evolving games. The rules
of engagement are written as companies and managers experiment and
adjust their approaches to competition.
Strategy in a Discontinuous Competitive Landscape

Strategists must start with a new mind-set. Traditional strategic planning
processes emphasized resource allocation—which plants, what locations,
what products, and sometimes what businesses—within an implicit busi-
ness model. Disruptive changes challenge the business models.
Four transformations will influence the business models and the work
of strategists in the decades ahead:
• The strategic space available to companies will expand
Consider, for example, the highly regulated power industry. All utilities
once looked alike and their scope of operations was constrained by public
utility commissions and government regulators. Because of deregulation,
utilities can now determine their own strategic space. Today utilities have
Box 2.1
(continued)
a choice regarding the level of vertical integration: Do I need to be in

power generation? Do I need to be in power transmission? Companies
can unbundle assets and can also segment their businesses: Should we
focus more on industrial or domestic consumers? They can decide their
geographical scope: Should I become global, regional, national, or just
remain local? And finally, they can change their business portfolio: Should
I invest in water, telecoms, gas lines, services?
The forces of change—deregulation, the emergence of large developing
countries such as India, China, and Brazil as major business opportuni-
ties—provide a new playing field. Simultaneously forces of digitalization,
the emergence of the Internet, and the convergence of technologies
provide untold new opportunities for strategists. The canvas available to
the strategist is large and new. One can paint the picture one wants.
• Business will be global
Increasingly the distinction between local and global business will be nar-
rowed. All businesses will have to be locally responsive and all businesses
will be subject to the influences and standards of global players. Consider,
for example, McDonald’s and Coca-Cola—held up as examples of truly
global players unconstrained by local customers and national differences.
In India, McDonald’s had to change its recipe to serve lamb (instead of
beef) and vegetarian patties (a radical departure from its normal western
fare). Coke had to recognize the power of “Thums Up,” a local cola
(which Coke purchased) and promote that product. The need for local
responsiveness, especially when global companies want to penetrate
markets with different levels of consumer purchasing power, is very clear.
On the other hand, Nirula’s, a local fast-food chain in India, was, in its
own restaurants, forced to respond to the cleanliness and ambience of
McDonald’s. This is a case of global standards being imposed on a local
player.
Global and local distinctions will remain in products and services. Glo-
balization may have as much to do with standards—quality, service levels,
safety, environmental concerns, protection of intellectual property, and
talent management. Needless to say, globalization will force strategists to
come to terms with multiple geographical locations, new standards, capac-
ity for adaptation to local needs, multiple cultures, and collaboration
across national and regional boundaries in everything from manufactur-
ing, product development, global account management, and logistics.
• Speed will be a critical element
Given the nature of competitive changes, speed of reaction will be a critical
element of strategy. At a minimum it will challenge the yearly planning
cycle. For example, consider the traditional strategic planning process in a
54 Chapter 2
Box 2.1
(continued)
large company. The process of strategy discussion and commitments typi-

cally starts in October. It identifies the strategic issues for the next calendar
year and three to four years hence. What is the use of such a process in an
Internet-based start up? Speed of reaction, not tied to a rigid corporate
calendar is of the essence. Strategy must be a topic of discussion and
debate all the time not just during the planning sessions—strategy making
and thinking cannot be a “corporate rain dance” during October!
Speed is also an element in how fast a company learns new technologies
and integrates them with the old. As all traditional companies are con-
fronted with disruptive changes, the capacity to learn and act fast is
increasingly a major source of competitive advantage.
• Innovation is the new source of competitive advantage
Innovation was always a source of competitive advantage. However, the
concept of innovation was tied to product and process innovations. In
many large companies, the innovation process is still called the “product
creation process.” Reducing cycle time, increasing modularity, tracking
sales from new products introduced during the last two years as a percent-
age of total sales, and global product launches were the hallmarks of an
innovative company. Increasingly the focus of innovation has to shift
toward innovation in business models. For example, how does an auction-
based pricing market (e.g., airlines, hotels) in an industry with excess
capacity change the business model? How do you think about resources
available to the company for product development when customers
become co-developers of the product or service? Should we have an
expanded notion of resource availability? What impact does mass custom-
ization or, more importantly, personalization of products and services have
on the total logistics chain? Business innovations are crucial in a competi-
tive landscape subject to disruptive changes.
Strategy in the Next Millennium

Given the dramatic changes taking place in the competitive landscape, I
believe that both the concept of strategy and the process of strategy
making will change. Older approaches will not suffice. Managers will have
to start with two clear premises. First, they can influence the competitive
environment. Strategy is not about positioning the company in a given
industry space but increasingly one of influencing, shaping and creating it.
What managers do matters in how industries evolve. This is not just about
the reactions of large, well-endowed companies. Smaller companies can
also have an impact on industry evolution . . .. Second, it is not possible to
influence the evolving industry environment if one does not start with a
point of view about how the world can be, not how to improve what is
available but how radically to alter it. Imagining a new competitive space
Box 2.1
(continued)
and acting to influence the migration toward that future is critical. Strategy
is therefore not an extrapolation of the current situation but an exercise
in “imagining and then folding the future in.” This process needs a differ-
ent starting point. This is about providing a strategic direction—a point of
view—and identifying, at best, the major milestones on the way. There is
no attempt to be precise on product plans, or budgets. Knowing the broad
contours of the future is not as difficult as people normally assume. For
example, we know with great uncertainty the demographic composition of
every country. We can recognize the trends—the desire for mobility, access
to information, the spread of the web, and the increasing dependence of
all countries on global trade. The problem is not information about the
future but insights about how these trends will transform industries and
what new opportunities will emerge.
While a broad strategic direction (or strategic intent and strategic archi-
tecture) is critical to the process, it is equally important to recognize that
dramatic changes in the environment suggest managers must act and be
tactical about navigating their way around new obstacles and unforeseen
circumstances. Tactical changes are difficult if there is no overarching point
of view. The need constantly to adjust resource configuration as competi-
tive conditions change is becoming recognized. A critical part of being
strategic is the ability quickly to adjust and adapt within a given strategic
direction. This may be described as “inventing new games within a
sandbox,” the sandbox being the broad strategic direction.
The most dramatic change in the process of strategy making is the
breakdown in the traditional strategy hierarchy—top managers develop
strategy and middle managers implement it. By its very nature discontinu-
ous change in the competitive environment is creating a whole new
dynamic. People who are close to the new technologies, competitors, and
customers appear as managers in the middle. They have the information,
urgency, and motivation to act. They are also the ones who have direct
control over people and physical resources. Top managers, in an era of
discontinuous change, are rather removed from the new and emerging
competitive reality. . . . Middle managers must take more responsibility for
developing a strategic direction and, more important, in making decentral-
ized decisions consistent with the broad direction of the company. The
involvement of middle managers is a critical element of the strategy
process.
Finally, creating the future is a task that involves more than the tradi-
tional stand-alone company. Managers have to make alliances and collabo-
rate with suppliers, partners, and often competitors to develop new
standards, infrastructure, or new operating systems. Alliances and net-
works are an integral part of the total process. This requirement is so well
understood that it is hardly worth elaborating here. Resources available
56 Chapter 2
Box 2.1
(continued)
to the company are dramatically enhanced through alliances and

networks.
The New View of Strategy

The emerging view of strategy contrasts dramatically with the traditional
view . . .. The shift in emphasis in the concept of strategy and the process
of strategy making is dramatic. It is clear the disruptive forces that have
wrought this change are accelerating. It is time for managers to abandon
the comfort of the traditional, and tried and tested, tools and concepts and
embrace the new. Disruptive competitive changes will challenge the status
quo. Those who take up the challenge and proactively change will create
the future. The markets will decide the drivers, passengers, and the rate of
“roadkill” soon enough.
Reprinted from Financial Times. Publication date: October 4, 1999.
Industry and market

attractiveness
Firm
Revenue position profitability
compared to rivals
Firm’s relative
competitive positioning
in the industry
Cost position
compared to rivals
Figure 2.2
Drivers of firm profitability
From Besanko et al. (2004, p. 360)
Figure 2.2 summarizes the drivers of firm profitability according to

Besanko et al. (2004). The first driver determines whether a firm operates
in an attractive market or industry, as can be ascertained via detailed
industry analysis. Profitability does not only vary across industries but
also across firms within a given industry, requiring a closer look at the
revenue or cost position of the firm relative to its competitors.
Analyzing the firm’s environment involves taking a close look at a
range of factors, some of which may be beyond the firm’s control (e.g.,
macroeconomic factors) as well as at industry-specific factors. We
examine below how to analyze the macroeconomic environment and
subsequently examine industry-specific factors.
2.2.1 Macroeconomic Analysis
The firm’s macroeconomic environment can have a critical impact on

industry attractiveness. One way suggested to analyze the external envi-
ronment is the PEST framework (standing for politics, economics, social
culture, and technology).
• Politics (e.g., environmental legislation, antitrust rulings, tax policies,
employment laws, trade restrictions, tariffs) may influence the profitabil-
ity and viability of the overall industry, as well as specific firms within it.
For multinational corporations (MNCs), assessing the impact of such
political factors can be involved as MNCs have to constantly monitor
governmental stability, monitor import and export regulations, and be
abreast of local business legislations.
• Economics can have a serious impact on the profitability of an industry
or firm. The unemployment level, the relative value of the domestic
versus foreign currencies, inflation, growth, and productivity can influ-
ence the health of the economy, by way of consumer demand or confi-
dence. These economic factors determine the growth potential. A poor
economic situation, such as the recent financial crisis, may lead to reduced
spending by consumers. A firm must carefully monitor these factors and
devise appropriate strategies to ride out an unfavorable economic envi-
ronment or take advantage of opportunities arising from an expanding
economy. Multinationality, in particular, enables a firm to shift operations
among several countries, taking advantage of opportunities or reducing
risks as relative labor costs, exchange rates, tax policies, and the like,
change.
• Social-cultural factors, such as the proportion of women in the
workforce, health and fitness trends, or the growth in discretionary
spending by the young, can also have a significant impact. A firm should
monitor these trends to ensure that its products and services meet chang-
ing consumer needs. Moreover, as the firm expands into new markets or
countries, differences in purchasing behavior due to social and cultural
idiosyncrasies must be taken into account.
• Technological changes have been unprecedented in recent decades
in terms of incremental improvements and technological disruptions.
Today one can travel faster, communicate instantly globally, and
produce in more efficient ways than ever before. New industries have
emerged (e.g., cellular phones and dot-coms), while others have entirely
disappeared (e.g., typewriters or argentic photo cameras). Businesses
58 Chapter 2
that thrived in the past have often taken advantage of emerging

technologies in other industries to serve their customers better or
cheaper.
2.2.2 Industry Analysis: Structure–Conduct–Performance Paradigm
A thorough industry and microeconomic analysis must complement the

analysis of the macroeconomic environment. Two countries with similar
macroeconomic environments may be quite different with respect to
their microeconomic profiles. For example, France and Germany are
roughly similar in terms of macroeconomic features, but many industries
are organized quite differently in the two countries (e.g., the banking
system or the waste management industry). Microeconomic analysis
enables a better understanding of the overall attractiveness of a particu-
lar market and the achievable profitability of the typical firm within that
industry.
A well-known industry analysis framework is the “structure–conduct–
performance” (SCP) paradigm.2 At its core this paradigm assumes a
causal link from market structure to firm conduct and performance:
market structure determines firm conduct, which in turn determines
industry and firm performance. This also works in the reverse direction,
since firms may pursue strategies that can alter the market structure
(e.g., M&A activities). Government intervention and basic demand
and supply conditions may also influence the components discussed
above.
Market Structure
In perfect competition, many firms (facing no entry or exit barriers)
populate the market. Moreover clients have a perfect flow of informa-
tion. Firms offer homogeneous products and behave as price takers. In
the long run a competitive industry will supply a good at a price that
reflects the marginal cost of the resources required to manufacture that
product. On the other extreme, in an industry characterized by a monop-
oly structure, there are high entry and exit barriers (e.g., large fixed
costs), and the customer base is relatively large and homogeneous. A
monopolist can earn excess profits stemming from market power as
reflected in its ability to set a price higher than the marginal cost of
production. Market structure, as proxied by the number and market
power of firms in the industry, is an important driver of industry
2. The SCP paradigm was developed by the “Harvard School,” including Joe Bain and
Edward Mason, based on empirical observations.
profitability. The fewer the number of producers in the market, the

greater their ability to wield market power and earn excess profits. The
structure and bargaining power of suppliers and customers may also
influence whether a firm exercises market power. This “extended rivalry”
can put significant pressure on the firm.
Firm Conduct in the Industry

Conduct refers to whether a firm actually exercises its market power to
earn excess profits, whereas market structure refers to whether market
power is structurally possible in the industry. In addition to individual
exercise of market power, firms may collude (explicitly or tacitly) in an
oligopolistic industry to sustain a higher price and earn excess profits.3
The ability to exercise market power is influenced by strategic invest-
ments, such as engaging in advertisement campaigns or investing heavily
in research and development, preventing potential rivals from market
entry.
Industry Performance
The performance of an industry is based on its profitability as well as its
static and dynamic efficiency. Excess profits earned by incumbent firms
imply that the given industry is not perfectly competitive as some firms
wield market power. A secure incumbent may have little incentive to
improve its production processes.4 Although a consolidated industry can
attain higher static efficiency resulting from larger production scale, the
technology employed may not be the most efficient, with firms investing
less in R&D compared to a highly competitive industry. In this sense
there may be a “cost” to society from consolidated industries since they
tend to be less dynamically efficient than a highly competitive industry.
This issue has raised a big debate among economists with no clear con-
sensus emerging on whether monopoly and the existence of patents is
beneficial or harmful in terms of encouraging innovation.5
2.2.3 Porter’s Industry and Competitive (Five-Forces) Analysis
The industry analysis above provides a benchmark for the profitability

of the “average” firm in an industry. A complementary approach to
the industry analysis above is Michael Porter’s (1980) “five-forces”
3. Usually a cartel attempts to set a price equal to what a monopolist would charge as
cartel members are attempting to maximize joint profits. The stability of a cartel is another
matter.
4. A widely known remark on monopolistic industries is that of Hicks (1935, p. 8): “the
best of all monopoly profits is a quiet life.”
5. See Tirole (1988, ch. 10) for a comprehensive economic analysis of the incentives to
conduct R&D in oligopolistic industry structures.
60 Chapter 2
Potential
entrants
Threat of new entrants
Competitors
Bargaining power Bargaining power
of suppliers of customers
Suppliers Customers
Rivalry among
existing firms
Threat of substitute
products or services
Substitutes
Figure 2.3
Porter’s “five-forces” industry and competitive analysis
From Porter (1980)
framework. Since the early 1980s, it has become a well-known paradigm

used both in academe and in practice for analyzing industry perfor-
mance. According to Porter (1980), the attractiveness of an industry
depends on two kinds of strategic interactions:
Interactions along the “value chain” These relationships, depicted

along the horizontal axis in figure 2.3, involve the relative bargaining
power of different parties along the value chain, from suppliers to manu-
facturers and distributors, to end customers.
Extended rivalry This includes the internal rivalry within a particular
industry (nature and degree of intra-industry competition) as well as
the threat posed to the firm from external forces, such as potential
entrants and the threat of substitute products or services. These
“extended-rivalry” interactions are illustrated along the vertical axis in
the figure.
Porter categorizes the relevant economic factors into five groups or

forces (hence, the “five-forces” analysis). He proposes a thorough
assessment of (1) the impact of these factors on the intensity of competi-
tion within the industry or internal rivalry, (2) the threat of substitute
products or services, (3) the threat of new firms entering the market, (4)
the bargaining power of suppliers, and (5) customers. These forces are in
turn affected by industry structure and other relevant variables, like
entry and exit barriers, product differentiation and availability of infor-
mation.6 We look at these forces in detail next.
Internal Rivalry
Internal rivalry is a central piece of Porter’s analysis. It refers to competi-
tive actions taken by each firm to gain market share within the industry.
A means to assess the intensity of competition within an industry is to
use a concentration ratio. Industrial economists and antitrust authorities
have long attempted to find a quantitative measure of the intensity of
rivalry using various concentration ratios. A common feature is that they
are based on the market shares of the firms already active in the indus-
try.7 Two concentration indexes are most commonly used to measure
internal rivalry within an industry: (1) the cumulative market share of
the k biggest firms, Ck, and (2) the Herfindhal–Hirschman index, devel-
oped by Herfindhal (1950) and Hirschman (1945, 1964), commonly
referred to as HHI.8
Cumulative Market Share of the k Biggest Firms (Ck )

Let si denote the market share of firm i in an industry consisting of n
active (incumbent) firms. A simple proxy of the concentration in a indus-
try with n active firms is the cumulative market share of the k biggest
firms (k ≤ n), that is,
k
Ck ≡ ∑ si . (2.1)
i =1
The market shares of the few “big” players are generally available in
market reports. This concentration ratio has a major drawback: it fails to
capture heterogeneity among the largest firms. For this reason industrial
economists and antitrust authorities generally prefer alternative concen-
tration measures, such as the Herfindhal–Hirschman index. This is dis-
cussed in example 2.1 below.
6. Although conceptually very useful, Porter’s (1980) framework does not give a clear
prescription as to whether to invest in a given industry. Its primary benefit is that it helps
frame an industry and identify key forces affecting market attractiveness.
7. These concentration ratios fail to capture whether external parties can easily enter these
markets.
8. Tirole (1988) provides an alternative to these concentration indexes, namely the entropy
index that involves a logarithmic function of the market shares. Encoua and Jacquemin
(1980) describe desirable properties a concentration index should satisfy and assert that
the HHI and entropy indexes are better suited to analyze industry concentration. Here we
only discuss the Ck and HHI indexes due to their relative simplicity.
62 Chapter 2
Herfindhal–Hirschman Index (HHI)

The HHI index has the merit of combining information about all firms
in the market, not just the five (or k ) biggest firms. The Herfindhal–
Hirschman index is given by
n
HHI ≡ ∑ si ². (2.2)
i =1
From a practical viewpoint, it is more difficult to gather information

(market shares) on all firms operating in a given industry.
Example 2.1 Concentration Indexes

Consider the market share distribution of five firms in the three different
industry situations described in table 2.1. The last two columns give the
values of C 4 and HHI in each case. The industry in case 3 is clearly more
concentrated than in case 2, which in turn is more concentrated than
in case 1, as the market shares are less uniformly distributed. Using
the C4 index, one cannot distinguish the difference in concentration
within the industry in case 3 or 2, as the index is equal to 88 percent in
both cases.
The C4 index does not capture the fact that in case 3 a single firm is
dominant with a 50 percent market share, compared to case 2 where the
three biggest firms have comparable power. The HHI does a better job
since it properly captures this difference, giving a higher value in case 3
relative to case 2.
As summarized in figure 2.4, concentration indexes are used by econo-

mists and antitrust authorities to identify and differentiate among differ-
ent market structures. A monopoly is generally characterized by only one
seller and very high barriers to entry and exit. An example, from the
diamond business, is DeBeers, which has exclusive access to scarce
Table 2.1
Concentration indexes based on the first three (C3 ), four (C4 ), or all firms in an industry
Concentration
Case Market share distribution index
s1 s2 s3 s4 s5 C4 HHI
1 /5
1
/5
1 1
/5 1
/5 1
/5 80% 2,000
2 ¼ ¼ ¼ ⅛ ⅛ 88% 2,188
3 ½ ⅛ ⅛ ⅛ ⅛ 88% 3,125
Note: By convention, the HHI is often given as 10,000 times the HHI number given by the
definition in equation (2.2).
Perfect Monopolistic Dominant

Oligopoly Monopoly
competition competition firm
Ck(%) 0 0 < C4 < 40 40 ≤ C4 < 60 60 ≤ C1 < 90 C1 ≥ 90
HHI HHI < 1,000 1,000 ≤ HHI < 1,800 HHI ≥ 1,800
Figure 2.4
Classification of market structures based on different concentration index ranges
resources giving it a (quasi-) monopoly position due to high barriers to

market entry. A monopoly is characterized by C1 ≥ 90 percent. In an
industry with a dominant firm and some fringe competitors, the dominant
firm can typically ignore strategic interactions with the smaller rivals.
Barriers to entry and exit are fairly high. Apple and its iPod® have a
dominant position in the portable music industry: despite smaller com-
petitors, Apple has built an uncontestable entry barrier thanks to its
unique brand name. Firm dominance is characterized by 60% ≤ C1 < 90%
(and HHI ≥ 1, 800). An oligopoly is characterized by few competing
firms with 40% ≤ C 4 < 60%. A classic case is the duopoly involving Airbus
and Boeing in the airframe industry. Barriers to entry due to technologi-
cal expertise or huge sunk capital costs are generally very high. National
quality standards may also raise entry barriers for foreign competitors
and explain oligopoly situations.9 Monopolistic/differentiated competition
is characterized by many suppliers with heterogeneous products appeal-
ing to different customer or market segments. A good example is the
luxury goods industry where distinct brands lure different customer
groups (youth, fashion followers, etc.). Product differentiation makes it
possible for firms to price products above the marginal cost even if many
firms compete in the marketplace.10 Differentiated competition is char-
acterized by 0 ≤ C4 < 40 percent. Perfect competition involves a homoge-
neous product (commodity) with no single firm having significant market
power to influence the price-setting process. The agricultural sector, for
example corn production, is considered a good approximation to a per-
fectly competitive industry. Typically HHI is below 1, 000.
9. A case in point is the French pipeline and valve industry. In France, valves for public
water management pipes turn counterclockwise, whereas in most other European countries
valves turn clockwise. For this reason only manufacturers that meet French standards are
active in France, mostly French companies.
10. In monopolistic competition free entry of new brands leads to zero economic profit
with gains from pricing over marginal costs exactly offsetting fixed cost.
64 Chapter 2
One explanation for the existence of imperfect competition lies with

the large fixed costs incurred by incumbent firms: if the market is not
sufficiently large, only a limited number of firms can afford incurring
these high fixed costs. Even when the market-clearing price exceeds
marginal production costs, no external party enters since it cannot recoup
its large fixed costs.
Threat of Substitutes
In assessing the threat of substitute products, a key prerequisite is to
determine what the relevant product market is and define the relevant
substitute products. Are train and plane substitutes in the transportation
market? To travel from France to Cyprus, the train is certainly not an
option. However, from Paris to London the train is a valuable option
thanks to the Eurotunnel.11 Many economists and antitrust authorities
define the relevant market as the smallest set of products for which a
firm, should it become dominant, would find it profitable to raise prices
significantly (and permanently).12 Once the relevant market is defined,
the threat of close substitutes can be assessed.
The extent to which a company might be affected by substitute prod-
ucts depends on several factors, including the propensity of buyers to
substitute, switching costs, the value added by the company’s product or
service in the clients’ perception, as well as the price-performance char-
acteristics of substitute offerings.
Potential Entrants
Another key force affecting firm performance is the threat of entry. New
entrants pose a threat to incumbent firms as higher rivalry generally
leads to lower profit margins (negative externality). How easy or difficult
it is for a potential entrant to penetrate a market depends on entry bar-
riers.13 Entry barriers may be structural (exogenous) or strategic (endog-
enous). An example of structural entry barriers is when the incumbent is
protected by a favorable government policy or other administrative bar-
riers (e.g., property rights,14 state, market or environmental regulation).
11. This travel option has become more attractive especially after September 11 since it
reduces substantially the time to check in and out.
12. To determine the relevant product market, economists utilize various measurement
tools, such as cross-price elasticity of demand, price correlation analysis, and shock
analysis.
13. Bain (1956) has extensively analyzed entry barriers. A barrier to entry is a mechanism
that allows incumbents to make economic profits without threat of entry by competition.
14. Examples include patents, copyrights, and licenses. The property right problem for a
social planner hinges on the trade-off between erecting entry barriers (which is not socially
optimal) and giving firms incentives to invest in R&D.
Structural barriers may also stem from other economic phenomena, such
as fixed entry costs, economies of scale, scope, or learning, access to
scarce resources,15 reputation, network effects,16 product differentiation
advantages, process innovation, and vertical integration. Strategic entry
barriers involve actions taken by incumbents to deter the entrance of
new competitors into the market, for example, by manipulating prices
before (limit pricing) or after entrance (predatory pricing), by building
excess capacity, or by launching aggressive advertising campaigns to
create brand loyalty. They may also create a new brand to capture a
previously unsatisfied customer segment (product proliferation). We
elaborate on corporate strategies to deter entry later in chapter 4.
Bain (1956) identifies three kinds of behavior by incumbents in the
face of an entry threat. Entry is blockaded if the incumbent is well pro-
tected by insurmountable structural barriers to entry and exit so that it
continues to enjoy incumbency profits. The incumbent can ignore the
threat of entry so that strategic interactions play a minor role in this case.
Entry is deterred if the incumbent is not exogenously protected and
behaves strategically to make it unprofitable for new competitors to
enter. For instance, by massively investing in automated production pro-
cesses and reducing its production costs (a strategic first-stage invest-
ment), a firm may ensure that the rival’s post-entry profits are driven
close to zero. This kind of deterrence strategy may be extremely expen-
sive to pursue, but nonetheless strategically justified. Entry is accommo-
dated when the incumbent finds it preferable to allow entry than to erect
costly barriers. A strategy of entry accommodation is not tantamount to
a passive stance toward one’s rivals: the incumbent can still build up an
early competitive advantage (e.g., via excess capacity or strong brand
image).
Bargaining Power of Suppliers and Customers

Both suppliers and customers can extract profits from manufacturers
depending on who influences the price-setting process when the manu-
facturer buys or sells. The firm’s ability to influence or set prices depends
on a number of factors:
• The concentration and market power of customers and suppliers. If the
customer base is small (e.g., B-to-B clients) but suppliers are numerous,
15. A case in point is Nutella. The firm has an exclusive right to acquire a given species of
nuts, so no entrant can imitate Nutella’s unique taste.
16. The combination “PC + MS DOS” won the computer war against “Apple Mac OS”
partly because IBM had a less restrictive licensing policy than Apple.
66 Chapter 2
customers will wield more bargaining power. L’Oréal, one of the major
cosmetic companies worldwide, puts significant pressure on its packaging
services suppliers, which have to toe the line.
• The price elasticity of demand for the product (inputs or outputs).
• Customer and supplier switching costs (purchase from another party).
• The ability of customers to backward integrate or of suppliers to
forward integrate.
• The relation specificity of the firms’ assets (specific to clients or
suppliers).
2.3 Creating and Sustaining Competitive Advantage
The profitability of a firm depends both on industrywide characteristics

(e.g., competitive pressures, market power, bargaining power) as well as
on firm-specific attributes. We already discussed the main strategic man-
agement frameworks for assessing industry attractiveness. We next focus
on firm-specific factors that might help explain why certain firms in a
given industry are more successful than the “average” firm considered
in industry analysis. We review the “generic strategies” proposed by
Michael Porter (1980), namely the incentive to be a cost leader, a dif-
ferentiation leader, or focused on a specific customer segment. To under-
stand these concepts from a microeconomic viewpoint, it is necessary to
first address the notion of value creation and competitive advantage.17
2.3.1 Value Creation
To earn profits in excess of the industry average, a firm must strive to be

superior to its competitors in the industry. A key to superior performance
is creating more value for customers than one’s rivals by exploiting some
competitive advantage. Firms’ strategies aim to create such comparative
advantages. To assess the value created by a firm, we need to go back to
basic microeconomics. For each product there is a maximum value the
consumer is willing to pay. This maximal value (“willingness to pay” or
“consumer value”) determines whether the customer purchases the
product. If the price asked for the good exceeds the customer’s willing-
ness to pay, the customer will reject the product. If the price is lower,
the customer will purchase it, “earning” the difference (between the
17. For a more detailed analysis of how firms can create competitive advantage, refer to
Besanko et al. (2004, ch. 11) and Grant (2005, chs. 8 and 9).
customer value and the product price) as consumer surplus or utility.

If p denotes the price and u the consumer’s willingness to pay (utility),
the consumer surplus is represented by u − p if p ≤ u, and 0 otherwise. If
the product is homogeneous, meaning the products offered by rivals are
considered perfectly identical, a rational consumer will purchase from
the lowest price supplier. For instance, if a consumer sees no significant
difference among airline carriers and does not care much about small
differences in the time schedules, she would choose to fly with a low-cost
airline like Ryanair.
We must also consider the incentive of a given firm to sell in the mar-
ketplace. This incentive is captured by the producer surplus or economic
profit, and represents the bottom-line criterion for many managerial
decisions. The value created by the producer is the difference between
the price at which the firm sells the good, p, and its unit cost of producing
it, c.18 The total economic value created through such an exchange in the
marketplace is the difference between the utility the product brings to
the consumer and the amount it costs to be produced, namely u − c. A
portion of this value is captured by the consumer in the form of con-
sumer surplus, u − p, and the remaining part is earned by the producer
as economic profit, p − c. That is,
Total value created = consumer surplus + producer surplus

u−c = (u − p) + ( p − c) (2.3)
The relation above is depicted in figure 2.5. A necessary condition for

market exchange to take place is that the value (utility) the product
represents for the consumer (u) exceeds the cost of producing it (c). In
this case both the consumer and the producer gain.
In equilibrium the producer does not set the price arbitrarily; this
choice is closely related to the consumer price elasticity of demand, the
production cost, the nature and degree of competition, as well as the size
of the customer base. In a perfectly competitive market all economic
value created by the product offering is captured by the consumer and
competing firms make no economic profit. In order to be economically
profitable, firms need to find ways to deviate from perfect competition.
A firm has a competitive advantage when it is able to deliver more eco-
nomic value than its rivals.
18. Included in c are the labor costs, input prices, and cost of capital per unit of the
product. The profit and value measures we discuss here are net of the opportunity cost of
capital. The term used for profits in this case is “economic profit.” A financial translation
of this economic concept is economic value added (EVA).
68 Chapter 2
Consumer
value u
Consumer
surplus
(u−p)
Total
Price p economic
value
u− c
Producer
surplus
(p− c)
Cost c
Figure 2.5
Total value created consisting of consumer surplus plus producer surplus
In reality, if consumers are not identical, a given product may represent

a higher utility for one consumer than for another. Distinct market
segments can be identified in which consumers (with uniform prefer-
ences) are more willing to accept one particular offering versus another,
namely the one for which their consumer surplus (u − p) is the highest.
This basic economic principle underlies market segmentation.
To create higher economic value, firms pay considerable attention to
what drives customer value and production costs. The following factors
typically drive the customer’s willingness to pay:
• The appeal of physical characteristics and the perceived fitness of the
product (e.g., the size of furniture may be an important criterion if one’s
flat is only 20 square meters or 200 square feet).
• The quality of services associated with the product (the price premium
one may be willing to pay for a night at Sofitel in NYC rather than the
Best Western Hotel is linked to the perceived services one receives
rather than the quality of the bed).
• Brand name (Apple®’s brand name creates a unique competitive
advantage for the iPhone® in the now-commoditized mobile telephony
market).
• Perception by customers.
Firm infrastructure (e.g., finance, accounting, legal)
Support Human resource management

activities Technology development
Procurement
Primary Inbound Outbound Marketing

Production Services
activities logistics logistics and sales
Main activities
Figure 2.6
Porter’s value chain
From Porter (1980)
The following factors typically drive production costs:

• Drivers related to the size of the firm (economies of scale and scope,
capacity utilization and bargaining power).
• Experience of the firm (learning-curve effects).
• Factors related to organizational structure (organization of transac-
tions, agency efficiency, vertical chain).
• Other costs (lower input prices, production in a low labor cost country).19
To understand how value is created along the vertical chain, Porter

(1980) proposes a conceptual framework (shown in figure 2.6) involving
the organization of value-creating activities referred to as the value
chain.
Porter’s value chain essentially divides the organization into a series
of value-creating activities that can be broadly classified as supportive
or primary. Regardless of whether an activity belongs in the first or the
second category, it can potentially contribute to creating more economic
value either by increasing the value perceived by the consumer or by
reducing the cost of producing it. Primary activities are involved with the
physical creation of the product or development of the service until it
reaches the end customer. Inbound logistics, production or operations,
outbound logistics, marketing and sales, and services are typical primary
activities. Additional activities support these primary activities by pro-
viding procurement and technology services, human resources manage-
ment, and various firmwide functions such as finance, accounting, and
19. For more details on benefit and cost drivers, see Besanko et al. (2004, pp. 411–18).
70 Chapter 2
legal services. Increased value added may also be a result of these firm-
wide functions. The organization as a whole is embedded in a larger
stream of activities that include suppliers, distributors, and buyers’ value
chains, which together with the firm’s value chain form the so-called
value system. These activities are all interrelated, so events in one of
them may affect the company’s overall strategy basis. The notions of
value creation and value chain are essential for understanding the
“generic competitive strategies” proposed by Porter (1980).
2.3.2 Generic Competitive Strategies
A generic competitive strategy refers to how a firm positions itself to

compete in the marketplace. Porter (1980) identifies three generic strat-
egies—cost leadership, differentiation, and focus strategy. The choice of
one strategy over another partly depends on the size of the market the
firm wants to cover. When covering a broad market, firms can mainly
pursue two generic strategies: cost leadership or differentiation. In
homogeneous goods markets, cost leadership can play a central role
since customers primarily decide based on the price. In a market where
customers prefer customized products, a benefit leader or differentiated
firm that offers a perceived superior product may obtain a stronger
competitive advantage. A third strategic alternative is to specialize in a
narrow customer segment, namely develop a niche, following a focus
strategy.
Cost Leadership
In homogeneous goods markets, cost leadership consists in offering
similar products as rivals but at lower price. This strategy typically
involves producing larger quantities and appealing to a broader market
(broad scope). It is more likely to succeed when customers are sensitive
to prices, as measured by the price elasticity of demand. A cost-
leadership strategy is advisable when products are commodity-like or
customer services are hard to differentiate. Cost advantage can result
from economies of scale, scope, or learning-curve effects. Economies of
scale offer unit-cost savings that increase with the level of output: the
average production cost of a single product decreases with the number
of units produced. Fixed costs here play a critical role: when volume rises,
the fixed-cost component per unit declines. Such savings may have a
material impact on the equilibrium market structure. If fixed costs are
large, only a limited number of firms can profitably operate in the market:
the price markup over the marginal cost needs to be sufficiently large to
justify spending the fixed costs by the incumbents. Economies of scope
correspond to cost savings gained by operating several product lines or

businesses: the production of good A reduces the production cost of
product B. Learning-curve effects are related to the experience and
know-how firms cumulate over time when they produce a given product
or provide a certain service. The classic BCG matrix originated from
work related to the learning-curve effect.20 Cost leadership can also
result from improved process efficiencies, increased bargaining power
with suppliers, higher capacity utilization (especially when fixed costs are
high), lean organizational structure, better compensation systems, or
location advantages (manufacturing in low-cost countries). Firms employ
several approaches to achieve cost leadership: cost leadership under
benefit parity, cost leadership under benefit proximity, and product rede-
sign. In case of benefit parity, the cost leader offers a product identical
to the products offered by competitors but the cost of producing it is
significantly lower. In case of benefit proximity, the cost of producing the
good is lower but the consumer perceives the product to be of lower
quality; here the increase in consumer surplus due to the lower price
offsets the quality decrease. Alternatively, a firm may offer a product to
consumers that is qualitatively different from competitors’ offerings
(product redesign). Whether achieving cost leadership enhances firm
value also depends on the size of the initial investment.
Differentiation Strategy
Consumer preferences in the marketplace may not be homogeneous.
Within the same market some customers may have preferences for spe-
cific product features and others for other features. A differentiation
strategy enables a firm to create more economic value than its rivals
by offering higher consumer value than other products supplied in
the marketplace. In exchange for this higher consumer surplus, a con-
sumer may be willing to pay a price premium. A differentiation strategy
may encompass the whole value chain. This strategy is more appealing
when price elasticity is low or when cost advantages are limited.
Traditionally one distinguishes two kinds of differentiation. In case of
horizontal differentiation, product differentiation can be achieved
thanks to new combinations of product characteristics (e.g., MP3-player
for mobile telephone handsets), new distribution or sales outlets (e.g.,
online shopping for people living on the fast lane), better marketing dif-
ferentiation (lenovo® laptop, mainly focused on corporate customers),
20. The BCG matrix paradigm asserts that a conglomerate should finance promising
“stars” with excess cash generated by “cash cows.” By so doing, the “stars” commence
production early on and accumulate experience ahead of competitors, leveraging on
learning-curve effects.
72 Chapter 2
or better complementarities owing to network effects (e.g., Blu-ray

players on Sony’s PlayStation3®).21 Vertical differentiation is achieved
when all perceive the product as being of higher quality. Customers
without budget constraints would be willing to pay a premium for it.
Again, three cases may be distinguished here. In case of cost parity, the
cost of producing the good remains unchanged, but the differentiated
product is perceived as being of higher quality by a given customer
segment. In case of cost proximity, the differentiated product implies
higher production costs (than the standard product), but consumers
appreciate the higher quality and willingly pay a price premium that
compensates for these higher costs. Product redesign consists in offering
a product with new characteristics that appeal to new or existing
customers.
Focus Strategy
Alternatively, a firm can devise a focus strategy and tailor its products
and services to the requirements of a specific customer group. In doing
so, the firm creates higher economic value for this specific segment. One
type of focused strategy is to be a local player or appeal to a given popu-
lation group (e.g., Mecca Cola® as an alternative to CocaCola® and
Pepsi® for Muslim consumers). A key advantage of a focused strategy
is that the targeted market may not be large enough to accommodate
many producers, enabling the focused firm to enjoy a quasi-monopolistic
position within its segment.
2.3.3 Sustaining Competitive Advantage
It is said that history repeats itself in cycles. Many once-leading firms

have been dethroned abruptly for not being able to protect and sustain
their once-formidable competitive advantage. Imitators and new
entrants with superior technologies can quickly erode competitive
advantages that have taken years to build. Firms that persistently out-
perform their peers are those able to sustain or renew their competitive
advantage over the long run. Sustainability of competitive advantage
invariably depends on the dynamics of the market. In a market with low
entry and exit barriers, it is more likely that a firm will enter when it
sees a window of opportunity. To avoid this, an incumbent can erect
entry barriers.
Just as there are various mechanisms to protect the profitability of an
industry (e.g., erection of entry and exit barriers), there exist mechanisms
within an industry to protect a firm’s competitive advantage from rivals’
21. See Besanko et al. (2004, p. 415).
imitation. A firm’s ability to create and sustain a competitive advantage

depends on its firm-specific resources and the distinctive capabilities
arising from these resources. To keep competitors from duplicating its
competitive advantage, the firm should constantly strive to create or
enhance asymmetries by acquiring and managing distinctive resources
and capabilities that cannot be readily duplicated by would-be imitators.
Heterogeneity among firms is the cornerstone of the resource-based
view of the firm, emphasizing firm specificity and uniqueness. Imitation
can only be precluded if there is heterogeneity and imperfect transfer-
ability of key resources. Besides the scarcity and immobility of unique
resources, firms can erect isolating mechanisms to prevent rivals from
internally developing similar resources.
Isolating mechanisms fall into two main categories: (1) barriers to
imitation (e.g., property rights or exclusive access to scarce resources)
and (2) early-mover advantages, such as learning-curve effects and
brand-name building. When a firm cannot acquire distinctive key
resources, it has to build them up over time. In its history of investment
and commitment, a firm accumulates skills, assets, and resources involv-
ing path dependencies. The experience, relationships, and reputation a
firm has built over time enable it to leverage its resources and capabilities
and represent sources of uniqueness. It is the exploitation of firm-specific
resources and capabilities in a dynamic way that enables a firm to enjoy
higher (excess) profit flows. Apple®, frequently ranked as one of the
most famous brands in the world, has successfully leveraged its brand
image to sustain its profitability over time.
Conclusion
In this chapter we provided a brief overview of the main paradigms and

issues in strategic management, focusing on how prevalent frameworks
view the key drivers of market attractiveness and firm profitability. We
elaborated on market structure and discussed how limited access to a
market and the existence of entry barriers can enhance a firm’s profit-
ability. We described Porter’s five-forces paradigm and how it can help
structure market analysis. We also discussed how, within a given industry,
a firm can build competitive advantage through production efficiency
(cost leadership), branding (differentiation leadership), or a focus strat-
egy. Finally, we discussed the importance of sustaining competitive
advantage dynamically.
74 Chapter 2
Selected References
Bain (1956) examines barriers to market entrance in detail. Porter’s

(1980) seminal work on industry and competitive analysis is a corner-
stone for understanding the art of strategy and competitive advantage.
Besanko et al. (2004) provide an easy-to-read economic perspective on
strategy.
Bain, Joe S. 1956. Barriers to New Competition. Cambridge: Harvard

University Press.
Besanko, David, David Dranove, Mark Shanley, and Scott Schaefer.
2004. Economics of Strategy, 3rd ed. New York: Wiley.
Porter, Michael E. 1980. Competitive Strategy. London: Macmillan.
3 Market Structure Games: Static Approaches
Studying industrial organization is useful to deduce managerial insights

to help explain how firms should behave strategically when faced with
competition. In this chapter and the following one, we review some basic
principles and models in this area, discuss industry structures, and
examine information asymmetry, commitment, and collaboration. Basic
ideas developed in these chapters serve as building blocks in subsequent
discussions. In this chapter we deal mainly with static models that help
explain the modus vivendi in competitive situations when firms focus on
the short-run impact of their decisions. We discuss simple economic
models that characterize optimal firm behavior under different industry
structures. Chapter 4 extends the discussion to include long-term,
dynamic strategy formulation, helping explain phenomena such as
restraining one’s own freedom (commitment) or collaboration among
rival firms.
This chapter is organized as follows. Section 3.1 discusses the bench-
mark case of a monopolist, developing the basic building blocks for
subsequent models. We then turn to oligopolistic situations where firms
have enough market power to influence the decisions of rivals. Such
analysis requires the use of game-theoretic tools. Section 3.2 introduces
static models of duopoly, presenting first the case of Bertrand price com-
petition and then discussing the classic Cournot quantity duopoly model.
Section 3.3 extends the standard Cournot quantity competition analysis
to accommodate a larger number of firms in oligopoly, obtaining
the market equilibrium in perfect competition as a polar case. Going
beyond earlier models that involved complete information, section 3.4
explores the impact of incomplete information on market structure in a
duopoly.
76 Chapter 3
3.1 Monopoly
In monopoly entry barriers are typically sufficiently high to shield the

incumbent firm from competitive entry (blockaded entry). Customers
take price as given and cannot influence the price-setting process.
Monopoly may naturally arise when demand is not sufficient or fixed
costs are too high to accommodate other incumbents (natural monopoly)
or when regulation prohibits further market entry (e.g., patents).1 In
western Europe the electricity market used to be considered a national
natural monopoly because of the prohibitive fixed costs. Price setting in
a competitive market leads to lower prices, making it difficult or impos-
sible for more electricity utilities to make a profit once large fixed costs
are considered. The equilibrium market structure critically depends on
such fixed costs. Economies of scale and scope are thus one of the main
drivers of industry structures (Viner 1932). When large-scale production
plants are needed (e.g., nuclear power plants), a monopoly is economi-
cally justified and may be socially preferable.2 In this chapter we simplify
and ignore fixed production costs, focusing instead on the relationship
between the market-clearing price and marginal production costs.3
In perfect competition a firm takes the market price as given and
produces until the marginal cost of an additional unit is just below the
market price. In contrast, a monopolist is a price setter. Consider a
monopolist facing (inverse) demand function p (⋅) and variable produc-
tion cost C (Q), as a function of the quantity Q supplied in the market-
place. Given a downward-sloping demand (∂p ∂Q < 0), the monopolist
faces a trade-off between price and quantity. Setting a higher price p
implies earning a higher profit margin but selling a lower quantity.
Inversely, if the monopolist sells an additional unit of output, it moves
down the (inverse) market demand curve, suffering a (marginal) price
reduction. This trade-off is linked to marginal revenues. The monopolist’s
profit function is concave in its own quantity, Q,
π (Q) = R (Q) − C (Q),

1. A natural monopoly may exist when a firm can make excess economic profits when
operating alone, while a duopolist cannot. If π (i) indicates the equilibrium profit of a firm
in an industry with i incumbent(s), π (2) < 0 < π (1) holds for natural monopoly.
2. Today, following deregulation, the electricity market is sufficiently mature to accom-
modate more suppliers.
3. Under certain conditions we show that firms can make excess economic profits (gross
of fixed costs). Considering fixed costs might invalidate some of these results.
Market Structure Games: Static 77
where total revenues are given by R (Q) = p (Q) × Q. To earn maximum

profit, the firm must choose to produce that output, Q *, that equates its
marginal cost, MC (Q) ≡ C ′ (Q), to its marginal revenue, MR (Q) ≡ R ′ (Q).4
This principle, MR (Q *) = MC (Q *), holds whatever the industry struc-
ture and the assumed profit function. In perfect competition, the mar-
ginal revenue equals the price (since the output decision of an individual
firm does not affect the price-setting process, p = MC in equilibrium). In
monopoly, since the firm’s output decision influences the market-clearing
price and ∂p ∂Q < 0, the firm loses revenue on already produced output
when it decides to produce more. Box 3.1 and figure 3.1 describe common
types of demand functions.
Consider the linear (inverse) demand function
p (Q) = a − bQ (3.1)
and a linear cost function C (Q) = cQ with c < a, b > 0. In this case the
marginal revenue is MR (Q) = R ′ (Q) = a − 2bQ and the marginal cost is
MC (Q) = C ′ (Q) = c. In monopoly we thus have a − 2bQM = c. The equi-
librium quantity produced by the monopolist is
a−c
QM = . (3.2)
2b
The equilibrium price, corresponding to point E′ in figure 3.2 (deter-
mined by substituting equation 3.2 for QM into the inverse demand
function 3.1) is
a+c a−c
pM = = c+ (> c ) . (3.3)
2 2
From the equilibrium quantity and price, equations (3.2) and (3.3), the
equilibrium profit for the monopolist is
4. The marginal benefit (revenue) is
∂p
MR (Q) ≡ R′ (Q) = p (Q) + (Q) × Q.
∂Q
The profit function is concave so the first-order condition is both sufficient and necessary
for a maximum output (Q *) to obtain. The first-order derivative of the profit function is
∂π ∂p
(Q) = p(Q) − C ′(Q) + (Q) × Q .
∂Q ∂Q
The first two terms yield the profitability of an extra unit of output (i.e., the difference
between the price and marginal cost), while the third term recognizes that an increase in
output (implying a decrease in ∂p ∂Q < 0 ) affects the profitability of units already
produced.
78 Chapter 3
Box 3.1
Common demand functions
Industry structure models rely on certain assumptions. One key assump-

tion relates to the (inverse) demand function used to determine market-
clearing prices and firm profits. We assume that firms can observe customer
demand. There are several deterministic inverse demand functions. The
most widely used are the following:
• The linear demand function, p(Q) = a − bQ, where p (Q) is the market-
clearing price, Q the total quantity produced by all firms in the industry,
b > 0 , and a is the demand intercept. Figure 3.1a depicts this linear demand
function. Here p(·) is downward sloping (with slope − b < 0 ), indicating that
for an increased industry output ( Q) the market-clearing price ( p (Q))
declines. This property holds for most markets (with notable exception the
luxury market, where a high price may signal a more exclusive product).
One limitation, however, is that for the price to be (or remain) positive,
total industry output must be limited to a certain range (if Q > a b, the
price is negative).
• The isoelastic demand function, p(Q) = 1 (Q + W ), where W is a positive
constant. This curvi-linear demand is depicted in figure 3.1b. Here
Price (p) Price (p)
1
p(Q) = a−bQ p(Q) =
Q+W
Slope − b
0 a /b 0 Quantity (Q)
Quantity (Q)
(a) (b)
Price (p) Price (p)
p(Q) = Q−1 ⁄ ep
p(Q) = a × exp(−e p Q)
0 Quantity (Q) 0 Quantity (Q)
(c) (d)
Figure 3.1
Different (inverse) demand functions
(a) Linear demand; (b) isoelastic demand; (c) exponential demand; (d) constant-
elasticity demand
Box 3.1
(continued)
whatever the total industry output Q, the market-clearing price remains

positive.
• The exponential demand function, p(Q) = a exp ( − ε p × Q), where ε p is the
price elasticity of demand. This is illustrated in figure 3.1c. This steeply

declining demand function has the property of excluding negative prices
even for very high quantity levels and allowing a limited price for low
output.
−1
• The constant-elasticity demand function, p (Q) = Q ε p . This demand
function is often used because of its relative simplicity. It is depicted in

figure 3.1d. A condition on the price elasticity parameter ε p is often
imposed to obtain nice mathematical properties.
Since the linear (inverse) demand function is the simplest and most widely
used, many industrial organization models rely on it to obtain simple
expressions for equilibrium quantities, prices, and profits.
Price (p)
a
Equilibrium
price
a+c E'
pM =
2
E Marginal cost (c)

c
Demand function
p(Q) = a−bQ
Marginal revenue
MR(Q) = a−2bQ
−2b −b
0 Equilibrium quantity
Quantity (Q)
a− c
QM =
2b
Figure 3.2
Equilibrium price and quantity in a monopoly
80 Chapter 3
(a − c ) ²
πM = . (3.4)
4b
As confirmed in figure 3.2, the monopolist firm maximizes its profit by
selecting the output that makes its marginal revenue, MR (Q), just equal
to its marginal cost, c, as represented by the intersection point E.
Inverse Elasticity Markup Rule or Lerner Index

Lerner (1934) complements the discussion on price setting by a monopo-
list by adopting an approach based on the price elasticity of demand,
ε p. This elasticity measure corresponds to the percentage decrease in
quantity sold due to a 1 percent increase in price, all other things equal.
It is given by
∂Q Q pQ
H p (Q ) ≡ − =− . (3.5)
∂p p ∂p ∂Q
From the profit-maximizing condition, a markup formula measuring the
firm profit margin in equilibrium obtains as5
pM − c 1
L≡ = . (3.6)
pM εp
This markup rule, commonly known as the Lerner index, provides a
practical rule of thumb for pricing a product in a monopoly. It asserts
that the profit margin received by a monopolist in equilibrium, L, is
inversely proportional to the price elasticity of demand, ε p ≡ ε p(QM ). If
customers are highly sensitive to a price increase (i.e., ε p is high) and
would refrain from purchasing the product in case of a price increase,
the firm’s profit margin L will be low, since ∂L ∂ε p < 0. In contrast, if
the price elasticity of demand is low such that customers are hardly
sensitive to the price increase, the monopolist can set a very high price
( pM ) and still enjoy a high profit margin (L). The price distortion is
larger when customers reduce their demand only slightly in response to
an increased price. Table 3.1 gives an indication of price-elasticity
ranges.
5. We can rewrite the marginal revenue in note 4 based on the price-elasticity formula
(3.5), obtaining
∂p ⎛ Q ∂p ⎞ ⎛ 1 ⎞
MR (Q) = p + (Q) × Q = p⎜1 + (Q)⎟ = p ⎜ 1 −
ε p (Q) ⎟⎠
.
∂Q ⎝ p ∂Q ⎠ ⎝
Expression (3.6) obtains from the first-order condition in the special case of a linear cost
function. If demand is linear as in (3.1), it obtains from (3.3) that L = (a − c ) (a + c ) and
ε p = (a + c ) (a − c ), giving L ≡ 1 e p.
Table 3.1
Range of price elasticity of demand
Perfectly elastic εp → ∞
Elastic 1 < εp < ∞
Unit elastic εp = 1
Inelastic 0 < εp < 1
Perfectly inelastic εp = 0
Example 3.1 Market Equilibrium in Monopoly

Assume a linear demand as in equation (3.1) with parameters a = 10
and b = 1; that is, p (Q) = 10 − Q. The marginal cost is constant, c = 1, and
the profit function is π (Q) = ( p (Q) − 1) × Q. In this case equations (3.2)
to (3.6) give
a − c 10 − 1 a + c 10 + 1 (a − c )
2
QM = = = 4.5 , pM = = = 5.5 , π M = = 20.25,
2b 2 2 2 4b
pM / Q M 5.5
e p (QM ) = − = − ( −1) = 1.22 ,
∂p / ∂Q 4.5
and
pM − c 5.5 − 1 4.5 ⎛ 1 ⎞
L= = = = .
pM 5.5 5.5 ⎜⎝ ε p ⎟⎠
Figure 3.3 illustrates the price-setting trade-off (higher profit margin vs.
lower sales) that occurs in this situation and the optimal price markup
using the Lerner index.
3.2 Duopoly
A duopoly is characterized by competition among two firms in an

industry. The analysis of duopoly or oligopoly situations requires a
clear depiction of the influence of each firm on the other firms in the
industry. An appropriate tool kit is offered by game theory that gives
prediction about the likely outcome of such strategic interactions. A
game has a certain structure, rules, and characteristics as discussed in
box 3.2. The tools borrowed from game theory, used throughout the
book, are sometimes criticized for being based on the strong assump-
tion of rationality by all agents. In box 3.3 Reinhard Selten addresses
82 Chapter 3
Demand function,
marginal revenue Profit
12 25
5.5−1 1
L≡ ≈
5.5 1.22 πM = 20.25
a =10 10
20
8
Equilibrium Profit function 15
Demand function
price E'
6 p(Q)=10−Q
pM = 5.5
10
4
Marginal revenue
MR(Q)=10−2Q 5
2
c=1 E
−1
0 0
0 2 4 6 8 10
Equilibrium quantity Quantity (Q)
QM = 4.5
Figure 3.3
Trade-off and optimal price markup for a monopolist
The demand function is p (Q) = 10 − Q and marginal cost is constant ( c = 1).
Box 3.2
“Rules of the game”
The players These are the individuals, firms, entities, or actors who make
decisions. In games under exogenous uncertainty, a player’s actions depend
not only on the strategies played but also on external events, called “states
of the world.”a
Alternative actions and strategies Each time players are called upon to
“play” (possibly only once), they face different alternative actions they can
choose from. The collection of alternative actions at a given stage is called
the action set. It is either discrete (e.g., involving choices whether or not
to enter a market) or continuous (e.g., a decision on the output to supply
or the size of the production capacity expansion). A strategy is a contingent
a. Occasionally so-called pseudoplayers, such as nature, are used to account for or
explain outside exogenous factors, such as R&D success or demand realization.
Nature selects the state of the world at random regardless of the players’ actions.
The probability distribution of nature’s moves is a key element of certain games,
especially in option games modeling demand uncertainty.
Box 3.2
(continued)
plan of actions indicating which action to take at each and every stage or
state.b
Information set Players condition their actions on the information they
possess. An information set consists of all relevant information available
to a player at the time of a decision.c Over time players generally collect
more information. A key question is whether players can react to informa-
tion revealed over time or if they stay committed.d
Payoff structure Each strategy combination, also called strategy profile,
results in a specified payoff value for each player. In equilibrium, each
player pursues a strategy that maximizes its expected well-being. In a busi-
ness context, ignoring agency problems, this corresponds to managers
acting to maximize shareholder value.
Order (sequence) of decisions In a simultaneous game, all players make
their decisions at the same time so that no player observes other players’
actions before making its own decision.e If one player makes its decision
after the other, having observed the earlier actions, we face a sequential
or dynamic game. In such games, “time” is interpreted in terms of decision
time, not necessarily real time.f
b. At the start of the game, each player determines, as part of a contingent rule,
what to do at each subsequent decision node, conditional on information available
then. A strategy prescribes action choices at decision nodes that might not be
reached during the actual (equilibrium) evolution of the game (i.e., decision nodes
off the equilibrium path). A strategy profile encompasses the strategies pursued by
all the players. The distinction between actions in one-stage problems and strategies
as a contingent plan of actions in dynamic problems is essential to the understanding
of dynamic games.
c. One often distinguishes various types of information structure, such as perfect,
incomplete, or imperfect information. Under perfect information, decision makers
know the previous moves over the play of the game. Under incomplete information,
players do not know the exact payoffs received by rivals. Such games are typically
transformed into games of imperfect information by assuming that players have
probabilistic information (beliefs) about some characteristics (types) of their rivals
(Harsanyi transformation).
d. In dynamic games, strategies that depend on calendar time but not on previous
plays are called open-loop. Strategies that take account of previous plays as well are
closed-loop. This distinction can substantially affect the resulting equilibrium
outcome. We come back to this distinction later when discussing commitment and
games of timing.
e. When competing firms face such a problem under perfect information, each is
aware that there is another player that is similarly aware of the potential choices of
the former and the impact of its decisions on their payoffs (common knowledge).
f. A two-period game where the second player faces information asymmetry con-
cerning the move of the first player is tantamount to a simultaneous game.
84 Chapter 3
this issue and suggests how to refine the standard approach by incor-
porating behavioral considerations.
There are two archetypical economic models of duopoly competition,
Cournot quantity competition and Bertrand price competition. These
two basic models serve to illustrate how competitive advantage can
result from a better cost position or from product differentiation. They
thus provide an economic foundation to Porter’s (1980) generic business
strategies and enable an economic study of strategic management issues
via option games.
Cournot (1838) first introduced the quantity competition model. The
original treatise did not explicitly rely on game theory, but Cournot
(1838) roughly anticipated the equilibrium concept developed by Nash
(1950) over a century later. A half century after Cournot presented his
analysis of quantity competition, Bertrand (1883) criticized the model’s
fundamental premise, arguing that in the real world firms do not compete
in quantity but in prices. The basic Cournot model essentially assumes
that each individual firm sets the quantity it wishes to provide to the
market, and once all delivered quantities are aggregated, the market
(acting as a “representative auctioneer”) determines the market-clearing
price given the total quantity supplied by producers and the demand
sought by consumers. In contrast, rather than assuming that the market
price is exogenously determined, Bertrand posited that individual incum-
bent firms directly set their prices.
The theory of industrial organization has since largely relied upon
these two cornerstone models. Apart from the early criticisms of these
models, economists have interpreted (for reasons explained later) Ber-
trand price competition as a short-run, tactical approach, while Cournot
quantity competition is thought to involve long-term capacity commit-
ments. For this reason we first present the basic Bertrand model where
identical firms compete in price over homogeneous products. This model
leads to what is called the Bertrand paradox, describing a situation where,
due to competitive pressures, duopolists make no excess profits at all (a
fortiori if fixed costs are material). Subsequently, we discuss a refinement
allowing firms to produce differentiated products (differentiated Ber-
trand model). This extended model gives interesting insights for under-
standing the incentive of firms to differentiate their product offerings
from those of rivals, avoiding cutthroat competition. We next consider
the basic Cournot model of duopoly where firms compete in quantity
Box 3.3
Interview with Reinhard Selten, Nobel Laureate in Economics (1994)
1. Your work on game theory refined existing solution concepts to select

equilibria more in line with intuitive prediction. Do you think there is room
for heuristics in economic analysis?
My work on equilibrium refinement was guided by rational game theory

and intuitions based on this approach. I think that rational game theory
has to be complemented by a descriptive approach. This leaves room for
heuristics but of a different kind. These heuristics involve plausible
assumptions about nonoptimizing decision procedures that are within the
boundaries of human cognitive abilities.
2. You are a pioneer of experimental economics. Do you believe that experi-

mental economics has revealed limited usefulness or relevance of mathe-
matical modeling in economic analysis?
Experimental economics is very important for the development of a

behavioral approach of decision and game theory. Mathematical methods
are also needed for that purpose, but they are different from those used
in the mainstream of economic theory. They might involve the analysis of
dynamic systems, for example, learning processes and stationary concepts
replacing game equilibrium.
3. Game theory generally hinges on the assumption of rationality by all

players. What if people do not react rationally? Do you believe that the use
of rational game theory in social sciences is necessary or appropriate?
Rational game theory assumes common knowledge of the rationality of

all players. When rationality is defined in terms of Bayesian decision
86 Chapter 3
Box 3.3
(continued)
theory, human behavior is not rational in this sense but it is not irrational.
Therefore it is necessary to build a theory of bounded rationality. However,
this task is far from being completed, and as long as we do not have a good
substitute, rational game analysis may still be valuable because it reveals
the strategic structure of a problem and may serve as a benchmark for
experimental economics. We must be very skeptical, however, about the
descriptive validity of rational decision and game theory.
facing the same production cost and subsequently extend the analysis to
allow for (variable) cost asymmetry.
3.2.1 Bertrand Price Competition
Here, to analyze strategic interactions based on the Bertrand model of

price competition, we distinguish between two cases, depending on
whether firms offer identical products or not.
Standard Bertrand Model

Consider first a market where two symmetric firms compete over a
homogeneous product, have no capacity constraint and can supply what-
ever quantity is required. Firms decide what price to set, and customers
decide to purchase the product if the set price is lower than the value
they attribute to the product (their willingness to pay). As the products
offered by the rival firms are not distinguishable (they are perfect sub-
stitutes), customers have an incentive to purchase from the firm with the
lowest price. Suppose that firm i sets a price pi. The best response for
firm j is to set a price pj just lower than its rival’s, namely pj = pi − ε,
where ε (> 0) is small, as long as its profit margin is nonnegative. Similarly
firm i will then consider selling its product at a somewhat lower
price pi − 2ε (< pj ) if this price is still higher than (or equal to) its mar-
ginal cost of production. Firm j will likely follow suit, and so on and on.
Eventually, the rival duopolists will reduce the price they set all the way
down to the marginal cost of production (assumed identical for both
firms at a constant level c), at which point they stop further pointless
price reduction. Consequently the duopolists will make no excess eco-
nomic profit, a result analogous to the outcome found in perfectly com-
petitive markets.
Thus, according to the standard Bertrand model of price competition,

there is no need for a large number of players to be active in an industry
to create the economic conditions most beneficial to customers (i.e.,
perfect competition). Two firms competing in price over an undifferenti-
ated product suffice to create a situation involving no excess economic
profit for any firm and the highest possible consumer surplus. This
outcome has been coined the “Bertrand paradox” in industrial organiza-
tion since it challenges common business sense. One may wonder why
firms bother to enter the market if they make no economic profit once
they enter. A firm typically incurs a fixed cost upon entry. If a firm already
operates, the other firm will not invest, however small the fixed entry
cost; the market is thus likely to yield a monopoly. This standard Ber-
trand model rests on strong assumptions that can be relaxed but derives
its appeal by illustrating cutthroat competition among a few firms. Por-
ter’s business strategies are essentially meant to circumvent such unde-
sirable outcome, allowing for firms to earn excess profits. To achieve this,
firms compete over dimensions other than price.
Differentiated Bertrand Model

One noted business strategy is for firms to differentiate their product
offerings. This is the differentiation strategy proposed by Porter (1980).
Economists can justify this strategy thanks to the differentiated Bertrand
model. Following Gibbons (1992), suppose that two firms, i and j, produce
a differentiated product while facing symmetric (linear) cost6
Ci (qi ) = cqi,
where qi is the quantity produced by firm i, with constant marginal cost

of production c. The (modified) linear inverse market demand function
for each differentiated good (allowing to charge a different price by firm
i, pi) is given by
pi (qi , q j ) = a − b ( qi + sq j ), (3.1′)
where a > c ≥ 0, b > 0, and parameter s ∈ [ 0, 1) represents the substitution

effect between the two differentiated product offerings.7 Products are
unrelated if s = 0; here each firm can disregard the rival’s price decision
since it has no impact on its own, with demand function (3.1′) reducing
to the linear demand in (3.1) faced by a monopolist. If s approaches 1,
6. We formulate the demand function somewhat differently than Gibbons (1992).
7. The substitution effect captures the price change of one product for a unit change in the
supply of its substitute product.
88 Chapter 3
products are undifferentiated or perfect substitutes; equation (3.1′) then

reduces to the traditional linear demand faced by duopolists in the
homogeneous-product case. Note that here products are horizontally
differentiated, whereby the characteristics of a differentiated product
appeal to a certain customer base with particular taste.8
In the case above, by inverting (3.1′), one gets the demand function9
a (1 − s ) − pi + spj
qi ( pi , pj ) = . (3.7)
b (1 − s 2 )
Firms select their prices pi , pj (≥ 0 ) simultaneously not knowing the
rival’s price decision. The Nash equilibrium prices under Bertrand com-
petition ( piB , pBj ) are such that each firm’s price choice is the best response
to the other’s optimal price decision (see related box 3.4):
⎧ π i ( piB , pBj ) ≥ π i ( pi , pBj ) , ∀pi ≥ 0,

⎨
⎩π j ( pi , pj ) ≥ π j ( pi , pj ) , ∀pj ≥ 0.
B B B
In the continuous case the first-order profit maximizing condition for a

Nash equilibrium is
∂π i a(1 − s) − 2 pi + spj + c
( pi , pj ) = = 0.
∂pi b (1 − s 2 )
Firm i’s best-reply or reaction function is
a (1 − s ) + c s
piB ( pj ) = + pj. (3.8)
2 2
Solving the system of two equations (first-order conditions for firms i
and j) with two unknowns ( pi and pj ) results in the following equilibrium
prices and quantities:
⎧ B 1− s
⎪⎪ p = pi = pj = c + 2 − s (a − c ) ( > c ) ,
B B
⎨ a−c (3.9)
⎪ q B = qiB = q Bj = .
⎪⎩ b(1 + s)(2 − s)
8. In this case there are no commonly agreed best features for the product, just individual
preferences. Products are not qualitatively ranked on a scale where customers desire the
top-quality products but cannot afford them due to budget constraints. This category of
differentiated products (Ferrari vs. a standard car) relates to vertical differentiation. Hori-
zontal differentiation refers to situations where customers have taste preferences among
a pool of products with comparable quality standards.
9. The resulting profit function is (twice) differentiable and concave, as can be seen from
∂ 2π i 2
=− < 0.
∂pi 2 b (1 − s 2 )
Box 3.4
Solution concepts and Nash equilibrium
Once model assumptions are laid out, one can solve a game-theoretic
model using a so-called solution concept.a A solution concept is a method-
ology for predicting players’ behavior intended to determine the decisions
(actions or strategies) that maximize each player’s payoff.b The rationality
of each player is typically accepted as a common knowledge; namely each
player is aware of the rationality of the other players and acts accordingly.c
To obtain stronger predictions about a game outcome, one may impose
assumptions beyond common knowledge of rationality.d
Here equilibrium strategy profiles must form a Nash equilibrium. Con-
sider n players. Let a i (∈ Ai ) denote firm i ’s pure strategic action (and Ai
its strategy set). By convention, a −i represents the strategies played
by all other players except i . When firm i chooses strategy a i and her
rivals a −i , firm i receives payoff p i (a i , a − i ). A Nash equilibrium is a set of
decisions—strategy profile—such that no player can do better by unilater-
ally changing their decision. A strategy profile (a i*,a − i*) forms a Nash
equilibrium if, for any player i, i = 1, …, n,e
p i (a i*, a − i*) ≥ p i (a i , a − i*) ∀a i ∈ Ai .
Equivalently, each firm i, i = 1, . . ., n, is faced with the following profit-
optimization problem:
max p (a i , a − i*).
a i ∈Ai
We can interpret the above in terms of best-reply or reaction functions.

Let R(a − i ) denote firm i ’s best response to her rivals’ strategies a −i . In Nash
equilibrium each player formulates her best response to the other players’
optimal decision; that is, a i * ∈ R(a − i*). Depending on the game specifica-
tion, such as the order of the play or the available information, the solution
concept used may be more stringent as discussed in chapter 4.
a. We do not intend here to provide a mathematical account of game theory.
Readers should refer to the readings suggested at the end of this chapter for a more
formal discussion of game theory.
b. We are being vague on the optimality notion. While in problems involving a single
decision maker optimality has an unambiguous meaning, in multiplayer decision
settings “optimality” is not a well-defined concept. Its understanding is closely
related to the solution concept chosen.
c. The rationality assumption imposes an important limitation in situations where
pride and irrationality play a role. However, building up a reputation as being irra-
tional or unpredictable can also make strategic sense: One can turn such reputation
to its advantage by altering opponents’ beliefs. Reagan’s foreign policy toward the
Soviet Union might be interpreted in this light. Similarly a firm that has a reputation
to wage war with any contestant imposes a credible threat on potential entrants
who might think twice before entering.
d. Rationalizability, introduced by Bernheim (1984) and Pearce (1984), is considered a
fundamental solution concept. Based on the weak assumption that payoffs and players’
rationality are common knowledge, it predicts that a player will not play a strategy that
is not a best response to some beliefs about her opponents’ strategies. By iteration, we
can narrow down the set of strategies that could be reasonably played (so-called ratio-
nalizable strategies). By design, rationalizability makes very weak predictions: the set
of rationalizable strategies can be large since it contains all strategy profiles that cannot
be excluded based on the assumption of common knowledge of rationality. Nash’s
(1950b) equilibrium concept is usually preferred for being more restrictive.
e. We consider, here, pure strategies. An equivalent definition exists for mixed
strategies, namely convex combinations of pure strategies. By employing mixed
strategies, one ensures that (at least) one Nash equilibrium exists (Nash 1950b).
90 Chapter 3
Thus, in differentiated Bertrand–Nash equilibrium firms set a price, pB,

strictly higher than the marginal cost of production, c, earning excess
profits. This contrasts to the previous standard Bertrand case involving
perfect substitutes (homogeneous products). Moreover, in equilibrium,
prices for both differentiated products are equal ( piB = pBj ); this results
from the fact that products are horizontally differentiated and that
there is (by assumption) no quality premium for one of the products over
the other. Finally, the equilibrium price decreases with the degree of
substitutability s (∂pB ∂s = − (a − c ) ( 2 − s ) < 0). From (3.9) firm profits
are
1− s ⎛ a − c⎞
2
π B = π iB = π Bj = ⎜ ⎟ (> 0) . (3.10)
b (1 + s ) ⎝ 2 − s ⎠
Thus, for products that are close to being perfect substitutes (s → 1), the
excess profits for the duopolists become zero, a result equivalent to the
outcome obtained in the standard Bertrand price competition case.
Clearly, firms have an incentive to differentiate their product offerings
to soften price competition, departing from the undesirable Bertrand
paradox where no firm makes excess profits. This is in line with most
marketing and strategic management practices.10
Example 3.2 Differentiated Price Competition

Assume the linear market demand function of equation (3.1′) with
parameters a = 24, b = 2 3, s = 1 2 and constant variable production
cost c = 3. From (3.7) the demand functions are given by
⎧ qi ( pi , pj ) = 24 − 2 pi + pj ,
⎨
⎩q j ( pi , pj ) = 24 − 2 pj + pi .
From equation (3.8), firm i’s reaction function is
1
piB ( pj ) = 7.5 + p j.
4
Firm j’s reaction function is obtained symmetrically. In (differentiated)
Bertrand price competition, reaction functions are upward-sloping. In
Nash equilibrium, equilibrium prices, quantities, and profits, obtained
from equations (3.9) and (3.10), are pB = 10, q B = 14, and π B = 98, respec-
tively. This situation is illustrated in figure 3.4.
10. For an economic discussion of the advisable degree of differentiation, refer to Tirole
(1988, pp. 286–87).
Price by firm j ( pj )
20
Firm i’s reaction function

15 piB(pj )
10
E Firm j’s reaction function
pjB( pi)
0
0 5 10 15 20
Price by firm i (pi)
Figure 3.4
Upward-sloping reaction functions in differentiated Bertrand competition
a = 24, b = 2 3, s = 1 2 , and c = 3
The differentiated Bertrand model above is fairly descriptive of many

real-world rivalry situations in the short term. This model underscores
that competition is not just about price but that additional parameters
may come into play, such as heterogeneous tastes among customers.
The main alternative to price competition is quantity competition
represented by the Cournot model.11 Although Bertrand price competi-
tion seems more descriptive of certain real-world situations in the short
run, Kreps and Scheinkman (1983) suggest that the implicit assumption
of a “market auctioneer” in the Cournot model is not necessary. Cournot
11. In Cournot quantity competition, producers simultaneously and independently make
production quantity decisions. The output is brought to the market and a “market auction-
eer” sets the market-clearing price. In (differentiated) Bertrand price competition, produc-
ers simultaneously and independently set prices and there is no need for a price-setting
party.
92 Chapter 3
outcomes may also result from a two-stage competition game where

duopolists first make a capacity choice, and once these capacity choices
become common information, firms set prices as in Bertrand price com-
petition under capacity constraints.12 The two-stage model of Kreps and
Scheinkman (1983) results in Cournot-like outcomes and may be more
realistic than strict Bertrand price competition in situations involving
long-term investments and constrained capacities. For this reason capac-
ity (quantity) is often thought of as a long-term strategic variable, while
price is a short-run, tactical action variable. Most of the models discussed
in subsequent chapters deal with long-horizon investment problems and
therefore build upon the Cournot quantity setting.
3.2.2 Cournot Quantity Competition
Cournot’s (1838) classic quantity competition model characterizes indus-

tries in which firms set production schedules in advance and cannot alter
them in the short run. The price-setting process is driven by the capacity
or quantity chosen by the active firms in the industry.13 Firms produce a
homogeneous good. We discuss next two variants of the Cournot duopoly
model. We consider first the situation where firms have symmetric costs,
and then relax the symmetric cost assumption. A comparison of these
two models helps illustrate why firms have an incentive to be cost leader
in quantity competition involving a homogeneous good.
Cost Symmetry
Consider two identical firms (i and j) that face the same, constant unit
variable production cost c (≥ 0 ). The linear (inverse) demand function,
driven by the total quantity supplied in the market Q ( = qi + q j ), is given
by
p(Q) = a − bQ, (3.1)
with a > c and b > 0. Firms’ strategies consist in selecting an output that
maximizes profit.14 Equivalently, one can assume that they maximize net
12. From this perspective we can consider the (equilibrium) profit functions in Cournot
competition as reduced-form profit functions in which later price competition has been
subsumed. Kreps and Scheinkman (1983) show this property in the case where firms face
a concave demand function and cannot satisfy all demand according to the “efficient-
rationing rule.” Investment in new capacity units must be costly for this result to hold.
13. The ex ante chosen production schedules are hard to reverse, so firms cannot influence
the market-clearing price-setting process in the short-run.
14. An important assumption of the Cournot model is that firms invest simultaneously and
therefore do not observe the strategy chosen by their rivals. This is a case of complete
information in a simultaneous game. The appropriate solution concept is the “simple” Nash
equilibrium.
present value (NPV) where value is given by the perpetuity of profits

(π k , where k is the risk-adjusted discount rate).15 Firm i’s profit, result-
ing from the action profile ( qi , q j ), is given by16
p i ( qi , q j ) = [ p (Q) − c ] qi. (3.11)
As in the monopoly case there is a trade-off between increasing the

quantity supplied (qi) and receiving a lower price (and profit margin)
because of the upsurge in total industry quantity. This time, however, the
firm’s own output choice is not the only factor influencing the price-
setting process; the rival influences it as well. The Nash equilibrium
outputs ( qiC , qCj ) are such that each firm’s quantity choice is the best
response to the other’s optimal quantity decision. Taking the rival’s quan-
tity choice as given, the first-order condition for firm i’s profit maximiza-
tion (∂π i ∂qi = 0) yields
a − 2bqiC − bq j = c, (3.12)
or
1⎛a−c
qiC (q j ) = ⎜ − q j ⎞⎟ . (3.13)
2⎝ b ⎠
Firm j’s first-order profit maximizing condition is obtained symmetri-

cally. If one of the firms does not produce (i.e., if q j = 0), the sole active
firm i will supply in equilibrium QM = (a − c ) 2b, as in monopoly. In quan-
tity competition, the reaction functions of duopolists given by (3.13) are
downward sloping (i.e., decreasing in rival’s capacity-setting action), as
depicted in figure 3.5.
The Nash equilibrium outputs can be determined by solving the system
of the two equations (3.12) (for firms i and j) with two unknowns (qiC
and qCj ) or by substituting firm i’s reaction function from (3.13) into firm
j’s (and reciprocally). The equilibrium is found at the intersection (point
E) of the two reaction functions:
1⎛a−c 1⎛a−c
qiC ≡ qiC (qCj ( qiC )) = ⎜ − ⎜ − qiC ⎞⎟ ⎞⎟ .
2⎝ b 2⎝ b ⎠⎠
Since symmetric firms presumably produce the same output, the

Cournot–Nash equilibrium output by each firm is
15. We assume that firms settle in steady state and that there is no (expected) growth for
the underlying profit flow π .
16. The profit function π i (⋅, ⋅) is concave and twice continuously differentiable in qi.
94 Chapter 3
Quantity supplied by firm j (qj)
( 0; (a−c )/ b)
Firm i’s reaction function
( 0; ( a−c ) / 2b)
(qiC ; qjC )
E
Firm j’s reaction function
(( a−c ) / 2b; 0 ) (( a−c )/ b; 0 )

Quantity supplied by firm i (qi)
Figure 3.5
Downward-sloping reaction functions in (symmetric) Cournot quantity competition
a−c
qC = qiC = qCj = . (3.14)
3b
The total industry output then is
2 ⎛ a − c⎞
QC = qiC + qCj = ⎜ ⎟. (3.15)
3⎝ b ⎠
Two observations are of particular interest. First, in Cournot duopoly
each individual firm produces less than does a monopolist firm:
qC ≤ QM ⎛ 1 a − c ≤ 1 a − c⎞.
⎜⎝ ⎟
3 b 2 b ⎠
Second, firms collectively produce more than does a monopolist:
QC ≥ QM ⎛ 2 a − c ≥ 1 a − c⎞ .
⎜⎝ ⎟
3 b 2 b ⎠
Consequently, given the downward-sloping demand (∂p ∂Q < 0), the
market-clearing price in Cournot duopoly is lower than in monopoly.
One can readily deduce the equilibrium price and profit. The equilibrium
market-clearing price in Cournot duopoly, pC, obtained by substituting
the equilibrium quantity of equation (3.15) into demand equation
(3.1), is
a−c
pC = c + (> c ) . (3.16)
3
The equilibrium profit for firm i ( j) is
(a − c )2
π C = π iC = π Cj = . (3.17)
9b
Due to the lower individual output and lower market-clearing price, a
Cournot duopolist earns lower profits than a monopolist (π iC ≤ π iM ).
From a social-welfare viewpoint, Cournot duopoly is better than monop-
oly as the total quantity supplied is higher, the equilibrium market-
clearing price lower, and the profit or producer surplus lower.17
What would happen if the duopolists could collaborate to improve
their joint profits? Suppose that firms could (tacitly) collude, choosing to
maximize their joint profit instead of their individual profits. In this case
the symmetric duopolists would select the optimal cumulated quantity,
Q, and then divide up the higher joint-profit pie. The optimal total indus-
try output selected by the cartel would be the monopoly quantity, QM.
Each firm could, for example, produce half of it and earn half of the
monopoly rent. Since π M 2 ≥ π iC, a collusive agreement seems preferable
at first sight. This strategy profile is not stable, however. The contract
ruling the cartel is not self-enforceable because each firm has an incen-
tive to cheat, increasing the quantity it supplies to benefit from a higher
price.18 Firms would increase their output until the Cournot–Nash equi-
librium output ((a − c ) 3b ; (a − c ) 3b) is reached. This is the only stable
equilibrium in this simultaneous quantity game. Collusion is not likely
17. This efficiency result is based on the premise that fixed costs are immaterial. The pres-
ence of material fixed costs might substantially alter this result, since a natural monopoly
might turn out to be socially optimal.
18. To demonstrate the instability of the collaborative outcome, consider first the
optimal reaction of the deviating party (e.g., firm i). Substituting half the monopoly
quantity given in (3.2) into firm i’s reaction function in (3.13), the best reply obtains
qiC (Q M 2 ) = 3 (a − c ) 8b . The resulting market-clearing price is p = c + 3 (a − c ) 8 . The profit
for the deviating party is higher than half the monopoly profit, creating an incentive to
deviate from the cartel agreement:
9 πM ⎛ πM ⎞
πD = ⎜> ⎟.
8 2 ⎝ 2 ⎠
96 Chapter 3
to occur since each firm has an incentive to deviate, being pulled as in a

prisoner’s dilemma to the inferior Nash equilibrium outcome. Collusion
will thus not occur in such a static one-shot duopoly game. This ultimately
benefits consumers who can purchase the product at a lower price.19
Cost Asymmetry
Suppose now that the two firms have different marginal costs ci ≠ c j, with
firm i’s cost function given by Ci (qi ) = ci qi , ci ≥ 0. If ci < c j , firm i pro-
duces the (homogeneous) good more efficiently than firm j, enjoying a
cost-leader advantage. Assuming the same (inverse) demand function as
before, firm i’s profit function is p i (Q) = ( p (Q) − ci ) qi. Due to strategic
interaction, firm i’s quantity choice ultimately depends on its own cost
ci as well as on its rival’s cost c j. The cost differential, c j − ci (≠ 0 ), does
matter. From the first-order profit-maximizing condition, firm i’s reaction
function is
1 ⎛ a − ci
qiC (q j ) = ⎜ − q j ⎞⎟ . (3.18)
2⎝ b ⎠
Substituting the reaction functions (into each other), firm i’s equilibrium
quantity is20
a − 2ci + c j
qiC = . (3.19)
3b
In equilibrium, firm i produces more when its rival is cost disadvantaged
or the latter’s marginal production cost is increased (∂qiC ∂c j > 0). The
resulting industry equilibrium price is
a + ci + c j
pC = . (3.20)
3
Firm i’s resulting equilibrium profit is
(a − 2ci + c j )2
π =
C
i . (3.21)
9b
Useful insights can be deduced from the latter expression. The cost
leader (here firm i) earns higher profits in the market than its less effi-
cient rival. This provides an economic rationale for the cost leadership
strategy proposed by Porter (1980). As the firm’s profit decreases in its
19. We discuss later how (tacit) collusion can sustain itself as stable industry equilibrium
in certain repeated games.
20. The formulas for firm j are analogous, meaning one can obtain firm j’s quantity by
substituting j for i and i for j in the expression above.
own cost (∂π iC ∂ci < 0), the cost leader would further benefit from an
improved cost position. An alternative, indirect tactic to achieve cost
leadership is to increase the rival’s cost (∂π iC ∂c j > 0), for example, by
limiting its access to scarce resources it needs.
3.2.3 Strategic Substitutes versus Complements
As noted earlier, reaction functions may be downward sloping (as in the

Cournot quantity competition model) or upward sloping (as in differen-
tiated Bertrand price competition). This distinction between these two
kinds of reactions is at the core of the notion of strategic substitutes
versus strategic complements introduced by Bulow, Geanakoplos, and
Klemperer (1985). The notions of strategic substitutes and complements
are meant to capture how competitors are expected to react when a firm
changes its strategic decision variables, such as price or quantity. This
distinction is informative on whether a firm reacts to its rivals’ strategic
actions in a reciprocating or in a contrarian way. The notion of commit-
ment—analyzed extensively in industrial organization—rests on these
types of reaction functions.
When reaction functions are downward sloping, the actions are strate-
gic substitutes. Let α i ∈ Ai be firm i’s strategic action variable (with Ai its
action set) and Ri (α j ) its best reply to rival action αj.21 The general form
of the equilibrium in case of strategic substitutes is depicted in figure 3.6.
In figure 3.6a, a particular case of interest is the reaction function in
Cournot quantity competition. Assuming a linear (inverse) demand
function as in equation (3.1) and a linear cost function, Ci (qi ) = cqi with
c constant, firm i’s reaction function is obtained in (3.13) as
a−c 1
qiC (q j ) = − qj.
2b 2
Since ∂qiC ∂q j < 0, if a Cournot duopolist increases its output, its rival
will do the opposite by reducing it, a contrarian reaction. Cournot quan-
tity competition is a game where actions are strategic substitutes.
In case of strategic complements, competitive reactions are similar or
reciprocating. The distinction again relates to the shape (slope) of the
reaction function. When reaction functions are upward sloping, as in
figure 3.6b, the firms’ actions are strategic complements or reciprocal. In
the (differentiated) Bertrand model, we deal with strategic complements
21. We assume that the firms’ reaction functions are characterized by slopes of the same
sign, meaning both are downward sloping or both upward sloping.
98 Chapter 3
aj
R i (a j)
E
a j*
R j (a i )
a i* ai
(a)
aj
R i (a j)
E' R j (a i )
a j*
a i* ai
(b)
Figure 3.6
Downward and upward-sloping reaction functions compared: strategic substitutes versus
complements
(a) Strategic substitutes or contrarian reactions ( ∂Ri ∂α j < 0 ); (b) strategic complements
or reciprocating reactions ( ∂Ri ∂α j > 0 )
since a reduction in price by a firm is an optimal response to its competi-

tor’s price cut. If the inverse demand function is linear as in equation
(3.1′), firm i’s reaction function is given by (3.8) above, namely
a (1 − s ) + c s
piB ( pj ) = + pj .
2 2
Since ∂piB ∂pj ≥ 0, when a Bertrand duopolist decreases its price, its
rival will follow suit and decrease its price as well, a reciprocating reac-
tion. For perfect substitutes (s → 1), such reciprocating reactions can lead
to the Bertrand paradox, where firms end up waging a fierce price war
and make zero economic profits (as in perfect competition). Equilibrium
outcomes in case of strategic substitutes vs. complements are illustrated
as outcomes E and E ′ in figure 3.6.
The slope of the reaction function matters. Whether actions are stra-
tegic substitutes or complements can greatly affect the optimal decision-
making in such settings. Following Gal-Or (1985), when reaction functions
are downward sloping (involving strategic substitutes or contrarian reac-
tions), each firm has an incentive to take the lead, acting as a Stackelberg
leader and enjoying a first-mover advantage. This can lead, however, to
situations involving preemption as firms strive to seize this advantage
ahead of competitors. By contrast, in case of strategic complements or
reciprocating actions, the Stackelberg follower is better off, benefiting
from a second-mover advantage. For instance, under price competition
no one has an incentive to set its price first if the follower can undercut
it later.22 This kind of strategic interaction could result in a war of attrition
where firms compete to be the last to make a move, each firm doing its
utmost not to be considered a coward (chicken game).
3.3 Oligopoly and Perfect Quantity Competition
In the previous sections we analyzed industry structure where only two

firms are incumbent. Although duopoly situations exist (e.g., the compe-
tition between Boeing and Airbus in the aircraft manufacturing indus-
try), there is often more than two players operating in a given industry.
Numerous examples of such industries abound. A case in point is the
automotive sector, with giants such as Volkswagen (including Audi,
Porsche, and Seat), Toyota, Ford, BMW, Daimler, and GM. The economic
analysis of such oligopolistic structures can provide interesting insights
as well.
The basic quantity duopoly setup analyzed by Cournot (1838) may be
refined to consider more than two competitors. At first we analyze below
an oligopoly with cost asymmetry. Subsequently we discuss the simpler
case of oligopoly under cost symmetry (as a special case). We confirm
that as the number of competitors substantially increases, the Cournot
oligopoly outcome tends toward the perfect competition benchmark.
This analysis is useful later in the analysis of option games in both dis-
crete and continuous time.
22. A firm is better off to defer its decision and select its own price until after having full
knowledge of the price charged by the leader.
100 Chapter 3
Assume n oligopolist firms competing in quantity over a homogeneous

product. Each firm i faces a linear demand function as in equation (3.1)
and marginal production cost ci. Without loss of generality, firms are
ranked in cost advantage with firm 1 having the largest cost advantage
or lowest cost c1. Firm i’s profit function is given by
π i (qi , Q− i ) = [ p (qi , Q− i ) − ci ] qi , i = 1, . . ., n,
where Q− i stands for the quantity produced collectively by all other sup-
pliers except firm i, with Q = qi + Q− i . To obtain the Cournot–Nash equi-
librium, one has to deduce the optimal production strategy profile
(q1C , . . ., qnC ) such that each firm i, i = 1, . . ., n, maximizes profit
p i ( qi , Q−Ci ) ,
considering other rivals’ choices as given. This leads to the first-order

condition:
∂p C C
MRi ( qiC , Q−Ci ) = qiC × (qi , Q− i ) + p (qiC , Q−Ci ) = ci , i = 1, . . ., n. (3.22)
∂qi
In the linear demand case, marginal revenue is MRi (qi , Q− i )
= a − 2bqi − bQ− i . In the general Cournot oligopoly with n asymmetric
firms, we must solve the following system of n equations
with n unknowns:
⎧ a − 2bq1C − b (QC − q1C ) = c1 ,

⎪
⎪⎪
⎨ a − 2bqi − b (Q − qi ) = ci ,
C C C
⎪
⎪
⎪⎩a − 2bqn − b (QC − qnC ) = cn .
C
Summation leads to a total quantity for the entire market of

n ⎞⎛a−c⎞
QC (n) = ⎛⎜
⎝ n + 1⎟⎠ ⎜⎝ b ⎟⎠
, (3.23)
where c ≡ ∑ j = 1 c j n is the average (variable) production cost in the

n
industry. Denote by c− i ≡ ∑ j ≠ i c j (n − 1) the average production cost for

all other firms except i. Individual firm quantities are obtained by sub-
stituting the total industry quantity of (3.23) into each equation of the
system above:
1 ⎛ a − nci + ( n − 1) c− i ⎞
qiC (n) = ⎜ ⎟⎠ , i = 1, . . ., n . (3.24)
n + 1⎝ b
The equilibrium price obtains from (3.1) and (3.23) as
a−c
pC ( n) = c + (> c1 ). (3.25)
n+1
Regardless of how many firms operate in the market, the most cost-
advantaged firm (absolute cost leader) always enjoys a price strictly
higher than its variable cost c1.23 The resulting profit for firm i
is
1 (a − nci + (n − 1) c− i )2
p iC ( n) = , i = 1, . . ., n . (3.26)
(n + 1)2 b
It can be seen that profits are increasing in the cost advantage. Moreover,
a firm’s profitability depends on its production cost, its market share, and
the price elasticity of demand.24
The special case of cost symmetry (with ci = c) has clear-cut insights.
The equilibrium quantity, obtained from equation (3.24), is the same for
each symmetric firm:
1 ⎛ a − c⎞
qC ( n) = ⎜ ⎟, i = 1, . . ., n. (3.27)
n + 1⎝ b ⎠
The equilibrium price, resulting from equation (3.25), is given by
a−c
pC (n) = c + ( > c ). (3.28)
n+1
The expression above suggests that even for a large oligopoly (n large),
the equilibrium price margin, pC − c, remains positive. From (3.26), the
profit for each identical oligopolist firm is
1 ( a − c )2
π C (n) = , i = 1, . . ., n. (3.29)
(n + 1)2 b
23. This holds as long as the demand intercept exceeds the average unit cost in the
industry.
24. Let si ≡ qiC QC denote firm i’s (equilibrium) market share and recall the price elasticity
of demand e p in equation (3.5). The first-order condition in (3.22) yields firm i’s Lerner
index: Li ≡ ( pC − ci ) pC = − si ε p . This measure proxies for firm i’s profit margin and
depends on ci , si , and ε p .
102 Chapter 3
In the special case when there is only one firm operating (n = 1), the
previous monopoly results in equations (3.2) to (3.4) obtain. In duopoly
(n = 2), we obtain the symmetric Cournot duopoly results of equations
(3.14) to (3.17). As the number of active firms is greatly increased
(n → ∞), the quantity produced by any one firm becomes negligible, the
market-clearing price approaches marginal production cost, c, and the
economic profit of an individual firm approaches zero. These outcomes
confirm the well-known results in perfect competition: firms make no
excess profits and set prices at marginal cost. The presence of fixed pro-
duction or investment costs may affect the number of firms operating in
the sector.
3.4 Market Structure under Incomplete Information
The standard Cournot model assumes that duopolists know perfectly the
cost structure of their rivals; their profit-maximizing quantities are
derived as a function of the known variable costs. This assumption might
not hold in certain industry settings characterized by information asym-
metry. Suppose that firm j does not know for sure firm i’s cost but that
“nature” will reveal it with certain probability. For example, firm i may
have invested in a new innovative process that could alter its cost struc-
ture if its R&D efforts succeed (with probability P). The rival’s cost can
be either low (cL) with probability P or high (cH ) with probability 1 − P
(cL < cH).25 That is, firm j has probabilistic beliefs about its rival’s type
(cost). Suppose also that firm i can perfectly observe what “nature”
decided concerning its own cost (e.g., the outcome of its own R&D
efforts), as well as its rival’s cost (e.g., the rival uses the prevalent produc-
tion technology). Firm j is aware of the information asymmetry in favor
of firm i. Once firm i knows its own cost, the two firms choose simultane-
ously their capacity or output. Figure 3.7 depicts this situation.
In selecting its optimal quantity, firm j no longer maximizes its deter-
ministic profit function but instead maximizes its expected profit function,
taking into account the uncertainty it faces concerning firm i’s type or
cost. Firm j knows that if the low-cost outcome (cL) occurs (with prob-
ability P), firm i’s reaction function would be similar to equation (3.18)
in the Cournot game:
1 ⎛ a − cL
qiC ( q j , cL ) = ⎜⎝ − q j ⎞⎟ . (3.30)
2 b ⎠
25. Subscript L stands for low- and H for high-cost type.
Nature
cL cH
(low cost) (high cost)
Firm i Firm i
qi (cL ) = qL qi (cH) = qH
Firm j Firm j
qj qj
Figure 3.7
Extensive form of Cournot competition under asymmetric information
The dashed box indicates that firm j has two nodes in its information set and is unable to
anticipate its rival’s quantity decision.
However, in case the high-cost outcome (cH ) occurs (with probability

1 − P), firm i’s reaction function is instead
1 ⎛ a − cH
qiC ( q j , cH ) = ⎜ − q j ⎞⎟ . (3.31)
2⎝ b ⎠
Firm j’s expected profit reflects its belief (probabilistic distribution)

about firm i’s possible production costs. It is given by26
π j ( q j , qL , qH ) ≡ E [π j (qi , qL , qH )] (3.32)
= P × π j ( q j , qL ) + (1 − P ) × π j ( q j , qH ) ,
where qL and qH stand for firm i’s quantity choice as a function of its low
or high marginal cost. Firm j’s (Bayesian Nash) equilibrium strategy
consists in selecting its output q j so as to maximize its above expected
profit in (3.32), considering its rival’s optimal decision as given. From the
first-order profit optimization condition (and substitution of equations
26. Firm j ’s profit function is differentiable and concave in its own strategic action
q j ( ∂ 2π j ∂q j 2 < 0 since b > 0). The first-order condition is both necessary and sufficient for
a maximum to obtain.
104 Chapter 3
(3.30) and (3.31) into firm j’s reaction function) firm j’s equilibrium
quantity is27
a − 2c j + ci
qj * ≡ , (3.33)
3b
where ci = PcL + (1 − P ) cH is the mean (expected) value of firm i’s cost.
This result is similar to the equilibrium outcome in Cournot quantity
competition under complete information, except that here we utilize
firm i’s expected cost (ci). Firm i faces no information asymmetry and
may adapt the quantity it produces to its actual production cost realiza-
tion (cL or cH ). But firm j cannot. Firm i’s equilibrium quantities, depend-
ing on nature’s move, are obtained by substituting firm j’s equilibrium
quantity from (3.33) into the reaction functions (3.30) and (3.31). This
gives
⎧ q * = qC q *, c = qC − 1 − P c − c
⎪ L i ( j L) L ( H L) (≤ qLC ) ,
6b
⎨ (3.34)
⎪qH * = qiC ( q j *, cH ) = qLC + P (cH − cL ) ( ≥ qCH ) ,
⎩ 6b
where qLC = ( a − 2cL + c j ) 3b and qCH = ( a − 2cH + c j ) 3b are the asymmet-

ric complete-information Cournot quantities for firm i depending on
whether it has low or high cost. The equilibrium quantities for firm i are
not the same as the ones derived for the standard Cournot model (under
complete information), even though firm i has the same information as
before; that is, it knows both its cost and its rival’s. The difference arises
from the fact that firm j has an informational disadvantage and that
firm i knows it.
In the favorable case where firm i has lower cost cL, the total quantity
supplied in the marketplace, Q (cL ), is higher under asymmetric informa-
tion than under complete information. Indeed, from equations (3.33) and
(3.34), we have
1− P
Q (cL ) = q j * + qL* = QC (cL ) + ( c H − cL ) ( ≥ QC (cL )), (3.35)
6b
27. The first-order derivative of firm j’s profit with respect to its own quantity (holding
firm i’s quantity choices qL and qH fixed) is ∂p j ∂q j = a − 2bq j − bqi − c j , with
qi ≡ PqL + (1 − P ) qH . From the first-order condition,
1 ⎛ a − cj ⎞
qCj (qi ) = ⎜ − qi ⎟ .
2⎝ b ⎠
Equation (3.33) obtains from substituting firm i’s reaction functions (3.30) and (3.31) in
the expression above.
where QC (cL ) = qCj + qLC = ( 2a − c j − cL ) 3b is the total industry output in

the complete-information case obtained by summing the quantities for
firms i and j in equation (3.19). As the inverse demand function is down-
ward sloping, the market-clearing price is lower in the asymmetric-
information case since Q(cL ) ≥ QC (cL ). Firm i would have been better off
if its rival had known its cost.28 Due to the combined effect of lower price
and lower quantity for firm i, the informed party (i) is worse off as a
result of the rival’s information disadvantage in the favorable cost situ-
ation (cL).29 This rests on the fact that firm j forms a higher expectation
on i’s cost (than the actual low cost cL) and consequently produces more
compared to the situation where firm j actually knows the cost realiza-
tion. Since rivals’ actions are strategic substitutes or contrarian, firm i
will produce less as a best reply to firm j’s oversupply.
In the opposite (unfavorable) case where firm i turns out to have a
high production cost (cH ), the effects are reversed. Firm i produces more
than under complete information since its rival, firm j, believes it has a
lower average cost. The market-clearing price is higher, and the informed
party makes larger excess profit.30 This underscores that an informed
28. Given the linear demand function of equation (3.1) and the total industry output in
(3.35), one obtains the market-clearing price in the asymmetric-information case:
1− P
p (Q (cL )) = pLC −
6
( c H − cL ) (≤ pLC ),
where pLC = ( a + c j + cL ) 3 from equation (3.20).
29. Firm i’s equilibrium profit is
1 ⎡ ⎛ a + c j − 2 cL ⎞ 1 − P
2
p L = p i ( cL ) = ⎜ ⎟⎠ − (cH − cL )⎤⎥ (≤ p LC ) .
b ⎢⎣⎝ 3 6 ⎦
The equilibrium profit in the complete-information Cournot case, π LC = (a + c j − 2cL ) 9b ,
2
comes from (3.21).

30. In this case total industry output is obtained from equations (3.33) and (3.34):
P
Q (cH ) = q j * + qH * = QC (cH ) −
6
(cH − cL ) (≤ QC (cH )) ,
where QC (cH ) = ( 2a − c j − cH ) 3b is the total industry output in the complete-information
case. The equilibrium price in the asymmetric-information case is
P
p (Q (cL )) = pHC + ( c H − cL ) (≥ pHC )
6
with pLC = (a + c j + cH ) 3 . Firm i’s equilibrium profit is obtained from the above and equa-
tion (3.34) as
1 ⎡ a − 2cH + c j P
2
⎤
π H = π i ( cH ) =
b ⎣⎢
+ ( c H − cL ) ⎥ (≥ π CH )
3 6 ⎦
where the equilibrium profit of the high-cost firm, π CH = (a − 2cH + c j ) 9b, is obtained
2
from equation (3.21).

106 Chapter 3
Table 3.2
Equilibrium outcomes under various industry structures
A: Cost symmetry
Industry Firm i ’s quantity Industry quantity Firm i’s profit

structure ( qi*) (Q*)
1 ⎛ a − c⎞ 1 ⎛ a − c⎞ 1 (a − c )
2
Monopoly
⎜ ⎟ ⎜ ⎟
2⎝ b ⎠ 2⎝ b ⎠ 4 b
1 (a − c )
2
Cournot 1 ⎛ a − c⎞ 2 ⎛ a − c⎞
⎜ ⎟ ⎜ ⎟
duopoly 3⎝ b ⎠ 3⎝ b ⎠ 9 b
1 (a − c )
2
Stackelberg 1 ⎛ a − c⎞
⎜ ⎟
leadera 2⎝ b ⎠ 3 ⎛ a − c⎞ 4 b
⎜ ⎟ 1 (a − c )
4⎝ b ⎠
2
Stackelberg 1 ⎛ a − c⎞
⎜ ⎟
followera 4⎝ b ⎠ 16 b
1 ⎛ a − c⎞
2
Cournot 1 ⎛ a − c⎞ n ⎛ a − c⎞
⎜ ⎟ ⎜ ⎟ ⎜⎝ ⎟⎠
oligopoly n + 1⎝ b ⎠ n + 1⎝ b ⎠ b n+1
( n players)
Bertrand 1 ⎛ a − c⎞ 2 ⎛ a − c⎞ ⎛ 1 − s2 ⎞ ( a − c )2
⎜ ⎟ ⎜ ⎟
duopoly (1 + s ) (2 − s) ⎝ b ⎠ (1 + s ) (2 − s) ⎝ b ⎠ ⎝⎜ (1 + s )2 ( 2 − s )2 ⎠⎟ b
(differentiated)
B: Cost asymmetry
Industry Firm i ’s quantity Industry quantity Firm i’s profit

structure ( qi*) (Q*)
1 ⎛ a − ci ⎞ 1 (a − ci )
2
Monopoly 1 ⎛ a − ci ⎞
⎜ ⎟ ⎜ ⎟
2⎝ b ⎠ 2⎝ b ⎠ 4 b
2a − ( ci + c j ) 1 (a − 2ci + c j )
2
Cournot 1 ⎛ a − 2ci + c j ⎞
⎜ ⎟⎠
duopoly 3⎝ b 3b 9 b
1 (a − 2ci + c j )
2
Stackelberg 1 ⎛ a − 2ci + c j ⎞
⎜ ⎟⎠
leadera 2⎝ b 3 ⎛ a − ci ⎞ 4 b
1 ⎛ a − 2ci + c j ⎞ ⎜ ⎟ 1 (a − 2ci + c j )
2
Stackelberg 4⎝ b ⎠
followera ⎜ ⎟⎠
4⎝ b 16 b
1 a − nci + (n − 1)c− i n ⎛a−c⎞ 1 ⎛ a − nci + (n − 1)c− i ⎞
2
Cournot
⎜ ⎟ ⎜ ⎟⎠
oligopoly n+1 b n + 1⎝ b ⎠ b⎝ n+1
( n players)
Note: p (Q) = a − bQ with Q = qi + q j ; s is the substitutability parameter in

p (Q) = a − b ( qi + sq j ) ; the cost function is Ci (qi ) = cqi (symmetry) or Ci (qi ) = ci qi
(asymmetry). c = ∑ nj =1 c j n and c− i = ∑ j ≠i c j (n − 1).
a. The outcomes in case of the Stackelberg game are derived in chapter 4.
party cannot always benefit from its informational advantage when stra-
tegic interactions come into play. Rivals form beliefs about the informed
party’s cost type and may over- or under-react as a result of their infor-
mational disadvantage. These inaccurate beliefs can sometimes prove
detrimental for the better-informed firm.
Conclusion
In this chapter we provided an overview of static market structure

games. We first discussed the monopoly benchmark. We then gave appli-
cations illustrating how noncooperative game theory can provide pow-
erful insights about real-world problems. We considered several static
models involving price and quantity competition, and examined how
such models motivate certain generic competitive strategies of being a
cost leader or differentiating from one another. We analyzed the impact
of the number of players in a given industry on an individual firm’s
profit, as well as potential effects of asymmetric information on the
industry structure. Several equilibrium outcomes discussed in this
chapter are summarized in table 3.2, panels A and B, for cost symmetric
and cost asymmetric firms, respectively. These tables may be useful for
later reference.
The next chapter extends this analysis to dynamic models of oligopoly,
highlighting that, in the long term, a competitive stance such as commit-
ment or collaboration may be both value-enhancing for the individual
firms and sustainable as industry equilibrium.
Selected References
Osborne (2004) is a good introductory textbook on game theory. Tirole’s

(1988) appendix provides a short, concise manual on noncooperative
game theory. Averted readers might prefer the rigorous and more
advanced treatment of game theory offered by Fudenberg and Tirole
(1991). Besanko et al. (2004) provide a good overview of industrial orga-
nization issues focusing on the models’ strategic insights. Tirole (1988) is
considered a key reading on industrial organization.
108 Chapter 3
Besanko, David, David Dranove, Mark Shanley, and Scott Schaefer. 2004.
Economics of Strategy, 3rd ed. New York: Wiley.
Fudenberg, Drew, and Jean Tirole. 1991. Game Theory. Cambridge: MIT
Press.
Osborne, Martin J. 2004. An Introduction to Game Theory. New York:
Oxford University Press.
Tirole, Jean. 1988. The Theory of Industrial Organization, Cambridge:
MIT Press.
4 Market Structure Games: Dynamic Approaches
In chapter 3 we dealt with benchmark models of market structure from

a static perspective. These static games allow predicting the short-run
impact of a firm’s actions on its rivals. The current chapter extends this
discussion to dynamic approaches. These allow the inclusion of long-term
strategy formulations and discussion of phenomena that require more
dynamic thinking such as commitment and collaboration.
Dynamic games make explicit how today’s decisions may affect or
induce distinct future strategic situations. For example, if one adopts
today an aggressive stance toward a rival, this behavior might induce the
rival to act aggressively in the future. When assessing the benefit the firm
could gain from an aggressive stance, it has to figure out what is the
potential long-term impact of its decision today. One way to do this is to
“look forward and reason backward” (Dixit and Nalebuff 1991). This
dynamic way of thinking consists in figuring out what will be the likely
future reaction in the marketplace to today’s firm actions. Once this is
understood, one can assess alternative actions based on the impact they
may have in the future—possibly rejecting certain initiatives that appear
beneficial today but may have a negative long-term impact. This forms
the underlying logic behind backward induction and subgame perfection
used in dynamic games under perfect information. These notions require
that for every history (or subgame) players act optimally as part of Nash
equilibrium and that they make their early decisions knowing that all
future actions will be optimal given the current set of information.
Based on these notions, we discuss below two streams of models
dealing with multiplayer decision-making in multistage settings. In
section 4.1 we elaborate on commitment and discuss how limiting one’s
own flexibility might create strategic value for the committing firm,
thereby contradicting standard real options thinking that suggests that
flexibility is always of value. Subsequently, in section 4.2, we discuss
110 Chapter 4
situations when firms may find it beneficial to cooperate with their rivals
and have no long-term incentive to “cheat” on them.
4.1 Commitment Strategy
Industrial organization and game theory have evolved to help analyze

situations and concepts encountered in everyday life. Commitment is a
core topic in several books and movies. A case in point is Dr. Strangelove
or How I Learned to Stop Worrying and Love the Bomb (1964) by
Stanley Kubrick. The movie depicts an imaginary setting of the Cold War
in the aftermath of an unauthorized launch of nuclear weapons on the
Soviet Union. US General Ripper (who “went a little funny in the head”)
utilizes flaws in the US defensive system, deciding on his own to attack
selected targets with hydrogen bombs. He does this in the hope that the
US president will react by ordering an all-out attack, destroying all
Soviet military bases to circumvent any retaliation. The president,
however, reacts differently. He summons his senior officials to the War
Room to formulate alternatives to the unauthorized attack. He decides
to warn the Russians of the imminent US attack, but learns that the
USSR has installed a deterrence device—the “Doomsday Machine”—
that would be triggered automatically in case of a sneak US nuclear
attack, with no possibility to be reversed. This automatic retaliation
would destroy all human life. Astonished by the threat of this Doomsday
device, the president summons the director of Weapons Research and
Development, Dr. Strangelove, for advice: “How is it possible for this
thing to be triggered automatically and at the same time be impossible
to un-trigger?” the president asks. Dr. Strangelove replies:
It is not only possible, it is essential. That is the whole idea of this machine.
Deterrence is the art of producing in the mind of the enemy the fear to attack.
Because of this automated decision-making process—which rules out human
meddling—the Doomsday Machine is terrifying and simple to understand. It is
completely credible. . . . The whole point of this Doomsday Machine is [however]
lost if you keep it a secret.
The only flaw in the Soviet deterrence strategy was that General Ripper,
when deciding to attack the Russians, was ignorant of the very existence
of this deterrence device.1
1. Dixit and Nalebuff (1991) discuss a simple setting to underline the effectiveness
of strategic commitment to deter nuclear warfare (pp. 128–31), and explain how the
Doomsday Machine should have deterred sneak attacks if effectively communicated
(pp. 155–56).
Market Structure Games: Dynamic 111
(4, 3)
c
a
Firm j
d (2, 4)
Firm j
c d
a (4, 3) (2, 4)* Firm i (3, 2)*

Firm i
b (3, 2) (1, 1) b
Firm j
d (1, 1)
a. Simultaneous game b. Sequential game
Figure 4.1
Payoffs in a simultaneous versus sequential game for strategic commitment
The first element in (·, ·) corresponds to firm i‘s payoff, while the second denotes the rival’s
payoff.
4.1.1 Concept of Commitment
Commitment relates to strategic moves. A strategic move is intended

to alter the beliefs or actions of rivals to one’s own benefit by
purposely limiting one’s own freedom of action (e.g., killing one’s
options). The raison d’être of strategic moves counteracts a common
belief held in the real options literature that it is preferable under
uncertainty to always keep options open (e.g., see Dixit and
Pindyck 1994). As is well known in the industrial organization literature,
lack of freedom can have strategic value if it can change the rival’s
expectations about one’s future response, turning it to one’s own
advantage.
One approach to considering strategic moves is to look at how firms
can be better off by altering the rules of the game, such as by transform-
ing a simultaneous game into a sequential one. Consider the simultane-
ous game under complete information described in panel a of figure 4.1.
Firm i may choose between action a and b, and firm j between action c
and d . Firm i has a dominant strategy to take action a since whatever
firm j decides (c or d ), the payoff for firm i is always higher when choos-
ing action a (4 > 3 and 2 > 1). The best response to firm i’s choosing action
a is for firm j to choose action d (receiving 4 rather than 3). Given this,
112 Chapter 4
the Nash equilibrium (*) is the right-top situation, with equilibrium

payoffs of 2 for firm i and 4 for firm j.2
An alternative strategy for firm i is to move ahead of firm j, influencing
its subsequent reaction. In this way, firm i turns a simultaneous game into
a sequential one. To deal with the resulting sequential game shown in
panel b of figure 4.1, we need to refine the Nash equilibrium solution
concept to a multistage setting. Nash’s contribution to game theory and
refinements of the Nash equilibrium concept are discussed in box 4.1.
Figure 4.2 summarizes four basic game theory solution concepts.
The appropriate solution concept here is the subgame perfect Nash
equilibrium that rules out cheap talk and empty threats by the first mover
(e.g., having the possibility to un-trigger the Doomsday Machine). In this
finite-horizon problem (two stages) the solution is obtained by backward
induction along the game tree of figure 4.1b. Once firm i chooses action
a in the first stage and firm j observes this, the latter’s optimal action in
stage two is to choose action d since its payoff for the strategy profile
( a, d ) is higher than for (a, c ) as 4 > 3. Thus, if firm i pursues action a, it
will receive a payoff of 2 provided that firm j behaves optimally in the
next stage (choosing d to receive 4 rather than c receiving 3). However,
if firm i chooses action b in the first stage, firm j will select c (receiving
2 rather than 1), and so firm i will then receive 3. Firm i is thus better off
choosing action b in the first stage, receiving 3 rather than 2. Firm
i’s equilibrium payoff in the sequential game of figure 4.1b is higher than
the equilibrium payoff it would have received in the simultaneous game
depicted in figure 4.1a. To acquire this advantage obtained in the sequen-
tial game, firm i can announce early on it will pursue strategy b, whatever
the decision of its rival (e.g., no wavering by the Soviet Union following
a sneak attack by the United States). To behave strategically, firm i must
commit not to follow the static optimal action of the simultaneous game
(which was action a). Such strategic commitment makes firm i better off,
receiving 3 rather than 2.
The discussion above provides an example of how a player can act
strategically, changing the ex post subgames with its ex ante strategic
decision. If firm i declares upfront it will pursue action b regardless of its
rival’s subsequent action, it can change the rules of the game in its favor.
But for such a move to have real commitment value, it must be, among
other things, credible and observable. To be credible, such strategic
2. The Nash equilibrium (a, d ) consists of strategies that are rationalizable since they
survive iterated removal of never-best responses. This equilibrium selection relies on very
weak assumptions, namely common knowledge of rationality.
Box 4.1
Development of game theory and refined solution concepts
As far back as the early nineteenth century, beginning with Auguste

Cournot in 1838, economists have developed methods for studying strate-
gic interaction. But these methods focused on specific situations, and for
a long time no overall method existed. The game-theoretic approach now
offers a general toolbox for analyzing strategic interaction.
Game Theory
Whereas mathematical probability theory ensued from the study of pure

gambling without strategic interaction, games such as chess and cards
became the basis of game theory. The latter are characterized by strategic
interaction in the sense that the players are individuals who think ratio-
nally. In the early 1900s mathematicians such as Zermelo, Borel, and von
Neumann had already begun to study mathematical formulations of
games. It was not until the economist Oskar Morgenstern met the math-
ematician John von Neumann in 1939 that a plan originated to develop
game theory so that it could be used in economic analysis.
The most important ideas set forth by von Neumann and Morgenstern
in the present context may be found in their analysis of two-person zero-
sum games. In a zero-sum game, the gains of one player are equal to the
losses of the other player. As early as 1928 von Neumann introduced the
minimax solution for a two-person zero-sum game. According to the
minimax solution, each player tries to maximize his gain in the outcome
that is most disadvantageous to him (where the worst outcome is deter-
mined by his opponent’s choice of strategy). By means of such a strategy
each player can guarantee himself a minimum gain. Of course, it is not
certain that the players’ choices of strategy will be consistent with each
other. von Neumann was able to show, however, that there is always a
minimax solution, namely a consistent solution, if so-called mixed strate-
gies are introduced. A mixed strategy is a probability distribution of a
player’s available strategies, whereby a player is assumed to choose a
certain “pure” strategy with some probability.
John F. Nash
In his dissertation Nash introduced the distinction between cooperative

and noncooperative games. His most important contribution to the theory
of noncooperative games was to formulate a universal solution concept
with an arbitrary number of players and arbitrary preferences, that is, not
solely for two-person zero-sum games. This solution concept later came to
be called Nash equilibrium. In a Nash equilibrium all of the players’
expectations are fulfilled and their chosen strategies are optimal. Nash
proposed two interpretations of the equilibrium concept: one based on
114 Chapter 4
Box 4.1
(continued)
rationality and the other on statistical populations. According to the ratio-

nalistic interpretation the players are perceived as rational, and they have
complete information about the structure of the game, including all of the
players’ preferences regarding possible outcomes, where this information
is common knowledge. Since all players have complete information about
each others’ strategic alternatives and preferences, they can also compute
each others’ optimal choice of strategy for each set of expectations. If all
the players expect the same Nash equilibrium, then there are no incentives
for anyone to change his strategy. Nash’s second interpretation—in terms
of statistical populations—is useful in so-called evolutionary games. This
type of game has also been developed in biology in order to understand
how the principles of natural selection operate in strategic interaction
within and among species. Moreover Nash showed that for every game
with a finite number of players, there exists an equilibrium in mixed
strategies.
Despite its usefulness there are problems associated with the concept
of Nash equilibrium. If a game has several Nash equilibria, the equilibrium
criterion cannot be used immediately to predict the outcome of the game.
This has brought about the development of so-called refinements of the
Nash equilibrium concept. Another problem is that when interpreted in
terms of rationality, the equilibrium concept presupposes that each player
has complete information about the other players’ situation. It was pre-
cisely these two problems that Selten and Harsanyi undertook to solve in
their contributions.
Reinhard Selten
The problem of numerous noncooperative equilibria has generated a

research program aimed at eliminating “uninteresting” Nash equilibria.
The principal idea has been to use stronger conditions not only to reduce
the number of possible equilibria, but also to avoid equilibria that are
unreasonable in economic terms. By introducing the concept of subgame
perfection, Selten (1965, 1975) provided the foundation for a systematic
endeavor. An example might help to explain this concept. Imagine a
monopoly market where a potential competitor is deterred by threats of
a price war. This may well be a Nash equilibrium—if the competitor takes
the threat seriously, then it is optimal to stay out of the market—and the
threat is of no cost to the monopolist because it is not carried out. But the
threat is not credible if the monopolist faces high costs in a price war. A
potential competitor who realizes this will establish himself on the market
and the monopolist, confronted with fait accompli, will not start a price
war. This is also a Nash equilibrium. In addition, however, it fulfills Selten’s
requirement of subgame perfection, which thus implies systematic
Box 4.1
(continued)
formalization of the requirement that only credible threats should be

taken into account.
Selten’s subgame perfection has direct significance in discussions of
credibility in economic policy, the analysis of oligopoly, the economics of
information, and so forth. It is the most fundamental refinement of Nash
equilibrium. Nevertheless, there are situations where not even the require-
ment of subgame perfection is sufficient. This prompted Selten to intro-
duce a further refinement, usually called the “trembling-hand” equilibrium.
The analysis assumes that each player presupposes a small probability that
a mistake will occur, that someone’s hand will tremble. A Nash equilibrium
in a game is “trembling-hand perfect” if it is robust with respect to small
probabilities of such mistakes. This and closely related concepts, such as
sequential equilibrium (Kreps and Wilson 1982), have turned out to be
very fruitful in several areas, including the theory of industrial organiza-
tion and macroeconomic theory for economic policy.
John C. Harsanyi
In games with complete information all of the players know the other
players’ preferences, whereas they wholly or partially lack this knowledge
in games with incomplete information. Since the rationalistic interpreta-
tion of Nash equilibrium is based on the assumption that the players know
each others’ preferences, no methods had been available for analyzing
games with incomplete information, despite the fact that such games best
reflect many strategic interactions in the real world.
This situation changed radically in 1967–68 when John Harsanyi pub-
lished three articles entitled Games with Incomplete Information Played
by “Bayesian” Players. Harsanyi’s approach to games with incomplete
information may be viewed as the foundation for nearly all economic
analysis involving information, regardless of whether it is asymmetric,
completely private, or public.
Harsanyi postulated that every player is one of several “types,” where
each type corresponds to a set of possible preferences for the player and
a (subjective) probability distribution over the other players’ types. Every
player in a game with incomplete information chooses a strategy for each
of his types. Under a consistency requirement on the players’ probability
distributions, Harsanyi showed that for every game with incomplete infor-
mation, there is an equivalent game with complete information. In the
jargon of game theory, he transformed games with incomplete information
into games with imperfect information. Such games can be handled with
standard methods.
Source: Nobel Prize Committee Website.

Subgame perfect Bayesian Perfect Bayesian
Nash equilibrium
equilibrium equilibrium equilibrium
116
• Simultaneous moves • Players move • Simultaneous moves • Players move

Order of sequentially sequentially
• Static game • Static game
moves • Dynamic game • Dynamic game
• Complete information • Perfect information • Incomplete • Incomplete

Each player knows all Players do not know Players do not know
actions taken previously other players’ payoffs other players’ payoffs
Information
set • Almost perfect • Imperfect • Imperfect
information Players have probabilistic Players have probabilistic
At date t, players know beliefs about other beliefs about other
all moves before t –1 players’ type players’ type
• Select dominant • Determine Nash • Players form • Mixed form of

strategies equilibria at each expectation about the perfect and Bayesian
subgame outcome of the game equilibrium
• Eliminate dominated
Model and act accordingly
strategies • Go back to the • Actions are optimal
use beginning (backward
• Determine stable given the beliefs
induction)
(fixed) points among Beliefs are obtained from
possible strategy • Avoid profitable strategies and observed
profiles one-stage deviations actions using Bayes’s rule
Figure 4.2
Chapter 4
Main game theory solution concepts

The subgame perfect, Bayesian, and perfect Bayesian equilibria are essentially refinements of Nash equilibrium. Other solution concepts
include correlated equilibrium and sequential equilibrium.
commitments involve early decisions with a long-term impact that are

costly or difficult to reverse (e.g., they involve substantial fixed or sunk
costs).3 This is the “whole idea” of the Doomsday Machine that cannot
be un-triggered once initiated. The automatic Soviet retaliation is sub-
optimal from the second-stage perspective (annihilation of all human life
on earth) but has commitment value in a dynamic setting provided that
the attacking party is aware of the deterrence device (which was not the
case in Dr. Strangelove). Such strategic commitments differ from tactical
decisions that can be easily reversed.
According to Schelling (1960), for a strategic move to have commit-
ment value it must be:
Observable Rivals must be aware of the committing party’s strategic

move before making their own decision. The Doomsday Machine could
not impact on General Ripper’s decision since he was not aware of its
existence.
Understandable The commitment should affect the incentives of the
opponent. The strategic move must be able to change the ex post choices.
Credible A strategic decision has little commitment value if an
announcement is perceived as a bluff. Credibility influences the rival’s
estimation whether the committing party is willing to carry through what
it has stated regardless of circumstances.
Costly to reverse For a move to be credible, it must be hard, costly, or
impossible to reverse once set in motion. This typically involves substan-
tial sunk costs for the committing party.4
Credibility is crucial. Dixit and Nalebuff (1991) enumerate eight devices
for achieving credibility (coined the “eightfold path to credibility”).5
These are summarized in table 4.1.
Ex ante commitments can significantly alter ex post incentives, alto-
gether affecting the outcome of strategic interactions in dynamic games.
A classic case is when an incumbent can deter rival entry to protect its
own market by building overcapacity (e.g., see Spence 1977, 1979, or
Dixit 1980).6 When firms commit, they do not only anticipate the direct
3. If firm i were to announce it will pursue action b but later it may choose to implement
alternative action a —that is optimal from a simultaneous-game perspective—its announce-
ment will be seen as “cheap talk” and will be of little strategic value.
4. Sunk costs are significant when the ex post value of the investment outlay is significantly
lower. In the case of sunk investment with low or no salvage value, there is effectively no
option to abandon. This may be the case with relationship- or industry-specific assets.
5. See Dixit and Nalebuff (1991, pp. 142–67).
6. In the first stage, the incumbent can choose excessively high capacity (higher than the
second-stage optimal capacity) to deter entry by potential entrants.
118 Chapter 4
Table 4.1
Paths to credible commitment
Basic concept Credibility device
Make it costly to break your (1) Establish and use a reputation (bluffing may be
commitment costly in terms of reputation if revealed; in repeated
games, reputation is crucial and should be carefully
cultivated).
(2) Make contracts (agree on punishment if the
announcement is not followed through).
Limit the options to reverse (3) Cut off communication (e.g., seal off the base as
actions General Ripper did).
(4) Burn bridges behind you (deny yourself the
opportunity to retreat or to reverse your action).
(5) Leave the outcome beyond control (i.e., provide
automatic response to your rivals’ action). This was
the “whole idea” behind the Doomsday Machine.
Engage in a repeated (6) Move in small steps (build up a reputation of
relationship carrying through with your announcement via
repeated relationships rather than one-time
agreements).
Build credibility on others (7) Develop credibility through teamwork (individual
weaknesses can be resolved by forming groups, peer
pressure)
(8) Employ negotiating agents (agents have the
permission to negotiate up to a point).
Source: Adapted from Dixit and Nalebuff (1991).
effect of the commitment (e.g., direct cost savings from investment) but
also what will be the ex post strategic impact on rivals, called the strategic
effect. Under uncertainty there is a trade-off between this positive stra-
tegic value of early commitment and the flexibility to wait to invest.
Strategic commitment kills one’s option to wait, but it can make the firm
better off due to strategic interactions. It is thus of critical importance to
closely examine the trade-off between flexibility and commitment in an
integrated framework under uncertainty (considered in chapter 7).
4.1.2 Taxonomy of Commitment Strategies
Fudenberg and Tirole (1984) extend the theory on strategic commitment,

introducing a new classifying scheme for business strategies.7 They
7. The following taxonomy is based on Tirole (1988), who complements Fudenberg and
Tirole (1984) with elements from Bulow, Geanakoplos, and Klemperer (1985). The termi-
nology “strategic substitutes” and “strategic complements” was not used in the original
paper (of 1984). The names for the four main business strategies are unchanged. We col-
lectively refer to this work as Fudenberg and Tirole (1984) thereafter, although parts are
more directly based on Tirole (1988, pp. 323–28).
identify four main business strategies: top dog strategy, puppy dog ploy,
lean and hungry look, and fat cat strategy. These are closely linked to the
type (and sign) of the strategic effect brought about by the strategic com-
mitment. This strategic effect ultimately depends on whether the (ex post)
actions are strategic complements or substitutes, and whether the commit-
ment makes the firm tough or soft.8 We discuss next a firm’s incentive to
be tough or soft and present Fudenberg and Tirole’s taxonomy.
Entry Strategies
Standard competition models (e.g., Cournot, Bertrand) assume that the
number of firms in an industry is given exogenously. In reality the number
of firms may be endogenous and driven, for example, by the magnitude
of fixed entry costs. If there are low or no barriers to entry and exit and
incumbents make excess profits, other firms will contemplate entry to
take a slice of the pie. In such a contestable market, economic profits will
be forced down to zero. Excess profits may be sustainable if there exist
significant barriers to entry and exit. Bain (1956) initiated the study of
entry barriers, distinguishing three entry types: blockaded, deterred, and
accommodated. Fudenberg and Tirole (1984) build on this framework to
examine commitment strategies. The authors disregard the case of block-
aded entry, since it is an exogenous state that cannot be altered by
incumbents. They focus instead on entry-barrier erection strategies, spe-
cifically on deterred and accommodated entry.
For simplicity, consider two players: firm i is the incumbent and firm
j a would-be entrant. In the first stage, firm i may commit by incurring
a sunk investment outlay, K i. In the second stage, both firms compete
(deciding simultaneously) over tactical or short-term variables α i and
α j (e.g., prices).9 Firm i’s profit p i ( K i , a i , a j ) depends on the investment
commitment Ki and later action choices α i and α j.10 Under perfect
information, the relevant solution concept is the subgame perfect Nash
equilibrium. In subgame perfect equilibrium, firms’ second-stage
actions, α i* ( K i ) and α j* ( K i ), must form a Nash equilibrium for commit-
ment choice Ki. The first-stage strategic investment thus affects
ex post equilibrium choices; that is, the second-stage actions are func-
tions of the first-stage investment.11 Firm i can deter entry (entry
8. Smit and Trigeorgis (2001) use the terms “aggressive” versus “accommodating” instead
of “tough” versus “soft.”
9. If the two firms choose their actions simultaneously, the outcome will be, for example,
that of Cournot quantity or Bertrand price competition.
10. π i(⋅, ⋅, ⋅) and π j (⋅, ⋅, ⋅) are twice continuously differentiable with respect to α i and α j , and
concave in one’s action. π i(⋅, ⋅, ⋅) is concave in K i .
11. α i* (⋅) and α j * (⋅) are differentiable in K i .
120 Chapter 4
deterrence) if its investment Ki prevents firm j from making profits in

the second stage:
π j ( Ki , α i* ( Ki ) , α j * ( Ki )) ≤ 0.
Firm i accommodates entry (entry accommodation) if, despite commit-
ting, it allows its rival to make profits:
π j ( Ki , α i* ( Ki ) , α j * ( Ki )) > 0.
To analyze the strategic impact, we need to consider the total derivative
(total effect) of firm i’s equilibrium profit, π i, with respect to the first-
stage strategic commitment, Ki, namely
dp i ⎛ ∂p i ⎞ ⎛ ∂p i da i * ⎞ ⎛ ∂p i da j * ⎞
=⎜ ⎟ +⎜ ⎟+ . (4.1)
dKi ⎝ ∂Ki ⎠ ⎝ ∂a i dKi ⎠ ⎜⎝ ∂a j dKi ⎟⎠
The total derivative for firm j’s profit is obtained symmetrically. Business
strategies may differ depending on whether entry is deterred or
accommodated.
Deterred Entry
As noted, firm i’s commitment strategy is driven by its rival’s profit (π j).
We must thus consider the total derivative of π j with respect to Ki to
determine firm i’s optimal first-stage investment policy. Since in the
second stage firm j will select its action α j optimally (∂π j ∂α j = 0), the
third term in the total derivative of firm j’s profit—the symmetric version
of equation (4.1) above—drops out. This leads to
dπ j ⎛ ∂π j ⎞ ⎛ ∂π j dα i * ⎞
= ⎜⎝ ⎟ +⎜ ⎟.
dKi ∂Ki ⎠ ⎝ ∂α i dKi ⎠ (4.2)
(total (direct (strategic
effect) effect) effect)
Firm i’s first-period strategic investment, Ki, has several value effects.
First, it has a direct impact on firm j’s profit value, ∂π j ∂Ki ; this is the
direct effect. For instance, if firm i acquires all scarce resources in the first
stage, firm j cannot operate and make any profit; this is a positive direct
effect. In many cases, however, this effect is negligible. This is the case
when firm i invests in a process innovation that does not improve firm
j’s cost position (no spillover). The second term, ∂π j ∂α i × dα i* dKi ,
represents the strategic effect of the commitment. It results from firm
i’s ex post behavioral change due to its own commitment (dα i* dKi ) and
from the impact of this behavioral change on firm j’s profit (∂π j ∂α i ).
The total effect of the strategic investment is the sum of the direct and
the strategic effects.12
To determine what commitment strategy to follow, we further need to
discuss tough as opposed to soft commitment. These two concepts are
meant to capture whether a commitment by one firm places its rival at
an advantage (benefits them) or at a disadvantage (hurts them). Firm
i makes a tough commitment if the rival, firm j, is hurt, meaning
dπ j dKi < 0. Such an announcement is bad news for the competitor. In
this case firm i should overinvest in the first stage to hurt its rival and
deter entry.13 Fudenberg and Tirole (1984) coin this approach “top dog”
strategy because it consists in “being big or strong, to look tough or
aggressive.”
On the contrary, an early investment is a soft commitment if the rival
benefits from it, meaning if dπ j dKi > 0. If firm i commits or invests too
much in the first stage (Ki is high), entry will hardly be deterred since π j
will be increased. Firm i should then underinvest to deter entry, as part
of a “lean and hungry look” strategy. Whether one of the two approaches
is advisable also depends on the trade-off between the sunk investment
commitment cost and the value increment resulting from the direct and
strategic effects in equation (4.2). A general recommendation cannot be
readily formulated.
12. Fudenberg and Tirole (1991, pp. 132–33) propose an alternative, more technical inter-
pretation of equation (4.2) based on the notion of open-loop and closed-loop strategies.
Open-loop strategies depend only on calendar time but not on the actions previously played
in the dynamic game. Dynamic games where firms can only adopt open-loop strategies are
in a way static since firms cannot react optimally to previous plays by rivals. Closed-loop
strategies allow this since they take account of previous moves as well. In this setting, the
key difference between these two notions depends on whether the first-stage strategic
move by firm i is effectively communicated to firm j when the latter decides to act. The
direct effect in equation (4.2) refers to the first-order optimality condition in the open-loop
strategy case (open-loop equilibrium), whereas the second term (strategic effect) only
exists if firms observe their rival’s first-stage strategic moves, that is, if they can devise
closed-loop strategies. In Dr. Strangelove, the existence of the Doomsday Machine has no
strategic effect since General Ripper was not aware of it; that is, he could not formulate a
closed-loop strategy and act optimally (i.e., not attack the Russians) given this information.
We come back to the notions of open-loop versus closed-loop strategies (and the corre-
sponding equilibrium concepts) in later chapters.
13. The notion of “overinvestment” (and later of “underinvestment”) is defined with
respect to the benchmark case where firms cannot formulate closed-loop strategies, namely
where the strategic move is of no commitment value since firm j does not take its (second-
stage) action based on the information conveyed by the commitment. The difference
between the subgame perfect equilibrium outcome (in closed-loop strategies) and the Nash
equilibrium (in open-loop strategies) is captured by the strategic effect. This term fully
reflects the incentive to under- or overinvest.
122 Chapter 4
Accommodated Entry
If deterring entry is too costly or infeasible, firm i may accommodate
entry instead. This friendlier stance still leaves room for strategic behav-
ior because firm i can make an early move that enhances its position in
the (ex post) product market competition stage. Contrary to the case of
entry deterrence, firm i considers here its own profit function (not
its competitor’s) when it devises its business strategy. We thus look at
the total derivative of firm i’s own profit (π i) with respect to its invest-
ment Ki,
dπ i ⎛ ∂π i ⎞ ⎛ ∂π i dα i * ⎞ ⎛ ∂π i dα j * ⎞
=⎜ ⎟ +⎜ ⎟+ .
dKi ⎝ ∂Ki ⎠ ⎝ ∂α i dKi ⎠ ⎜⎝ ∂α j dKi ⎟⎠
Since firm i selects action α i as part of a Nash equilibrium in the second

stage, ∂π i ∂α i = 0 so the expression above simplifies to
dπ i ⎛ ∂π ⎞ ⎛ ∂π dα j * ⎞
= ⎜ i⎟ + ⎜ i .
dKi ⎝ ∂K i ⎠ ⎝ ∂α j dKi ⎟⎠ (4.3)
(total (direcct (strategic
effect) effect) effect)
The first (right-hand) term in equation (4.3) is the direct effect of
the investment on firm i’s own profit, ∂π i ∂Ki . This effect occurs even
if the rival does not observe the strategic move. Since sequential
strategic interaction has no impact on the direct effect, we set it aside as
irrelevant from a strategic viewpoint. The last term, ∂π i ∂α j × dα j * dKi ,
is the strategic effect. If this is positive, firm i should overinvest to
increase its total (gross) value. If this strategic effect is negative, the firm
should underinvest instead. Thus the strategic effect provides guidance
whether to over- or underinvest. Its sign depends on:14
14. Note that
∂π i dα j ∗ ⎛ ∂π i ∂α j ∗ ⎞ dα i ∗
= .
∂α j dKi ⎜⎝ ∂α j ∂α i ⎟⎠ dKi
If the two reaction functions are both downward or both upward sloping,
⎛ ∂ π dα j * ⎞ ⎛ ∂ π j dα i * ⎞ ⎛ ∂α j * ⎞
sign ⎜ i = sign ⎜ × sign ⎜
⎝ ∂α i dKi ⎟⎠ ⎝ ∂α i ⎠⎟
.
⎝ ∂α j dKi ⎟⎠
The last term, ∂α j * ∂α i , captures the effect of a change in firm i’s action α i on firm j’s best
reply. Its sign depends on whether the actions are strategic complements (positive sign) or
substitutes (negative). The first right-hand term is the strategic effect in (4.2) for the entry-
deterrence case. Ignoring the direct effect, its sign depends on whether the firm faces tough
(negative sign) or soft commitment (positive sign).
Strategic substitutes Strategic complements

(∂a *
j ∂a i < 0) (∂a *
j ∂a i > 0)
Tough investment Positive Negative

( dp j dKi < 0) strategic effect strategic effect
Soft investment Negative Positive

( dp j dKi > 0) strategic effect strategic effect
Figure 4.3
Sign of the strategic effect
1. whether firm i’s strategic commitment (Ki) hurts (tough investment)

or benefits (soft investment) its rival firm j (see the sign of dπ j dKi );
2. whether firms react to each other in a reciprocating (strategic
complements or ∂D j* ∂D i > 0) or a contrarian (strategic substitutes or
∂D j* ∂D i < 0) manner.
This analysis can be represented by the two-by-two matrix of figure 4.3.

Consider a different situation involving two incumbents where firm i
would like firm j to exit the market. Firm i would design its commitment
strategy to hurt firm j, considering the first-order (total) derivative of its
rival’s profit, dπ j dKi . This case is equivalent to the entry-deterrence
case discussed above.
Choosing Commitment Strategies

Following our previous discussion, we can differentiate among four
main business strategies. These rest on (1) whether the investment is
intended to be tough or soft, and (2) whether firms behave in a con-
trarian (substitutes) or reciprocating (complements) way. The objective
of the firm in each of the four strategies is to induce the rival to
behave less aggressively. The four main business strategies are summa-
rized in figure 4.4 in case of deterred entry (figure 4.4a) and of accom-
modated entry (figure 4.4b). The four business strategies are discussed
next:
Top dog strategy Two cases are distinguished. In the entry-deterrence

case (figure 4.4a) this means overinvesting when the investment is tough
to ensure that the rival will renounce entering the market (earning zero
profit). In the accommodated-entry case (figure 4.4b), it means
124 Chapter 4
Tough Top dog

investment strategy
Soft Lean and hungry

investment look
(a)
Strategic Strategic
substitutes complements
(Cournot quantity (Bertrand price
competition) competition)
Tough Top dog Puppy dog

investment strategy ploy
Soft Lean and hungry Fat cat

investment look strategy
(b)
Figure 4.4
Four main business strategies
(a) Deterred entry; (b) accommodated entry. Adapted from Fudenberg and Tirole (1984).
overinvesting for tough commitment (dπ j dKi < 0) when second-stage

actions are strategic substitutes (∂D j* ∂D i < 0) inducing rivals to back down.
Lean and hungry look In the deterred-entry case (figure 4.4a), this
means underinvesting to be soft or flexible (dπ j dKi > 0), ensuring that
the rival stays out. In the accommodated-entry case (figure 4.4b), this
business strategy is advisable if second-stage actions are strategic substi-
tutes (∂D j* ∂D i < 0) and the investment makes firm i soft, cushioning the
potentially negative strategic effect (see figure 4.3).
Puppy dog ploy In the accommodated-entry case (figure 4.4b), if the
investment makes firm i tough, hurting its rival (dπ j dKi < 0), the rival
will be more aggressive in the second stage as actions are strategic comple-
ments (∂D j* ∂D i > 0). Firm i should then underinvest (stay flexible).
Fat cat strategy In the accommodated-entry case (figure 4.4b), if
second-stage actions are reciprocating or strategic complements
Strategic Strategic
substitutes complements
Tough Submissive Mad

investment underdog dog
Soft Suicidal Weak

investment Siberian kitten
Figure 4.5
Suboptimal business strategies observed in practice (accommodated entry)
Adapted from Besanko et al. (2004)
(∂D j* ∂D i > 0), firm i should avoid being aggressive (dπ j dKi < 0), behav-
ing as a “fat cat.”
In the real world some companies sometimes follow suboptimal strate-

gies. Besanko et al. (2004) extend the taxonomy above to include
additional business strategies that have a harmful effect on the commit-
ting firm.15 They identify the following strategies, summarized in
figure 4.5:
Submissive underdog The firm underinvests to accommodate entry

when its commitment is tough (dS j dKi < 0) and actions are strategic
substitutes (∂D j* ∂D i < 0). This strategy is not advisable; the firm should
be a “top dog” instead (overinvest).
Suicidal Siberian Here the firm overinvests in case of strategic
substitutes (∂D j* ∂D i < 0) even though its investment makes it soft
(dπ j dKi > 0), instead of underinvesting to keep a “lean and hungry
look.”
Mad dog The firm overinvests in case of tough commitment
(dπ j dKi < 0) even though actions are strategic complements
(∂D j* ∂D i > 0). It would be better to be a clever, harmless “puppy dog,”
avoiding the negative effect depicted in figure 4.3 (underinvestment).
Weak kitten Here the firm underinvests in case of soft commitment
(dπ j dKi > 0) when actions are strategic complements (∂α j ∂α i > 0). The
“weak kitten” is not mature enough to recognize that it should put on
more weight (overinvest), becoming a “fat cat.”
15. See Besanko et al. (2004, pp. 246–47).
126 Chapter 4
Commitment in Differentiated Bertrand and Cournot Competition

Bertrand and Cournot competition are examples of games where actions
are strategic complements and strategic substitutes, respectively. We
illustrate next application of the four main business strategies in the
context of these benchmark models.
Bertrand Price Competition

Differentiated Bertrand price competition involves reciprocating actions
(strategic complements). If firm i decreases its price, firm j will respond
by following suit, and vice versa. Consider firm i’s reaction function from
equation (3.8):
a (1 − s ) + c s
piB ( pj ) = + pj ,
2 2
where s ∈[0, 1) is the degree of substitutability. We thus have
∂piB ∂pj ( = s 2 ) ≥ 0, confirming that price choices are strategic
complements.
Should firm i invest early in a new technology to attain reduced future
production costs? Firm i could then commit to a price cut, being more
aggressive toward its rival in the later product market stage. This tough
commitment by firm i is detrimental to rival firm j (as dπ j dKi < 0). If
firm i decides to charge a lower price in the second stage, the market-
clearing price will spiral downward since the reaction functions are
upward sloping. For a given level of the rival’s price pj , firm i’s price pi
will be lower, with the reaction curve shifting to the left as depicted in
figure 4.6a.16 Firm j is worse off ex post because it is obliged to reduce
its own price, following a reciprocating reaction. This strategy is not
advisable because the strategic move by firm i will backfire as the stra-
tegic effect (represented in the top-right in figure 4.3) is negative.
Firm i should instead underinvest, maintaining higher prices, to avoid
entering an intensified price war. The optimal business strategy here is
to be a nice “puppy dog.”
In contrast, if investment makes firm i soft (dπ j dKi > 0), the rival will
be less aggressive in the second stage. For a given level of competitor
price pj , firm i optimally charges a higher price pi as a result of this
16. The case before (without) investment is indexed “before,” whereas the case after
investment commitment as “after.” The case “before” corresponds to the open-loop equi-
librium where product-market decisions are taken in ignorance of the rival’s strategic
move, whereas the case “after” refers to closed-loop equilibrium where firms know that
their commitment is recognized in their rivals’ strategy formulation and firms maximize
profits accordingly (subgame perfection).
pj
RiBEFORE(pj)
RiAFTER(pj)
E Rj (pi)
pjBEFORE *
E'
pjAFTER *
piAFTER * piBEFORE * pi
(a)
pj
RiBEFORE(pj)
RiBEFORE(pj)
E' Rj (pi)
pjAFTER *
E
pjBEFORE *
piBEFORE * piAFTER * pi
(b)
Figure 4.6
Tough versus soft commitment in differentiated Bertrand competition
(a) Tough commitment (puppy dog); (b) soft commitment (fat cat srategy)
128 Chapter 4
commitment with the reaction function shifting to the right. The original
price, pj , however, is not on the reaction curve. To reach the Nash equi-
librium, firm j charges a higher price than before. The two firms are
better off due to this accommodating strategy. In this case firm i should
overinvest becoming fatter (fat cat), amplifying the positive strategic
effect (bottom-right in figure 4.3) as much as possible. This is illustrated
in figure 4.6b. An application of “soft” advertising strategy to the German
telecom market is discussed in box 4.2.
Cournot Quantity Competition

To illustrate the importance of tough versus soft commitment in case of
strategic substitutes or contrarian reactions, consider a tough investment
commitment such as an R&D investment in process innovation. This
would enhance firm i’s cost advantage in the Cournot duopoly setting
(section 3.2.2). By contrast, a soft commitment would worsen the cost
differential in favor of the rival, firm j; this would be the case, for instance,
if the firm announces the building up of new, fancy headquarters. The
(inverse) market demand function is linear as per equation (3.1). The
cost functions are also linear. We allow for distinct marginal production
costs, ci and c j (ci , c j < a). As seen from equation (3.13), firm i’s reaction
function in Cournot duopoly is
1 ⎛ a − ci
qiC (q j ) = ⎜ − q j ⎞⎟ . (4.4)
2⎝ b ⎠
Firm i’s reaction function qiC (⋅) is differentiable and decreasing in its own
cost (∂qiC ∂ci = − 1 2b < 0), implying that for a cost increase (soft com-
mitment) the reaction curve shifts to the left, whereas for a cost decrease
(tough commitment) it shifts to the right.
As seen in figure 4.7a, if firm i makes a tough commitment (curve shifts
to the right), then no matter what output its rival produces it will produce
more output (than it would without the commitment). Since quantities
are strategic substitutes, firm j behaves in a “contrarian” way, producing
less in equilibrium than it would have if this investment did not occur.
Ex post profit is higher for firm i if it makes a tough commitment ex ante
(without accounting for the cost involved in the first-stage investment).
This investment has a positive strategic effect and firm i should overin-
vest as in a “top dog” strategy.
By contrast, a soft commitment would lead firm i to produce less than
it would otherwise. The reaction curve now shifts to the left and firm i
produces less after the commitment, while firm j produces more. Firm
Box 4.2
European liberalization, “soft advertising” and the persistence of high prices in the
German telecom market
Fudenberg and Tirole’s (1984) framework can provide powerful insights.

Their framework is particularly useful to help explain how an industry
evolves once liberalization of the market is enforced. In most European
countries certain sectors (e.g., railway, electricity, post and telecommunica-
tions) have long been considered as natural monopolies. Governments
have erected high entry barriers (blockaded entry), believing that com-
petitive entry would be socially detrimental. Presumably there were not
enough room for several firms in these markets to make positive profits
or at least high enough profits to pay for the large fixed infrastructure costs.
In the last two decades a revolution has occurred in Europe. Policy makers
decided to enforce liberalization of these markets, believing that enhanced
competition would result in lower prices and be more beneficial to Euro-
pean consumers. A case in point is the telephone industry in Germany
where Deutsche Telekom, once a formidable monopolist, faces competi-
tive entry from rival companies such as Vodafone, Telecom Italia (Alice),
and other regional companies. Deutsche Telekom has been one of the
world’s leading telecommunication and information-technology service
providers, with an annual turnover of )60 bn a year. Although liberaliza-
tion of the telecommunication sector has taken place many years ago, the
German Federal Network Agency (“Bundesnetzagentur”) must still
wonder why no significant price decreases and market share shifts have
occurred in Germany up to now. This may be partly due to Deutsche
Telekom’s heavy investment in advertising campaigns. Every year Deutsche
Telekom channels nearly 15 percent of its revenues into ads. The telecom-
munication industry is typical of Bertrand price competition. Firms face
no serious capacity constraints and the key purchasing criterion for many
customers is the price. As it is difficult to differentiate among offerings in
the telecommunication industry (with the exception of bundling for the
iPhone), the advertising campaign of Deutsche Telekom was not meant to
build a differentiation advantage. It rather promoted telecommunication
services generally. As such, its ad campaigns have been beneficial to rivals
as well. The massive general advertising investment made by Deutsche
Telekom is soft (benefits its rivals) and rivals have been less aggressive in
second-stage competition. Consequently, despite liberalization, prices for
telecommunication services have not decreased significantly in Germany.
Market shares have not declined dramatically either since customers do
not find it worthwhile to incur switching costs if alternative offerings are
not sufficiently better or cheaper. Still, even though competition is not yet
that fierce, Deutsche Telekom has not taken full benefit since its advertis-
ing campaigns have been quite expensive.
130 Chapter 4
qj
RiBEFORE(qj)
RiAFTER(qj)
qjBEFORE * E
qjAFTER * E'
Rj (qi)
q iBEFORE * qiAFTER * qi
(a)
qj
RiAFTER(qj)
RiBEFORE(qj)
E'
qjAFTER *
qjBEFORE * E
Rj (qi)
qiAFTER * qiBEFORE * qi
(b)
Figure 4.7
Tough versus soft commitment in Cournot quantity competition
(a) Tough commitment (top dog strategy); (b) soft commitment (lean and hungry look
strategy)
i’s investment is beneficial to firm j who is more aggressive in the product

market stage. Firm i should refrain from committing and should thus
underinvest. This “lean and hungry look” strategy is depicted in figure
4.7b. This is what the strategic effect in the case of tough versus soft
commitment for strategic substitutes is about. There is a positive strategic
effect when its strategic investment makes firm i tough. This may domi-
nate even though the direct effect might be negative (e.g., due to sunk
costs). When its investment makes the first-mover soft, there is a negative
strategic effect and firm i should refrain from making this kind of
investment.
Box 4.3 describes entry accommodation in the Italian electricity
market, previously dominated by state monopoly Enel. Overinvestment
in capacity may also result in an alternative model, also famous in indus-
trial organization. It is the duopoly model developed by Stackelberg
(1934) where one of the firms makes an early move selecting its quantity
(i.e., capacity) first, while the second firm selects its own quantity in view
of the leader’s quantity choice. The following section develops the
sequential model by Stackelberg and discusses in which circumstances it
might be useful.
4.1.3 Sequential Stackelberg Game
Heinrich von Stackelberg (1934) proposed a dynamic duopoly model in

which a firm (the leader L) moves first (for whatever reason) and its rival
(the follower F ) follows suit. A key assumption is that the follower
observes the leader’s choice before selecting its own output.
The profit and cost functions are the same as used in Cournot quantity
competition (section 3.2.2). The (inverse) demand function is linear as
given by equation (3.1). Cost functions are also linear, allowing for dis-
tinct marginal costs cL and cF . In the second period, the follower chooses
output qF (≥ 0) to maximize its own profit, given the leader’s observed
quantity choice qL (≥ 0). The leader has no possibility to revise its pro-
duction plan and installed capacity ex post (i.e., it is irrevocably commit-
ted to its announced capacity decision, qL). The subgame perfect Nash
equilibrium of this sequential, finite-horizon game can be obtained by
backward induction. The follower’s optimization problem is to select its
output qF (≥ 0) to maximize its profit:17
π F ( qL , qF ) = [ p (Q) − cF ] qF .
17. The follower’s profit function is differentiable and concave in its own strategic
variable, qF .
132 Chapter 4
Box 4.3
Entry accommodation in the Italian electricity market
As electric utilities are subject to serious capacity constraints in offering

a homogeneous, nonstorable product, they effectively compete over capac-
ity as in Cournot competition. Firms first decide on their installed capacity
base (a long-term decision) and then compete in the short run in prices
under capacity constraints. The Italian electric utility Enel is recently
facing new challenges, having been a protected monopolist in the Italian
marketplace for decades. Since July 2007 the Italian electricity market has
opened up to foreign utilities in the wake of the European Commission
enforcing liberalization across European electricity markets. In the current
environment, traditional frameworks (e.g., SWOT, five-forces analysis, or
generic strategy framework) offer little guidance for Enel executives
about how to deal with the issues they face under uncertainty because they
lack the dynamic perspective necessary to understand market-entry prob-
lems. Fudenberg and Tirole’s (1984) framework of business strategies can
be helpful. The Italian electricity industry was previously blockaded due
to high administrative and other entry barriers. Now Enel cannot rely on
the Italian government to protect its home market from competitive forces
since the government has to toe the line dictated by the European Com-
mission. Even if Enel manages to deter competitive entry (deterred entry),
DG Competition, the European body responsible for implementing and
monitoring adherence to European antitrust law, may intervene. Enel has
one main choice left, to accommodate entry. Of course, Enel may accom-
modate entry but still behave in a way that makes entry less profitable for
potential entrants. In this industry, capacities are strategic substitutes in
that if one firm adds capacity, the optimal reaction of rivals is not to raise
capacities or revise their construction plans to accommodate less capacity.
Being the sole electricity provider in the Italian market (until July 2007),
Enel had the opportunity to make a “first-stage” strategic move to alter
the “second-stage” competition game. Given that investing in new capacity
was perceived as a tough initiative in this setting, Enel had the opportunity
to “over-invest” in capacity over the years to discourage potential entrants
from building new production units. Accommodation was likely a pre-
ferred strategy.
The follower’s reaction function (where superscript S stands for Stack-

elberg) is
1 a − cF
qFS ( qL ) = ⎛ − qL ⎞ .
2⎝ b ⎠
The leader L knows that the follower will choose its output once it
observes its own and will infer the follower’s reaction before determining
its own optimal output. The leader will thus choose its quantity qL so as
to maximize its profit:
π L(qL , qFS ( qL )) = [ p (qL + qFS (qL )) − cL ] qL.

The resulting Stackelberg equilibrium quantities for the leader (L) and
the follower (F ) are given by
⎧qS = a − 2cL + cF ,
⎪ L 2b
⎨ (4.5)
⎪qFS = a + 2cL − 3cF .
⎩ 4b
The Stackelberg equilibrium price, obtained by substituting the equilib-
rium quantity above in (3.1), is
a + 2 c L + cF
pS = . (4.6)
4
The profits for the leader (L) and the follower (F ) in subgame perfect
equilibrium are
⎧ S ( a − 2cL + cF )2
⎪⎪π L = 8b
,
⎨ (4.7)
⎪π S = ( a + 2cL − 3cF ) .
2
⎪⎩ F
16b
In case of cost symmetry between the leader and the follower (cL = cF = c),
the above equilibrium profit expressions simplify to
⎧ S ( a − c )2
⎪⎪S L = (> S C ),
8b (4.8)
⎨
⎪ S ( − c)
2
a 1
S
⎪⎩ F = = S LS (< S ),
C
16b 2
where π C = ( a − c ) 9b is the Cournot profit under cost symmetry given
2
in equation (3.17).
134 Chapter 4
The leader in the above sequential Stackelberg game is better off than
a symmetric Cournot duopolist (S LS > S C). The Stackelberg follower
receives a lower profit than the single-period Cournot duopolist
(S FS < S C ). Moreover the aggregate (total) quantity produced in the
sequential symmetric Stackelberg game (3 4 × (a − c ) b) is higher than
the industry output in symmetric Cournot duopoly (2 3 × (a − c ) b).
Therefore, given the downward-sloping demand, the market-clearing
price is lower in the sequential Stackelberg game. The leader could defer
its output decision to the second period but is better off not to do so.
The profit value of being a leader in the sequential Stackelberg game is
higher than in the simultaneous wait-and-see case, even if the price is
lower. Here the leader is not acting optimally from the second-stage
static (Nash-equilibrium) perspective since its output is not a best
response to the rival’s quantity in the second stage. From a dynamic
perspective, the leader is actually better off, thanks to its commitment to
a certain output. By contrast, the Stackelberg follower produces less than
under symmetric Cournot competition. Since the market price is lower,
the Stackelberg follower makes lower profits than in the Cournot case.
The sequential Stackelberg model provides an example of first-mover
advantage.
In the sequential Stackelberg setting, the follower might have been
better off ignoring the quantity chosen by the leader. Although the leader
is better off communicating its output decision to the follower, it should
be careful not to lose credibility because if the follower suspects “cheap
talk,” it will choose its quantity as if no communication occurred, namely
à la Cournot. The sequential Stackelberg game should thus be interpreted
in light of commitment theory: the leader should follow a “top dog” strat-
egy and overinvest in capacity, with investment costs being fully sunk.
The sequential Stackelberg model is also useful to help assess the
importance of information in multiperson games. In Stackelberg compe-
tition, the firm that knows its rival’s quantity decision (the follower) is
worse off than a firm that ignores this information (Cournot case). Con-
versely, when one gains a competitive advantage by deciding first (e.g.,
regarding capacity choice or market entry), the less-informed party (i.e.,
the leader) is not necessarily worse off. This may justify an early com-
mitment as a sound strategy for a firm even if not all information con-
cerning the market development is known or predictable. But why should
one firm have the possibility to commit and not the other? We discuss
in chapter 12 the timely interplay that occurs when firms compete over
early commitment (e.g., in the case of market entry).
4.2 Bargaining and Cooperation
So far we have discussed models where firms take a noncooperative

stance toward their rivals, ignoring the possibility of more complex or
repeated relationships based on both competition and collaboration. In
reality, however, fierce competition is not the only modus vivendi adopted
by firms in the marketplace. Firms often bargain or cooperate with other
parties, including competitors. Antitrust authorities generally prohibit
formal collaboration (explicit collusion) but may tolerate other forms
(e.g., tacit collusion). Such cooperation between rival firms is not neces-
sarily detrimental to customers. For example, customers may find it
advantageous to be faced with only one technology standard owing to
product externalities. An agreement on common technological norms
(e.g., Blue ray) may be beneficial both to the cooperating firms and to
the end consumers. Real-world competition calls for analytic models that
can better explain this kind of complex strategic interactions observed
in the marketplace. We discuss in turn bargaining and (tacit) collusion in
repeated games.18
4.2.1 Bargaining
Bargaining problems are treated as dynamic games under complete or

incomplete information. They are solved using solution concepts suited
to a multistage setting (e.g., subgame perfection or perfect Bayesian
equilibrium). Here we use subgame perfect equilibrium strategy profiles
under perfect information. When reasoning backward, one needs to con-
sider the time value of money (discounting) and the trade-off between
reaching an agreement today or continuing bargaining. The “patience”
of the bargaining parties is thus a key factor in negotiations. The bargain-
ing process can be limited in time (finite horizon) or continue indefinitely
until parties reach an agreement (infinite horizon).
Consider first a simple example of bargaining to help identify the key
drivers. A typical problem is how to split a pie among players. Ståhl
(1972) discusses such a model for finite horizon, and Rubinstein (1982)
extends it to infinite horizon.19 Suppose that two firms “bargain” over
market shares in the marketplace. One of the two firms (the bargaining
18. We discuss bargaining and tacit collusion in sequence owing to some similar economic
interpretations. We do not mean to suggest that the theory of repeated games is built upon
bargaining games. In fact sustainability of cooperative behavior in infinitely repeated
games can be established directly by using so-called grim-trigger strategies.
19. We here follow the treatment by Shaked and Sutton (1984) and Gibbons (1992).
136 Chapter 4
leader L) is allowed first to make a proposal to the follower (e.g., due to

its technological edge or market power). Subsequently the follower (F )
may make a proposal as roles are reversed. The slice (as a percentage of
the total market value) that accrues to the leader (L) is denoted by si
where subscript i stands for firm i that makes the proposal; the follower
(F ) receives the remaining slice, 1 − si. In the first period, the leader (L)
proposes the following deal to the rival: the leader takes sL (%) of the
pie (0 ≤ sL ≤ 1), with the follower (F ) receiving 1 − sL. The follower may
either accept the proposed deal or refuse it. If F rejects the proposal, it
may in turn make a new offer: the leader takes sF and the follower 1 − sF .
The leader may accept it or not. If no agreement is reached after two
negotiation rounds, an exogenously given settlement is applied: the
leader receives s (%) and the follower 1 − s (0 ≤ s ≤ 1). The extensive form
of this sequential bargaining game is depicted in figure 4.8. Over the
bargaining process, firms have a certain degree of “impatience” captured
by a common discounting factor δ (0 ≤ δ < 1). Note that δ ≡ 1 (1 + k ),
where k (k > 0) is the appropriate discount rate. Discounting future
payoffs at a higher discount rate gives the players an incentive to reach
an agreement earlier. We can conjecture that the equilibrium slicing is
Follower
Follower
Leader
Leader
Nature
t
( s, 1 − s )
jec
re
t
ec
rej
acce
sF
pt
(sF , 1 − sF )
accep
sL
t
( sL , 1 − s L )
Decision maker Leader Follower Follower Leader (Nature)
Decision time 1 2 3 4 5
Real time 1 2 3
Figure 4.8
Extensive form of the bargaining game under complete information
Here ( si , 1 − si ) are the payoffs to the leader and the follower, respectively. Two time refer-
ences are considered: the order of the play (decision time) and the real time at which
agreements (or settlement) may occur. Discounting relates to the second dimension.
affected by the magnitude of the discount rate since a later ( 1) settle-

ment has lower present value.
In such a sequential game with perfect information and a finite horizon,
the subgame perfect equilibrium is found backward. At decision time 4,
the leader may either accept the follower’s proposal, receiving sF today,
or reject it, receiving the exogenous amount s in the last period. This
latter settlement is worth δ s today (at real time 2). The leader will accept
the offer sF if sF ≥ δ s.20 What is the follower’s best continuation strategy
from decision time 3 onward, when the leader acts optimally in the sub-
sequent period? The follower (F ) faces this decision if it rejects the offer
made by the (bargaining) leader previously. The follower may construct
the offer (at decision time 3) in two alternative ways:
Deal A The leader accepts the offer. In this case, the follower is
better off offering the minimum acceptable level for the leader, namely
sF * = δ s, instead of any higher share. The follower would then receive a
slice of 1 − sF * = 1 − δ s (at real time 2).
Deal B The leader rejects the offer. In this case, the follower receives
1 − s at the last stage, worth δ (1 − s ) today (at real time 2). The leader
receives δ s (at real time 2).
When selecting between the two alternative deals, the follower considers
the relative value of 1 − δ s (deal A) versus δ (1 − s ) (deal B). For
0 ≤ δ < 1, we have 1 − δ s > δ (1 − s ). The optimal deal at decision time 3 is
deal A, where follower F proposes δ s to its rival who accepts it. The
follower would then earn 1 − δ s.
One step earlier (at decision time 1), the leader may design its pro-
posal in a similar manner:
Deal C The follower accepts the offer. F then receives 1 − sL.

Deal D The follower refuses the offer. The follower then proposes a
new settlement. As determined above, L would then receive δ s at real
time 2, which is worth δ 2 s at real time 1. F receives the present (real time
1) value of 1 − δ s, meaning δ(1 − δ s ).
The follower will not accept the offer unless it receives a higher value
than otherwise. In other words, firm F accepts if 1 − sL ≥ δ (1 − δ s ). The
leader would optimally retain for itself the maximum acceptable amount,
20. We assume that if a firm is indifferent between the present values of the two different
deals, it will select the proposal made first. This assumption enhances the model readability
but it can be relaxed.
138 Chapter 4
which is sL * ≡ 1 − δ (1 − δ s ) = 1 − δ + δ 2 s (≥ δ 2 s ). Both parties will thus

accept the equilibrium pie sharing ( sL*, 1 − sL*) at the outset.
The three-period model above is rather simplistic and not descriptive
of many real-world bargaining situations. In reality, although decision
times are discrete, firms sometimes bargain over a longer period until an
agreement is reached. In such a setting one can truncate the infinite-
horizon problem, leveraging on the earlier three-period setup. Previously
the final settlement ( s, 1 − s ) required the presence of a third party or
arbiter in the bargaining process. Instead of ( s, 1 − s ) being exogenously
given, suppose that this pie-sharing rule results from another similar
three-period bargaining game. As a result in perfect equilibrium the
bargaining leader’s payoff satisfies s* = 1 − δ + δ 2 s *; hence s* = 1 (1 + δ ).
In the subgame perfect Nash equilibrium for the infinitely repeated
game, the split is
δ ⎞
( s*, 1 − s *) = ⎛⎝
1
, . (4.9)
1+ δ 1+ δ ⎠
This equilibrium result is related to the firms’ “patience” via the discount
factor δ . The bargaining leader is better off receiving a higher share than
its rival.21
A case in point is negotiating a short-sale agreement over a real-estate
property. Suppose that newcomers have decided to acquire a cozy apart-
ment in the city center but stay in a hotel until they find the appropriate
opportunity. Staying in a hotel is costly and increases their opportunity
cost of waiting, resulting in a lower δ . They naturally prefer to find their
ideal apartment early on and avoid paying out rents for a prolonged time.
In bargaining for the apartment, they will likely accept to pay a premium
due to their higher opportunity cost and impatience. The owner of the
apartment may take advantage of the situation and sell the property at
a higher price.
4.2.2 Cooperation between Cournot Duopolists in Repeated Games
We analyzed in section 3.2.2 the classic case where Cournot duopolists

choose their quantity simultaneously in a noncooperative manner. The
simultaneous Cournot competition model rests on the premise that firms
maximize their short-term profit. This leads to a situation where even
21. If the follower suffers from delay, it is more likely to accept the deal offered by the
leader earlier as it is costly to wait longer for a more lucrative deal. The leader can take
advantage of this, proposing a less attractive deal. This first-mover advantage increases with
higher risk (higher discount rate or lower discount factor). Moreover the values obtained
in equilibrium by the parties decrease with the degree of impatience δ .
though the monopoly outcome would have been preferable for both
firms considered individually, it is never reached as a stable industry
equilibrium (prisoner’s dilemma). This result is based on the debatable
assumption that firms formulate their strategies at the same decision
time regardless of past history and ignoring the long-term impact of
today’s decisions. In real life, firms frequently compete with one another
over an extended period and are faced with recurring competitive situ-
ations over multiple stages. This kind of strategy setting may be captured
by repeated games or supergames.22 Box 4.4 provides a real-world example
of collusion in the German retailing market.
Here we sketch a refinement of the Cournot model to examine how
repeated strategic interactions may alter the equilibrium play.23 We again
consider duopolist firms facing linear demand as in equation (3.1) and
symmetric production cost, c. The Nash equilibrium for a duopolist in
the standard symmetric Cournot setup, obtained in equation (3.14), is
qC = ( a − c ) 3b, with total industry output being QC = 2 (a − c ) 3b. This
industry output in Cournot duopoly is higher than in monopoly
(QC ≥ QM). The price, however, is lower. Clearly, the two firms would be
better off setting jointly their aggregate production equal to the monop-
oly quantity (QM). However, in the standard Cournot model, each player
has an incentive to deviate from the collusive quantities (QM 2 , QM 2).
Eventually Nash equilibrium quantities (qC , qC ) that are not jointly
optimal are chosen.
In infinitely repeated games, however, the desirable cooperative equi-
librium (QM 2 , QM 2) may be sustainable under certain conditions.
Friedman (1971) considers such a duopoly game where the market is
assumed in a steady state.24 In each period, each duopolist makes a tacti-
cal decision on the quantity to supply to the market. In this repeated
game, duopolists end up being better off if they behave as follows:
22. In simultaneous games, firm actions maximize short-term profits. This mechanism
explains why the collectively optimal outcome is not necessarily reached as a (stable) Nash
equilibrium. In multistage games, a firm may have an incentive to cooperate if a (tacit)
agreement may create a favorable platform for future higher profits. Even though a firm
would earn a higher short-term profit by deviating from the collusive agreement, it will not
be enticed to do so if it values future collaborative profits more. The long-term benefits
gained from a tacit agreement may offset the short-term gains from behaving selfishly.
Infinitely repeated games can result in collaborative behaviors being sustainable in situa-
tions where sufficiently patient firms act in their own interest.
23. We do not intend to give an advanced account of repeated games here. For a compre-
hensive treatment of repeated games, reputations, and long-run relationships, see Maileth
and Samuelson (2006). A good treatment of repeated games is also given in Fudenberg
and Tirole (1991, ch. 5).
24. Growth is here assumed zero, so there is no need to account for the interplay between
growth and discounting.
140 Chapter 4
Box 4.4
Suspected collusion in the German retailing market
German Antitrust Authorities Investigate Mass Retailers

S. Amann and F. Ott, Spiegel Online
German antitrust officials are currently probing some of the country’s

largest supermarkets and retailers over suspected cases of price fixing on
chocolate—both at the production and resale levels. Investigators believe
as many as 24 companies set illegal minimum prices on products.
On Thursday morning, German antitrust investigators launched a sur-
prise search of the offices of some of the biggest names in the country’s
retail sector. A total of 56 German Cartel Office employees and 62 police
officers visited the offices of retail giant Metro, Germany’s largest super-
market chains, including Edeka, Rewe, and Lidl, as well as the drug store
chain Rossmann and pet supply store Fressnapf. Authorities also visited
the offices of chocolate bar-maker Mars.
Investigators have evidence that a total of 24 companies may have ille-
gally agreed to price-fixing deals on coffee, sweets, and pet food. They
believe millions of consumers may have paid more for these goods than
they should have.
For industry observers, however, the raids were less surprising. Late last
year, the Federal Cartel Office imposed )160 million ($233 million) in
fines against coffee producers Melitta, Dallmayr, and Tchibo for entering
into a secret agreement to coordinate price increases. American food
conglomerate Kraft was also involved but avoided penalty because it
turned itself in and cooperated with the competition authority during the
investigation. Both Tchibo and Melitta have contested the fines, and the
case is expected to go before the higher regional court in Düsseldorf. . . .
But it is also clear that the agency has been investigating some of the larger
players in the field over other products for some time now.
Industry expert Roeb says it’s not surprising that investigations are
now focused on makers of sweets following the coffee investigations.
“Certain product groups are particularly prone to price fixing,” he says.
There are high fluctuations in commodity prices, there’s a relatively small
number of countries that can produce the commodities and the number
of producers is limited. “That makes the market clear and manageable,”
he says.
Attractive for All Involved
What’s new in the current investigation, however, is the suspicion that both
producers and retailers may have agreed to price fixing. “The vertical price
fixing is unique in this case,” Cartel Office spokesman Kay Weidner said.
Companies are allowed to set recommended prices, but it is illegal to agree
Box 4.4
(continued)
to concrete prices. Antitrust investigators believe the 24 companies came

to a deal on a minimum price for products. If the allegations are true, it
would mean that both traders and companies adhered to that agreement,
thus violating German competition law.
Such agreements are, of course, attractive for all involved as they guar-
antee both producers and retailers reliable prices and higher profits. Such
arrangements are additionally attractive for retailers in that they can boost
the sales of their own brands. “Merchants can price their own brands
below the agreed-upon prices for name brands without the fear that the
name brand prices will follow,” said one branch insider . . .. Those familiar
with the market are convinced that the Cartel Office wanted to set an
example. “With today’s investigation, we wanted to make it clear that
vertical price fixings are also in violation of antitrust law,” said Cartel
Office spokesman Weidner.
A 2000 law allowing for those involved in price fixing to turn state’s
evidence and thus avoid penalty—a regulation recently taken advantage
of by Kraft Foods—is giving antitrust regulators a boost.
One measure of the Cartel Office’s recent success is the value of fines
it has levied from year to year. In 2006, the antitrust authorities collected
just )2.5 million in fines. In 2007, however, that number exploded to )114
million before almost tripling in 2008 to )317 million. In 2009, following
the penalties handed down to the coffee producers, the Cartel Office
brought in over )400 million.
Such statistics are good news for those companies not involved in price
fixing. And for consumers. According to German consumer protection
groups, coffee drinkers in Germany paid a total of )4.8 billion too much
for their morning jolt of caffeine from 2000, when the coffee producers
began colluding, until the three companies were first searched in July 2008.
Price Fixing Probe: German Antitrust Authorities Investigate Mass Retail-

ers by Susanne Amann and Friederike Ott reprinted with permission from
SPIEGEL Online. Publication date: January 15, 2010.
1. Agree to produce half the monopoly quantity if the other player also
produces half.25
2. Deviate from the (tacit) agreement and produce the Cournot–Nash
quantity forever if the other player deviates. This aggressive stance is the
(harsh) punishment from having deviated in the first place.
25. This assumes that (QM 2 , QM 2 ) is already the industry state at the outset.
142 Chapter 4
Such behavior relates to tit-for-tat or trigger strategies. Such strategies

are also observed in nature, as discussed in box 4.5. This strategic stance
is a translation of the biblical saying “an eye for an eye, a tooth for a
tooth.” It supposes that fair behavior by one player induces fairness
by the other, and vice versa. Under monopoly, the equilibrium quantity
is QM = ( a − c ) 2b and profit equals π M = (a − c ) 4b. In the standard
2
Cournot duopoly game, firms earn a profit π C = ( a − c ) 9 b in equilib-

2
rium. If firms behave cooperatively, such as by following a tit-for-tat

strategy, they each produce QM 2 = (a − c ) 4b, earning π M 2 = (a − c ) 8 b
2
at each stage. If firm i sticks to the tacit agreement and produces QM 2

while firm j deviates, the optimal quantity for firm j obtains by solving
⎡ ⎛ QM ⎞ ⎤ ⎛ QM ⎞
max ⎢ p ⎜ + q j ⎟ − c ⎥ q j = max ⎜ a − bq j − b − c⎟ q j .
q j ≥0 ⎣ ⎝ 2 ⎠ ⎦ q j ≥ 0 ⎝ 2 ⎠
When deviating, firm j would optimally produce q D = q j* = 3 (a − c ) 8b,

earning profit π D = 9 (a − c ) 64b. In the aftermath, however, firm j would
2
compete forever à la Cournot, receiving Cournot duopoly profit π C each

period. Since π D > π M 2 > π C , firm j has an incentive to deviate in the
short run. However, it must also assess the long-term negative effect of
this deviation. We next analyze this trade-off. The value of cooperating
forever is
∞ ∞
⎛ πM ⎞ πM 1 ⎛ πM ⎞
t
∑ ⎛⎝ 1 + k ⎞⎠
1
C ≡ ∑δ t ⎜ = = .
t =0
⎝ 2 ⎟⎠ 2 t =0 1 − δ ⎜⎝ 2 ⎟⎠
Alternatively, if the firm deviates this period and operates in Cournot

duopoly forever thereafter, it receives the present value:
∞ ∞ t
δ ⎞ C
D ≡ π D + ∑ δ tπ C = π D + π C ∑ ⎛
1 ⎞
= πD + ⎛ π .
t =1 t =1
⎝ 1 + k ⎠ ⎝ 1 − δ⎠
For tacit cooperation to sustain itself in each period, the following condi-
tion must hold: C > D, or
⎛ 1 ⎞ π > π D + ⎛ δ ⎞ πC.
M
⎝ 1−δ ⎠ 2 ⎝ 1−δ ⎠
Considering the given profit values π C , π M, and π D, the condition

above holds if δ > 9 17 or k < 8 9. So once again we confirm that the
degree of impatience or the opportunity cost of waiting (which is exog-
enous to the firms’ decisions) affects critically the sustainability of coop-
erative behavior. In industries characterized by high riskiness (high k
Box 4.5
Repeated prisoner’s dilemma and tit for tat in nature
Tit for Tat

Chris Meredith, Australian Broadcasting Co.
Long before humans started playing games, natural selection discovered

the fundamentals of game theory and shaped animal societies according
to its rules. Within species, individuals adopt alternative competing strate-
gies with frequencies that reflect the success of each strategy . . .. However,
cooperation within and between species has generated only one strategy,
tit for tat . . .
You Scratch My Back . . .
Evolutionary biologists have had considerable trouble explaining the evo-

lution of cooperative behavior. The problem is that cooperation can always
be exploited by selfish individuals who cheat. It seems that natural selec-
tion should always favor the cheats over the cooperators. Co-operation
involves doing and receiving favors, and this means that the opportunity
to cheat and not return a favor is a very real possibility. Trivers (1971)
tackled this problem and developed the theory of reciprocal altruism
based on the idea that cooperation could evolve in species clever enough
to discriminate between cooperators and cheats. The concept is summa-
rized in the saying “you scratch my back and I’ll scratch yours.” Trivers’s
theory of reciprocal altruism is particularly successful in explaining human
behavior because reciprocal altruism is a major part of all human activities
. . .. [it] was an important advance in our understanding of the evolution
of cooperation, but it was a “special theory” rather than a “general theory.”
The discovery of how cooperative behavior could evolve in species far less
intelligent than humans came in a surprising way—from a detailed study
of the well-known paradox “the prisoner’s dilemma.”
The Prisoner’s Dilemma
The prisoner’s dilemma refers to an imaginary situation in which two

individuals are imprisoned and are accused of having cooperated to
perform some crime. The two prisoners are held separately, and attempts
are made to induce each one to implicate the other. If neither one does,
both are set free. This is the cooperative strategy available to both prison-
ers. In order to tempt one or both to defect, each is told that a confession
implicating the other will lead to his or her release and, as an added incen-
tive, to a small reward. If both confess, each one is imprisoned. But if one
individual implicated the other, and not vice versa, then the implicated
partner receives a harsher sentence than if each had implicated the other.
The prisoner’s dilemma is that if they both think rationally, then each
one will decide that the best course of action is to implicate the other
although they would both be better off trusting each other. Consider how
144 Chapter 4
Box 4.5
(continued)
one prisoner thinks. If his partner fails to implicate him, then he should
implicate his partner and get the best possible payoff. If his partner has
implicated him, he should still “cheat”—since he suffers less than if he
trusts his partner. However, the situation is more complicated than this
analysis suggests. It is fairly obvious that the players’ strategic decisions
will also depend on their likelihood of future encounters. If they know that
they are destined never to meet again, defection is the only rational choice.
Both individuals will cheat and both will end up relatively badly off. But
if the prisoner’s dilemma is repeated a number of times, then it may be
advantageous to cooperate on the early moves and cheat only toward the
end of the game. When people know the total number of games of pris-
oner’s dilemma, they do indeed cheat more often in the final games.
Robert Axelrod was interested in finding a winning strategy for repeated
prisoner’s dilemma games. He conducted a computer tournament. The
result of the tournament was that the simplest of all strategies submitted
attained the highest average score. This strategy, called tit for tat, had only
two rules. On the first move cooperate. On each succeeding move do what
your opponent did the previous move. Thus tit for tat was a strategy of
cooperation based on reciprocity . . ..
Tit for Tat
These results provide a model for the evolution of cooperative behavior.

At first sight it might seem that the model is relevant only to higher
animals that can distinguish between their various opponents. If so, tit for
tat would simply be Trivers’s theory of reciprocal altruism restated. But tit
for tat is more than this and can be applied to animals that cannot recog-
nize each other—as long as each individual starts cooperative encounters
with very minor, low-cost moves and gradually escalates as reciprocation
occurs . . .. Four features of tit for tat emerged:
1. Never be the first to defect.
2. Retaliate only after your partner has defected.
3. Be prepared to forgive after carrying out just one act of retaliation.
4. Adopt this strategy only if the probability of meeting the same player
again exceeds 2/3.
According to Axelrod, tit for tat is successful because it is “nice,” “pro-
vokable,” and “forgiving.” A nice strategy is one that is never first to defect.
In a match between two nice strategies, both do well. A provokable strat-
egy responds by defecting at once in response to defection. A forgiving
strategy is one which readily returns to cooperation if its opponent does
so; unforgiving strategies are likely to produce isolation and end coopera-
tive encounters . . .
Source: Excerpts from Tit for Tat by Chris Meredith, [The Slab] Australian
Broadcasting Co., 1998.
or low δ ), tacit collusion between duopolists may not be individually

preferable and sustainable as an industry equilibrium. In such situations
firms may prefer higher short-run profit π D (π D > π M / 2) even at the
cost of sacrificing cooperative profits later on. A small value of δ (or
equivalently a higher value of k ) makes a punishment meant to begin
next period and apply thereafter (where punishment is tantamount to
going back to Cournot behavior) less effective in deterring a profitable
deviation this period (π D > π M / 2). If the market is more stable or less
volatile (high δ or low k ), tacit collusion may become self-enforceable as
firms have no incentive to cheat or deviate from the agreed-upon
behavior.
Friedman’s (1971) model of tacit collusion among Cournot duopolists
is a special case of what is referred to as the folk theorem (e.g., see
Friedman 1977; Fudenberg and Maskin 1986). This theorem basically
asserts that for infinitely repeated games, many strategy profiles, includ-
ing the tacit collusion profile, that are not optimal from a short-run,
static perspective can sustain as a perfect industry equilibrium provided
that players are sufficiently patient or discount factors are large (dis-
count rates are low).26 For more on the economic intuition behind
repeated games, see our interview with Robert Aumann in box 4.6
where he also discusses the underlying notion of rationality in game
theory.
Chamberlin (1933) recognizes other factors that influence the sustain-
ability of collusive behaviors, such as detection lags and firm heterogene-
ity. Tacit collusion is enforced by the threat of retaliation, for example,
as part of a trigger strategy. If firms cannot immediately react when rivals
deviate due to detection lags, retaliation is delayed. This makes deviation
26. The folk theorem formalized by Fudenberg and Maskin (1986) is more general than
suggested here. It asserts that if the players are sufficiently patient then any “feasible,”
“individually rational” payoffs can be enforced by a perfect equilibrium in infinitely
repeated games under complete information. In itself, the folk theorem has little to do with
collaborative behavior. Many strategy profiles are perfect equilibria for sufficiently patient
players in such infinitely repeated games. To improve the models’ prediction power, econo-
mists often look for an argument that allows selecting one equilibrium among many as
being more likely to arise. A selection process often used rests on the assumptions that (1)
symmetric players are likely to coordinate on an equilibrium that allows for symmetric
payoffs, and (2) the “focal” equilibrium should be Pareto optimal from the players’ perspec-
tive. This suggests that duopolists would coordinate on half the monopoly output. The
“correctness” of this selection is more a belief than a result relying on solid game-theoretic
foundations. One should ideally resort to more appropriate selection techniques, such as
risk-dominance, to select among equilibria. Harsanyi and Selten (1988) examine such
approaches. Fudenberg and Tirole (1986) suggest that infinitely repeated games are too
“successful” to provide a solid structure for analyzing oligopoly dynamics; they instead
propose several alternative approaches.
146 Chapter 4
Box 4.6
Interview with Robert J. Aumann, Nobel Laureate in Economics (2005)
1. Economic sciences have been criticized for the presumed rationality of

economic agents. Do you envision a role for a Center for the Study of
Irrationality?
I belong to the Center for Rationality at Hebrew University. We study

both, rational as well as psychological or behavioral approaches. Recent
experiments, such as the ultimatum game, probability matching, or
Tversky and Kahneman’s behavioral work, confirm that our acts are
not always rational, i.e., they do not follow self-interested optimizing
behavior in each situation. Rather, we often follow certain rules or
norms of behavior that usually, or on average, lead to broad desirable
outcomes for survival or success over many similar decision situations
over time. Thus optimization is over rules that provide repeated guid-
ance over time rather than over individual situation actions (I refer
to this as rule- vs. act-rationality). Rules may lead to optimal behavior
in general, but not necessarily in every case. Such rules may be evo-
lutionary or unconsciously adopted. For example, we eat when we feel
hungry.
2. Your work on repeated games is particularly interesting. Do you believe

that cooperation is more descriptive of real-world firm interactions than
classic competition? If so, what is the intuitive logic for this?
Box 4.6
(continued)
In repeated games players encounter the same situation over and over
again. In such games a player has to take into account the impact of his
current action on the future actions of other players, i.e., reputation or
relationship effects. In such situations cooperation is more likely to be
sustainable under certain conditions. Intuitively, the presence of a coop-
erative equilibrium arises because the threat of retaliation is real, since
one will play the game again with the same person. On many occasions
the optimal way of playing a repeated game is not to repeat a Nash strat-
egy of the constituent game (e.g., repeated prisoner’s dilemma), but to
cooperate and play a socially optimum strategy or follow the “social
norm.” In the repeated prisoner’s dilemma, cooperation can be sustained
if the discount rate is not too high, i.e., if the players are interested enough
in future outcomes of the game. Cooperation is more likely when interac-
tion over time occurs among a few players. The time element/repetition is
important. Cooperation may be harder to attain when there are many
players.
less costly in present-value terms and tacit collusion harder to sustain.27

In case of asymmetry among firms (e.g., involving different fixed or vari-
able production costs), it is difficult to determine a “focal” choice (e.g.,
production quantities) on which firms are likely to cooperate. This further
hinders the sustainability of tacit collusion.
4.2.3 Co-opetition: Sometimes Compete and Sometimes Cooperate?
It is by now well accepted by corporate executives that partnerships with

suppliers, customers, and sometimes even with competitors, may bring
about significant competitive advantages. As noted, some game-theoretic
models can provide economic rationale for this notion. However, until
recently strategic management frameworks have not adequately
addressed this issue. Porter’s five-forces framework, for instance, tends
to view other parties (competitors, suppliers, or buyers) as threats to a
firm’s profitability.
The various relationships along the value chain, however, do not nec-
essarily present a threat. Firms may create win-win relationships with
27. In the extreme case of infinite detection lags, firms cannot at all react to their rivals’
actions over the play of the game. This case collapses to a situation where firms formulate
open-loop strategies that are adapted to calendar time only. This is equivalent to a setting
where firms make their decisions simultaneously. In quantity competition, firms would
produce Cournot–Nash equilibrium quantities forever.
148 Chapter 4
their suppliers and even their competitors. There are various situations
where collaboration with external parties may create value:
• Joint R&D ventures with rivals.
• Partnership with suppliers to enhance the benefit to end consumers or
improve productive efficiency (e.g., via just-in-time production).
• Co-development with a customer’s R&D team to better tailor end-
products to customer requirements.
• Agreement among competitors to set industry standards (e.g., Blu-ray
technology).
• Coordinated lobbying among competitors in the same industry.
As a result of opportunities created by these broader collaborations,

the entire value chain, including activities performed by outside
parties, should be re-considered. Porter’s (1980) value chain is based
on the premise that everything is done in-house. Today it is possible
to redesign the value chain in many industries to better cope with
uncertainty and interactive relationships, including outsourcing. Strate-
gists have called for a more collaborative model of the value chain
based on partnerships. With an increasing number of business pro-
cesses becoming commoditized within and across industries, executives
need to rethink the very basis for competition in their businesses.
“Cooperative” strategies nowadays appear on top of corporate
agendas.
To provide a better framework that takes account of collaborative
relationships, Brandenburger and Nalebuff (1995) propose the concept
of value net, founded in microeconomics and game theory. They term
this kind of strategies co-opetition, as they involve a mix of cooperation
and competition. Firms need to decide which of their business pro-
cesses are core or crucial to make their strategies succeed, and which
can be performed in a relatively generic and low-cost fashion, poten-
tially outsourced to external parties. Interactions among firms are struc-
tured along the value net depicted in figure 4.9. The value net consists
of four key players: suppliers, customers, substitutors, and complemen-
tors. Substitutors are external parties who act in a contrarian fashion,
whereas complementors help create value since their actions benefit
both firms. The value net includes relationships with external parties
presenting threats or opportunities. A firm can increase economic
profits and value either through value creation (increasing the size of
the pie) or through value redistribution (sharing the pie in more
Reduce prices Customers Increase prices
Dividing up markets Making markets
Substitutors Company Complementors
Price competition Creating new value
COMPETITION COOPERATION
Reduce margin Suppliers Increase margin
Figure 4.9
Value net and co-opetition
Adapted from Brandenburger and Nalebuff (1995)
favorable terms). Value redistribution can be accomplished, for instance,

through more skillful bargaining with buyers and suppliers. Such a
focus is risky as firms rarely outperform their rivals solely through
value redistribution. Competition in redistribution is fiercer than com-
petition to create new value. Yet firms can cooperate in different ways
to increase the size of the pie. Once this is accomplished (in coopera-
tion with others), value redistribution can be easier.28 The value net is
helpful to better account for cooperation opportunities that might be
beneficial to the firm.
Such situations where firms can either compete or cooperate can
be analyzed with tools offered by option games. Trigeorgis and Baldi
(2010) assess the value of optimal patent leveraging strategies under
both demand uncertainty and competitive rivalry using a methodol-
ogy allowing for a mix between competition and cooperation. They
28. Brandenburger and Stuart (2007) subsequently develop a hybrid approach involving
both noncooperative and cooperative game theory called biform games to better account
for such complex strategic interactions. Their approach is characterized by two stages. In
the first stage, players behave cooperatively to increase the value of the total market “pie.”
Afterward they behave noncooperatively to share the market pie based on their market
power. The bargaining power wielded in the second stage may stem from competitive
advantages, such as technological leadership, created in the first stage. Biform games focus
on shaping the competitive environment, namely first creating or reshaping a market and
then building up competitive advantage to capture a larger slice of it. Such approaches
may gain in acceptance over the coming decades. A practical approach providing manage-
ment with state-of-the-art conceptual frameworks would be helpful.
150 Chapter 4
Demand
(asymmetric)
(symmetric)
Bracketing
Bracketing
1 2 3
High
H ht
Fig
Cross-licensing
Patent wall
(monopoly/
abandon)
ate
per
4 5 6
Licensing
Medium
M Coo
abandon
Sleep/
L 7 8 9 Low
No (zero) Small Large

(symmetric) (asymmetric)
Competitive advantage
(patent innovation)
Figure 4.10
Compete versus cooperate as part of a patenting strategy
Adapted from Trigeorgis and Baldi (2010)
illustrate how optimal patent strategy depends on the level and volatil-
ity of demand and on the size of competitive advantage arising
from the patented innovation. The key question they consider is, when
business conditions are uncertain, under what circumstances should
rivals fight and when should they collaborate in using their intellectual
property (IP) assets, namely when should two competitors follow a
fighting or a cooperating patent strategy? They show that the circum-
stances under which firms should fight or cooperate are not trivial.
Under demand uncertainty rivals may sometimes find it preferable to
compete (e.g., defending themselves via raising a patent wall around
their core patent or fighting fiercely by attacking each other via patent
bracketing) and at other times to collaborate (e.g., via cross-licensing
to each other or even licensing one’s patented innovation to its rival).
The menu of different fight or cooperate strategies is summarized in
figure 4.10. The option games approach enables to capture certain
features of an adaptive business strategy. The increasing cone of
market and strategic uncertainty makes the value of a dynamic strat-
egy that enables switching among a broader menu of competing or
cooperating alternatives key to survival and success in a changing
marketplace.
Conclusion
This chapter and the previous one discussed how industrial organiza-
tion can be helpful in providing insights about certain competitive situ-
ations. Chapter 3 discussed some static benchmark models involving
price and quantity competition. Chapter 4 considered the time dimen-
sion, discussing several dynamic settings. Dynamic models of complete
or incomplete information are more challenging than their simultane-
ous-move counterparts and give richer insights on how firms should
consider the long-term consequence of their current actions. In such
multistage games, strategic decisions that appear suboptimal from a
short-term, static perspective may indeed be optimal in the long term.
Dynamic games are useful to understand that committing and killing
one’s options may sometimes be advisable as a devise to create com-
petitive advantage in subsequent stages. They also provide economic
foundations for collaborative behavior in certain markets involving
repeated relationships. The results discussed in chapters 3 and 4
serve as building blocks for the option games methodology we deploy
later.29
Selected References
Osborne (2004) offers an accessible account of game theory. Averted

readers might prefer the more advanced treatment offered by Fudenberg
and Tirole (1991). Besanko et al. (2004) provide a good overview of
industrial organization focusing on the strategic insights of the models.
Tirole (1988) is a key reference in this area. Fudenberg and Tirole (1984)
discuss the taxonomy of commitment strategies. Rubinstein (1982) exam-
ines bargaining over an infinite horizon. Friedman (1971) elaborates on
the sustainability of tacit collusion in infinitely repeated Cournot games.
Besanko, David, David Dranove, Mark Shanley, and Scott Schaefer. 2004.
Economics of Strategy, 3rd ed. New York: Wiley.
Friedman, James W. 1971. A non-cooperative equilibrium for super-
games. Review of Economic Studies 38 (1): 1–12.
29. Most dynamic models in industrial organization assume either steady state or a deter-
ministic evolution of the underlying parameters. Mainstream industrial organization does
not explicitly consider the impact of stochastic market uncertainty on the equilibrium
results. Merging dynamic games with real options analysis helps bridge this gap, better
explaining optimal decision-making in the face of uncertainty.
152 Chapter 4
Fudenberg, Drew, and Jean Tirole. 1984. The fat cat effect, the puppy dog
ploy and the lean and hungry look. American Economic Review 74 (2):
361–66.
Fudenberg, Drew, and Jean Tirole. 1991. Game Theory. Cambridge: MIT
Press.
Osborne, Martin J. 2004. An Introduction to Game Theory. New York:
Oxford University Press.
Rubinstein, Ariel. 1982. Perfect equilibrium in a bargaining model.
Econometrica 50 (1): 97–109.
Tirole, Jean. 1988. The Theory of Industrial Organization. Cambridge:
MIT Press.
5 Uncertainty, Flexibility, and Real Options
Up to now we have mainly focused on industrial organization models in

a certain or deterministic world. Before discussing further how to
combine game theory with real options under uncertainty, we review in
this chapter the basics and insights of real options analysis to improve
our understanding of flexible real investment decisions.1 The real
options approach to analyzing investment under uncertainty has by
now gained standard corporate finance textbook status. Real options
analysis involves the application of methods utilized to price financial
options and other derivatives to real assets; that is, it is an extension of
option-pricing theory or contingent-claim analysis to real investment
situations. Financial options are financial assets (generally traded on the
capital market) that give their holders the right—but not the obliga-
tion—to buy or sell an underlying asset at a specified price for a given
time period. Option-pricing theory was developed to price this asset
class. Real options draw on an analogy between financial options (calls
or puts) and real-world contingent cash-flow streams. And yet, even
when an analogy can be drawn, real options are quite different. For
example, they may not be traded on the capital market and may simul-
taneously be held by more than one investors. Still, the analogy between
real investment projects and certain traded derivative assets holds con-
ceptual value. For instance, having the option to abandon a project for a
salvage value should the market evolve worse than expected is similar
to holding a put option giving the right—but not the obligation—to
“sell” the underlying asset at a strike price equal to the salvage value. In
such a case, the analogy applies well. Real options are now commonly
1. Readers familiar with real options analysis may skip this chapter and go directly to the
description of option games provided in the subsequent chapter.
154 Chapter 5
accepted as a powerful real asset valuation and management approach.

Several economics and finance books have been dedicated to this
approach, more prominently Dixit and Pindyck (1994) and Trigeorgis
(1996).
To put our examination of real options in a concrete, applied context,
we discuss in section 5.1 the investment challenges faced by European
electricity suppliers. Section 5.2 discusses how managers of an electric
utility can address such challenges utilizing real options analysis.
Section 5.3 describes option-pricing theory and illustrates its applica-
tion in situations involving concrete investment problems from the
energy sector.
5.1 Strategic Investment under Uncertainty—The Electricity Sector
Over the past few decades many firms have experienced new develop-
ments in their competitive landscape, including regulatory, technological
breakthrough and demand pattern changes. Few of these developments
could have been predicted. Increasing uncertainty casts doubt on current
predictions about market developments, technological trends or rivals’
behavior. In the midst of such uncertainty, adaptability to market devel-
opments can be of significant strategic impact.
The European energy sector exemplifies this challenge quite well.
National markets have opened up to new entrants and energy prices
have become increasingly volatile. Even though the need to add
generation capacities is well recognized in the electric utility sector
(see International Energy Agency 2007), tackling complex issues
such as when or where to invest in generation units is all the more
difficult in this highly unpredictable environment. From this industry
perspective we examine next the major sources of uncertainty and
the business risk exposures implied by the new generation technology
choices.
5.1.1 Need for New Investment in Europe
A key factor monitored by bodies regulating electric utilities is reserve

margins. This indicator measures the power adequacy in terms of
installed power generation capacity over peak demand in a given
geography. Energy suppliers have to build up sufficient generation
capacity to cover the base load as well as excess capacity to ensure
that even in peak demand periods electricity output is sufficient. In
Uncertainty, Flexibility, and Real Options 155
Europe (EU12) France Italy

CAGR% CAGR% CAGR%
4.5 4.5 4.5
4.0 4.0 4.0
3.5 3.5 3.5
3.0 3.0 3.0
2.5 2.5 2.5
2.0 2.0 2.0
1.5 1.5 1.5
1.0 1.0 1.0
0.5 0.5 0.5
0.0 0.0 0.0

86–91 91–96 96–01 01–06 86–91 91–96 96–01 01–06 86–91 91–96 96–01 01–06
Electricity consumption Generation capacity
Figure 5.1
Growth trends in the European electricity markets
From Energy Information Administration Database. CAGR stands for “compound annual
growth rate.”
other words, reserve margins must remain positive. If they fall to low
levels, consumers face generation inadequacy potentially leading to
blackouts. In the last decades most European countries have experi-
enced substantial energy demand increases. As shown in figure 5.1,
these increases were hardly met by capacity additions, resulting in
shrinking reserve margins. In addition, most power plants built in the
1970s in the aftermath of the oil crisis are expected to be decommis-
sioned or refurbished in the next decade across Europe as they
become obsolete or no longer abide by new environmental standards.
Reserve margins in some European regions (e.g., Brittany in France)
are already approaching critical levels, indicating dire investment need
in the coming years.
Another means to improve reserve margins is to curb electricity
demand, especially in peak load, by implementing energy-efficiency
156 Chapter 5
measures or other market mechanisms (e.g., customer participation) to

induce consumers shift demand from peak load to lower load periods.
Such initiatives are, however, not always as effective, so the need for
additional generation capacity remains. Electric utilities across Europe
are expected to channel huge financial resources into new power genera-
tion capacity to ensure system adequacy and reliability going forward.
These investments will take place under growing uncertainty and
increased environmental constraints with the aim to promote green
technologies.
5.1.2 Sources of Uncertainty
As illustrated in table 5.1, utilities face a number of uncertainties, be they

idiosyncratic (e.g., changing demand patterns, electricity demand growth),
technological, or firm specific. Rapid changes occurring in recent years
challenge would-be investors in determining when to invest (optimal
investment timing), where to add new generation facilities (network
Table 5.1
Uncertainty factors for electric utilities
Idiosyncratic risks Technology-specific risks Firm-specific risks
Demand uncertainty Construction risks Capital structure

• Demand growth • Investment cost • Bankruptcy risks
• Changing demand overruns • Interest payments
patterns • Unforeseeable lead
Cost structure
• Country-specific prices time • Economies of scale
• Price developments Fuel-related uncertainty and scope
• Effectiveness of • Unsecured supply (e.g., • Learning-curve effects
energy-efficiency wind, gas)a Company’s portfolio of
measures • Input price volatility
corporate activities
Regulatory risks (e.g., gas, coal, uranium) • Internal hedging
• Plant licensing and Environmental
approval uncertainties
• Regulation of • Prices on CO2 and
transmission lines greenhouse gas emissions
Competitive risks • Support on green
• Market power of technologies
incumbents • Waste management and
• Market entrance phaseouts (nuclear power)
• New environmental
standards
a. The 2008 dispute on gas between Russia and Ukraine led to serious supply disruptions
in eastern and central Europe (e.g., Ukraine, Poland, Germany).
Source: Adapted from International Energy Agency (2007).
Electricity price (monthly averages in €/MWh)

100
80
60
40
20
0
2002 2003 2004 2005 2006 2007 2008
Figure 5.2
Electricity price fluctuations in Europe from 2002 to 2008
From Powernext
design), or what mix of technologies to invest in (technology choice). We

next look at the business risks each company in the sector faces and the
risks involved in the generation technology choice.2
Idiosyncratic Business Risks

Since electricity cannot be effectively stored, electricity prices are very
sensitive to shocks (e.g., demand pattern fluctuations, plant disruption)
and are therefore extremely volatile. Figure 5.2 shows electricity price
fluctuations during the period 2002 to 2008. Wholesale electricity prices
in many European countries started to skyrocket in 2004 and have
remained at a substantial high average level since. This overall price
increase can be attributed to three underlying factors. First, most fuel
prices (e.g., gas, oil, coal) have trended upward. Second, utilities now have
to pay for CO2 emissions. Finally, the tightening of reserve margins has
resulted in utilizing more expensive generation technologies, leading to
higher average generation costs. Energy suppliers for the most part
managed to pass this cost through to their customers (given the low price
elasticity of demand).
2. We do not intend to elaborate on firm-specific risk factors but instead adopt the view-
point of an “average firm” in the electricity sector.
158 Chapter 5
Besides, demand patterns can vary markedly across regions, some

being more often subject to huge demand peaks (e.g., due to intense
use of air-conditioning in southern European geographies). Other
country-specific factors might also play a role. For instance, tempera-
tures are different across northern and southern Europe and have dif-
ferential effects. Some countries have a high share of industrial
consumption (e.g., Germany), while others have more tertiary activities
(e.g., the United Kingdom). The national production mix may also spill
over into the electricity prices. When demand increases, utilities need to
operate more generation units, including costly ones, to ensure power
adequacy. The national average market price is likely to be higher
owing to the costly national production mix if transmission lines are
ineffective. Local resistance in the form of “not-in-my-backyard” atti-
tudes may also act as a hindrance to ensuring adequate capacity and
investment.
Various European governments contemplate initiating energy-effi-
ciency measures to curb future electricity demand, besides achieving
environmental objectives. Smart meters have been introduced in some
European countries (e.g., in Italy) both for industrial customers and
households, enabling customers to be better informed of current electric-
ity prices and alter their consumption patterns accordingly. Although
governments and regulatory bodies have shown interest at pushing
energy-efficiency measures, it is not clear whether such initiatives will be
enforced and will achieve their goals. Governmental intervention may
take many forms: subsidies or fiscal incentives toward new technological
options, lengthy plant licensing processes for nuclear power plants, anti-
trust regulation or administrative market-entry barriers to protect
incumbents.
Technology-Related Business Risks

Capital expenditures may greatly vary from technology to technology
and might follow different development paths. The steel price is an
important variable in any generation plant investment. Other construc-
tion-related costs as well might fluctuate depending on general real-
estate market conditions. New technologies may be characterized by
decreasing investment costs over time due to economies of learning.
Through plant design standardization, R&D costs can be spread out to
a larger number of projects. This is critical for nuclear plants, especially
when lack of process optimization due to limited experience results in
substantial cost overruns.
Operating and fuel costs are a major source of uncertainty. Coal-fired

plants are more sensitive to the underlying fuel price volatility than
nuclear power, but much less than combined-cycle gas turbines (CCGTs).
Operating and maintenance costs may differ depending on the technol-
ogy considered and may undergo distinct development. At the end of
the day, the relative competitiveness of generation technologies varies
over time. Investment decision-making must be dynamic, with the up and
down potential of each underlying factor being seriously considered in
adjusting the generation mix.
Policy makers’ reluctance toward a steady, long-term environmental
policy is another source of uncertainty. From an individual value-maxi-
mizing viewpoint, utilities tend to select the “cheapest” technology
regardless of total societal costs. A practical means to avoid this problem
is to internalize the indirect costs (e.g., damage on the environment)
resulting from power generation. This is what the European Union
intended when introducing the EU Emission Trading Scheme (EU ETS)
in 2005.
5.1.3 Generation Technologies and Business Risk Exposure
A key question is not simply whether to invest but also which available
generation technologies to choose. The technology choice ultimately
determines the project’s sensitivity to certain underlying risk factors and
its overall business risk exposure. When selecting among available tech-
nological options, one considers the variable and fixed costs involved in
each case. The fixed cost components are the upfront investment cost,
the decommissioning cost, and the fixed operating and maintenance
costs. The up-front investment cost is very high for a nuclear or hydro
plant and less so for CCGTs. The major variable cost component is the
input fuel cost. Completion delays, cost overruns, and the plant’s lifetime
are also important factors. Supply security may also come into play.
Certain technologies may possibly put the system at risk as they might
not be always available or reliable (e.g., wind). Cost factors may vary,
which drives cost uncertainty for utilities.
There is no superior power generation technology among the group
of mature technological options. Each has certain features that make it
better suited in certain situations. No technology turns out to be cheaper,
cleaner, and more reliable than the others. Depending on whether a firm
is willing to pay large fixed costs (e.g., nuclear power) or large variable
costs (e.g., coal fired), one might prefer one technology over another.
160 Chapter 5
Among the alternative technological options some are considered more

conventional, such as coal fired, combined-cycle gas turbines (CCGT),
and nuclear power. The coal-fired technology involves the lowest (vari-
able) costs under most circumstances. This technology, however, has a
high carbon footprint and is significantly more expensive if environmen-
tal costs are factored in. The CCGT technology has several advantages,
including lower capital investment costs and short construction times. It
is also one of the technologies offering the greatest operational flexibility.
This is offset by current high fuel costs. This technology is highly sensitive
to gas prices since fuel costs represent a significant share of total costs.
CCGT technology, however, has a poor environmental footprint in terms
of CO2 emissions. Hydro power generation also involves very large
(sunk) investment costs. Reservoirs are very flexible, however, since they
can be closed and opened at very little cost.3 Available sites though are
limited and plant standardization is hardly possible, which may lead to
substantial delays and investment cost overruns. Recent high natural gas
prices and CO2 emission costs have lead certain countries (mainly
France) to boost investment in nuclear power plants, whose efficiency
has been significantly improved relative to other technological options.
However, civil nuclear power has a bad track record of delays, cost over-
runs, and catastrophic disruptions (e.g., Fukushima). Many countries
(e.g., Italy, Germany) are reluctant to embrace civil nuclear power, while
a few still invest in this technology with France taking the lead.
Certain alternative technological options are gradually emerging as
mainstream technologies. Onshore wind power has nearly reached a 10
percent capacity share in Europe (EU12). Other renewable technologies
such as biomass, small hydro, and solar, have not yet gained enough
acceptance but pave the way for more environmental-friendly power
generation. Over the past two decades investments in various new gen-
eration units have significantly altered the generation mix in many Euro-
pean countries. A noticeable trend is the increasing share of natural
gas-fired capacity (especially CCGTs) and of renewables technologies
(especially onshore wind-power turbines). The offshore wind power
technology has also gained in acceptance, with Germany commissioning
a 400-MW wind farm (BARD offshore 1) in 2011 and the United
Kingdom building up a 500-MW offshore wind farm on the eastern coast
(Greater Gabbard). EU member countries generally give subsidies to
3. Other technologies such as nuclear, coal or fuel, and gas (with the exception of CCGT)
power typically require a significant time lag between the decision to fire up the plant or
turbine and the production of electricity itself.
increase investment in renewables, primarily wind power and hydro.

Despite being environmentally friendly, the wind power technology is
often challenging for utilities as it can only operate with sufficient wind.
Another alternative for electric utilities is to invest in transmission
lines to enable improved integration of electricity systems with neighbor-
ing European countries. Transmission lines enable an electric utility to
compensate for low reserve margins in one region through imports from
another neighboring country. The presence of interconnection lines
between regions is beneficial not only to utilities, which have the option
to supply the market under better economic conditions, but also to the
general public. Transmission lines pave the way for “shared” options or
resources, enabling better power supply management when reserve
margins get tighter at the national level with higher regional demand
compensated by higher generation in areas that were not connected
before. Business risk exposure depending on generation technology is
summarized in table 5.2. Current market trends are not solely due to the
emergence of superior technologies but also to the prevailing market
and regulatory conditions favoring these technologies.
Figure 5.3 shows the development in terms of generation capacity of
various technological options over the recent two decades in Europe.
Changes in fuel costs, construction costs and CO2 emission prices signifi-
cantly affect the relative attractiveness of each technology. Since
Table 5.2
Business risk exposure of conventional generation technologies
Investment Time-to- Operating Security of CO2

Technology cost build cost Fuel cost supply emissions
Coal-fired
CCGT
Hydro
Nuclear
Wind
Low exposure
Medium exposure
High exposure
Note: The table excludes idiosyncratic uncertainty (which is the same whatever the technol-
ogy) as well as firm-specific risk.
162 Chapter 5
CAGR%
Generation capacity by technology type in EU12 (in million kW) (1987–2007)
600 Total 1.5
Renewables 17.7
500
Nuclear 1.2
400
Hydro 0.2
300
200
Thermal 1.2
100
0
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Figure 5.3
Generation capacity by technology type in Europe
From Energy Information Administration Database
investment in generation capacity is largely sunk, firms face high business

risks when deciding at the outset which technology to select. Unexpected
events may make other technological alternatives more suitable under
specific future market conditions. A key parameter an electric utility
should take into consideration when committing to a given power plant
is exposure to fuel price (variable cost) volatility. Wind power needs no
fuel as such. For nuclear plants, fuel costs (mainly uranium) represent a
small share of total operating and investment costs (most being dedi-
cated to enrichment, conversion, and fabrication, being therefore quasi-
fixed). In contrast, CCGTs are very sensitive to fuel costs. Because
natural gas prices are very volatile, this brings substantial fuel-sensitivity
for CCGTs.
5.2 Common Real Options
Electric utilities must take into account the aforementioned risk factors
and market dynamics when they work out their investment strategies.
They can benefit from an improved understanding and guidance con-
cerning the risk factors, particularly when formulating investment deci-
sions to enhance their generation capacity and future economic profits.
Table 5.3
Common real options
Real option type Description Relevant industries
Deferral or waiting Management can wait before Resource extraction

option making the investment to see industries, real-estate
how the market unfolds. development, capital-
intensive industries.
Staging or When a managerial decision Technology-based firms
time-to-build takes time or is done in stages, (R&D), long-
option management can default if development capital-
market prospects prove worse intensive industries
than expected. (e.g., electric utilities),
startup ventures.
Expand or extend If the project turns out better Natural-resource
option than expected, management can industries (e.g., mining),
spend more to expand the real-estate development.
project scale or it can extend
the project’s useful life.
Contract or If the market prospects are Capital-intensive
abandon option worse than expected, managers industries (e.g., airplane
can contract or abandon it for manufacturers), new
salvage. product introductions.
Switching option Management can select among Multinational firms with
the best of several alternatives, production facilities in
e.g., inputs, outputs or locations, different currencies,
under the prevalent market platform strategy in the
conditions. automotive sector.
Compound option If investment takes place in High-tech, R&D,
stages, the first project can be industries with multiple
valued in view of the future product generations,
growth options it creates. strategic acquisitions.
As summarized in table 5.3, management can benefit from different

types of real options. We here discuss common types of real options in
the context of an electric utility. The necessary tools to quantify the
values of such real options are discussed in the subsequent section.
Deferral or timing option Management is not always confronted with

a now-or-never investment decision. Often it might have the flexibility
to time its investment decision after observing how events unfold.
Suppose that French utility EDF has identified that in the Brittany
region reserve margins are falling to such low levels that they may jeop-
ardize power supply security. EDF, being authorized to open up nuclear
power plants in France, resolves to operate such a plant in Brittany if it
is deemed worthwhile. Since the involved capital investment cost I is
large and cannot be recouped, management wishes to decide on solid
ground when more sure that the need for new generation capacity in this
164 Chapter 5
region is here to stay. EDF in effect holds an investment timing or “wait-

and-see” option to benefit from the resolution of uncertainty about
electricity prices (reflective of the regional imbalance between demand
and supply). Suppose that EDF may exercise its option to invest only
once, at maturity (year T ). Let VT indicate the time- T value of the invest-
ment’s expected operating cash flows. Just before expiration the option
will pay off the greater of the net value created, VT − I , or 0, meaning at
maturity the option is worth max {VT − I ; 0}. The option to invest or defer
is thus analogous to a call option on the gross project value VT with
exercise price equal to the required capital investment outlay I . Waiting,
though it may come at the cost of forgoing early cash flows, may pay off
under certain conditions and help avoid costly premature investment.
Option to stage or default during construction (time-to-build option)
Cash flows are not generated overnight once managers make an invest-
ment decision. Typically large construction projects are staged. During
power plant construction, if market conditions deteriorate, management
can choose to forego any future planned capital outlays. The actual
investment staging consists of a series of capital outlays, offering at any
given stage the opportunity to revise the initial go-decision and stop
incurring further costs should future prospects turn out worse than
expected. In such a case each stage t ( ≤ T ) can be viewed as an option
written on the value of subsequent stages by incurring the (time-t) invest-
ment cost outlay I t required to proceed to the next stage. The investment
opportunity can be valued similarly to compound options (options on
options).
Option to expand or extend Given the raised public awareness
of environmental challenges ahead and the enforcement of more
stringent environmental legislation, electric utilities are increasingly
investing in renewables technologies, such as wind power. A possible
plan design for the utility is to start up small, scalable wind farms
with a limited number of turbines, with the possibility to expand.
The value of the initial wind farm is Vt at time t ( ≤ T ). If future
electricity prices or governmental subsidies are higher than expected,
management can expand the number of turbines or the scale of
production (by e percent) by making an additional cash outlay I e.
At time t ( ≤ T ), the entire project can be viewed as the base-scale wind
farm, Vt, plus a call option on future (expanded) investment, namely
Vt + max {eVt − I e ; 0} = max {(1 + e ) Vt − I e ; Vt }. The initial wind farm thus
enables the firm to capitalize on future expansion opportunities. This
expansion option, which will be exercised only if future electricity prices

or subsidies turn out more favorable, can make the basic small, scalable
wind farm project worth undertaking.
Option to scale down or contract If market conditions turn out weaker
than originally expected, management can operate below total power
generation capacity or even reduce the scale of operations (by c percent),
thereby saving part of the planned cash outflows or fixed costs (I c). This
flexibility to mitigate loss is analogous to a European put option on part
(c percent) of the base-scale project, with exercise price equal to the
potential cost savings (I c), paying off max {I c − cVT ; 0} at maturity. It
may sometimes be preferable to build a plant with lower initial construc-
tion costs and higher maintenance expenditures in order to acquire the
flexibility to contract operations by cutting down on maintenance if
market conditions turn out unfavorable.
Option to shut down (and re-start) operations A power plant does not
necessarily have to operate in each and every period. It may be profitable
to operate flexible (e.g., CCGT peak-load power) plants with higher
marginal costs if they can be shut down when electricity prices are low
and not sufficient to cover variable operating costs. In this case the utility
might be better off not operating temporarily, especially if the costs of
switching between the operating and idle modes are relatively small.4 In
peak-demand periods, as market electricity prices rise to peak levels,
operation can start up again and be quite profitable. Enron allegedly
made huge profits in California operating such peak power plants only
a few days or weeks in the year when prices peaked, exploiting the tre-
mendous volatility in local electricity prices. Operating such a peak-load
plant is analogous to a call option enabling management to receive in
year t revenues Pt by incurring variable costs Ct as exercise price. The
contingent payoff at time t (≤ T ) is π t = max {Pt − Ct ; 0}, with present
(option) value π 0(t ) ≡ e − rt Eˆ 0[π t ]. Because the plant embeds such shut-
down and restart options at each (discrete) time period t until maturity
T , the total plant value is V0 = ∑ t =0 π 0( t ) provided switching costs are
T
small or negligible.5
Option to switch use (e.g., inputs or outputs) Instead of committing
to a certain input an electric utility may select the best of several fuel
alternatives should future conditions vary. We discuss below two types
4. For simplicity, we assume henceforth that switching costs are negligible, allowing deci-
sion-making to be path independent.
5. This case with no switching cost has been analyzed by McDonald and Siegel (1985) along
the Black–Scholes lines.
166 Chapter 5
of switching options, relating to inputs or outputs. Over the past years

natural gas has been under increasing competitive pressure owing to
the introduction of substitute products, especially liquefied natural gas
(LNG). The prices for natural gas and LNG are positively correlated,
but they undergo different market development trends that can make
one input more affordable than the other (for an equivalent output
efficiency) in a given period. An effective strategy is to invest in flexi-
ble gas-fired generation technologies (especially CCGT) that can use
either of these fuels. The utility would be willing to pay a certain
premium to acquire such a flexible technology, compared to the (best
of the) rigid alternatives that confer no or less choice (either natural
gas or LNG).6 Naturally the correlation between natural gas and LNG
is fairly high since the products are close substitutes. If the correlation
between the two fuels is lower, the switching option will be even more
valuable. Generally, process flexibility can be achieved not only
through an adequate technology choice (e.g., building a flexible gener-
ation facility that can switch among alternative fuel inputs) but also by
maintaining relationships with a variety of suppliers, changing the mix
as their relative prices change. Another form of switching option
relates to the optionality to design operations such as to produce alter-
native outputs, selecting the most profitable output once price uncer-
tainty gets resolved. Recently there has been a consolidation trend in
the energy industry toward the merging of electric and gas utilities.
A case in point is the merger of the French gas utility GDF with Suez.
This move partly resulted from the synergies arising from the increas-
ingly growing share of gas-fired power generation (CCGTs) in Europe.
From this viewpoint the gas utility (GDF) may either sell the natural
gas to the end consumers or supply natural gas to gas-fired power gen-
eration units in view of the actual energy prices (gas vs. electricity).
Another example of the option to switch outputs relates to the inte-
gration of European electricity markets due to the introduction of
merchant transmission lines. Such interconnection lines enable the
Italian electric utility Enel buy cheap nuclear power from France, or to
6. Let At be the value (as of time t) of utilizing natural gas and Bt of using LNG as input.
The cost of switching from one input to the other may differ depending on which fuel was
previously in use, exhibiting some form of path dependency. Denote by I ( At −1 → Bt ) the
switching cost when swapping from natural gas to LNG and by I ( Bt −1 → At ) the cost
of switching from LNG to natural gas. Should market conditions prove currently better
for LNG over natural gas, the firm may switch from natural gas to LNG by incurring
the switching cost I ( At −1 → Bt ) . The utility can select the best of the two operating
modes, max { At ; Bt − I ( At −1 → Bt )} . Inversely, if the LNG fuel was initially used, the payoff
at the following node will be max {Bt ; At − I ( At −1 → Bt )} .
sell electricity in France should the price there be higher than the
Italian market price.
Option to abandon for salvage value If electricity prices suffer a long-
standing decline, management does not have to sustain operations
forever. It may find it better to shut down operations, decommissioning
the less performing generation units (e.g., plants with higher variable
costs). Management has a valuable option to abandon a project perma-
nently and stop paying the production costs. This option is analogous
to an American put option on current project value, Vt, with exercise
price the “salvage value,” St, entitling management to receive
Vt + max {St − Vt ; 0} or max {Vt ; St } before option expiration in year T .
The option to close down the plant provides downside risk protection if
the firm is not committed to go on generating electricity when market
prospects worsen. Since most assets in the electricity sector are dedicated
to generate power with no possibility to produce other goods, the resale
price of production facilities is limited. The prospect to forgo negative
cash flows when shutting down a plant can provide a sufficient incentive
and make the abandonment option valuable. The salvage value for which
the plant can be sold or exchanged, St, may fluctuate over time as does
the project’s value Vt.7
Corporate (compound) growth options An early investment may set
the path for future opportunities to follow. Such growth options are
particularly valuable when learning-curve effects are involved. Because
of more stringent environmental constraints and demand for higher
energy efficiency, several new generation technologies are being devel-
oped (while older ones are being substantially researched on and
improved). A case in point is the evolutionary pressurized reactor (EPR)
technology developed by Areva, EDF, and Siemens as the new genera-
tion of pressurized water nuclear reactors. Installing a single nuclear
plant with the EPR reactor may appear unattractive to developers owing
to high R&D costs and lack of scale economies. It could be of interest,
however, to build one as an operating prototype. Future nuclear power
plants could leverage on the experience gained from developing, design-
ing, and building the first EPR plant. The investment in the first EPR
plant is a prerequisite in a chain of interrelated projects. The prototype
derives its value not so much from its expected project-specific cash
flows but rather from unlocking future growth opportunities in the form
7. In this case the abandonment option can be viewed and valued as a switching option to
select between two stochastic assets (with no switching cost). Myers and Majd (1990)
examine a similar problem.
168 Chapter 5
of a chain of new, better performing nuclear power plants. From an

options perspective the opportunity to invest in an innovative generation
technology is analogous to an option written on options (construction of
other new-generation plants); that is, it is an interproject compound
option. Even if the initial stand-alone project does not generate positive
net value on its own, the experience generated during the development
of the first-generation EPR plant may serve as a springboard for devel-
oping future enhanced-efficiency nuclear power generation units. Unless
the firm decides to commit and initiate the first EPR investment, subse-
quent generations would not even be feasible. Such growth options are
found in many other industries especially in industries which are infra-
structure-based, R&D-intensive, or involving multiple product genera-
tions or applications (e.g., in semiconductors, computers, pharmaceuticals)
as well as in industries where having a global footprint is key.
Portfolios of real options A well-diversified power generation portfo-
lio includes several affordable technologies that hedge exposure to
various technology-specific business risks while achieving power ade-
quacy. Fluctuations in the key cost factors (e.g., investment costs, fuel
costs, CO2 emissions prices) can alter the relative attractiveness of alter-
native generation technologies. A well-diversified portfolio of generation
capacities allows utilizing technologies better suited to changing market
conditions. Portfolios of options may also involve negative interactions
or positive synergies.8
Even though the installed generation capacity is well-diversified on the

overall European level, it is not necessarily the case at the national level.
There are noticeable “unbalanced” mixes in France (large share of
nuclear power) or the Netherlands (almost 70 percent gas fired). The
technology portfolios in the European Union compared to individual
member countries are shown in figure 5.4. Diversification in terms of
technologies is a sensible strategy for an electric utility to help manage
risks. As part of their risk management strategies, utilities can consider
investing in other technology types or setting up transmission lines.
Transmission lines make it possible to leverage on the Europe-wide well-
diversified generation mix and reduce exposures in a given geography to
certain technology-specific business risks. Plants involving high fixed
costs (e.g., nuclear plants) should be committed to base-load demand in
8. For general option interactions, see Trigeorgis (1996, ch. 7). In the electricity market,
coupling wind farm and hydro with pump storage creates a portfolio of power generation
technologies whose value is higher than the sum of the parts. In such coupled systems,
overproduction from wind farm can be used to pump water back in the hydro system using
this energy source (in the hydro system) at a later point in time.
Total capacity
100%
Renewables
80% Nuclear
Hydro
60%
40%
Thermal
20%
0%
BE DK FR DE GR IE IT LU NL PT ES UK EU12
Total capacity
15 13 112 127 13 6 82 1 23 14 77 80 562 (in million kW)
Figure 5.4
European generation capacity in 2007 by technology type—Europe (EU12) and member
countries
From Energy Information Administration Database
order to spread these costs over as many hours as possible. Flexible

power plants (e.g., CCGTs) characterized by large variable costs should
operate during peak hours when load is higher and electricity prices suf-
ficiently high to cover these costs. A precise rigid recommendation for
the generation mix is unwarranted since the optimal mix changes con-
tinuously over time. Figure 5.5 shows a static version of the recom-
mended generation mix as a function of electricity demand and marginal
costs. The marginal costs are hardly stable over time, so the graph changes
dynamically. Box 5.1 discusses how to think about managing portfolios
of options via a gardening metaphor. Marco A. G. Días from Petrobras
discusses some real options applications in Brazil in box 5.2.
5.3 Basic Option Valuation
Should electricity prices or other market factors evolve differently

than initially expected, the utility’s management has several options
to adapt to enhance the future cash flow stream or limit losses. The
aforementioned real options, however, cannot be properly valued
using the classical discounted cash-flow (DCF) approach. Real options
analysis is a more useful tool to analyze managerial flexibility since it
170 Chapter 5
Marginal costs
(in €/MWh)
Demand-off Demand Extreme
peak peak demand
Old plants
Gas-fired
Coal-fired
Nuclear, hydro
Must run
(e.g., wind)
Electricity demand (in MW)
Figure 5.5
Technology use as a function of demand level
Adapted from International Energy Agency (2007, p. 127)
Box 5.1
Managing portfolios of options: A gardening metaphor
Strategy as a Portfolio of Real Options

T. Luehrman, Harvard Business Review
Managing a portfolio of strategic options is like growing a garden of toma-

toes in an unpredictable climate. Walk into the garden on a given day in
August, and you will find that some tomatoes are ripe and perfect. Any
gardener would know to pick and eat those immediately. Other tomatoes
are rotten; no gardener would ever bother to pick them. These cases at the
extremes—now or never—are easy decisions for the gardener to make.
In between are tomatoes with varying prospects. Some are edible and
could be picked now but would benefit from more time on the vine. The
experienced gardener picks them early only if squirrels or other competi-
tors are likely to get them. Other tomatoes are not yet edible, and there’s
no point in picking them now, even if squirrels do get them. However, they
are sufficiently far along, and there is enough time left in the season, that
Box 5.1
(continued)
many will ripen unharmed and eventually be picked. Still others look less
promising and may not ripen before the season ends. But with more sun
or water, fewer weeds, or just good luck, even some of these tomatoes may
make it. Finally, there are small green tomatoes and late blossoms that
have little likelihood of growing and ripening before the season ends.
There is no value in picking them, and they might just as well be left on
the vine.
Most experienced gardeners are able to classify the tomatoes in their
garden at any given time. Beyond that, however, good gardeners also
understand how the garden changes over time. Early in the season, none
of the fruit falls into the “now” or “never” categories. By the last day, all
of it falls into one or the other because time has run out. The interesting
question is: What can the gardener do during the season, while things are
changing week to week?
A purely passive gardener visits the garden the last day of the season,
picks the ripe tomatoes, and goes home. The weekend gardener visits
frequently and picks ripe fruit before it rots or the squirrels get it. Active
gardeners do much more. Not only do they watch the garden, but based
on what they see, they also cultivate it: watering, fertilizing, and weeding,
trying to get more of those in-between tomatoes to grow and ripen before
time runs out. Of course, the weather is always a question, and not all the
tomatoes will make it. Still, we would expect the active gardener to enjoy
a higher yield in most years than the passive gardener.
In option terminology, active gardeners are doing more than merely
making exercise decisions (pick or not to pick). They are monitoring the
options and looking for ways to influence the underlying variables that
determine option value and, ultimately, outcomes. Option pricing can
help us become more effective, active gardeners in several ways. It allows
us to estimate the value of the entire year’s crop (or even the value of a
single tomato) before the season actually ends. It also helps us assess
each tomato’s prospects as the season progresses and tells us along the
way which to pick and which to leave on the vine. Finally, it can suggest
what to do to help those in-between tomatoes ripen before the season
ends.
Source: Reprinted with permission of Harvard Business Review from

“Strategy as a Portfolio of Real Options,” by T. Luehrmann, September–
October 1998, pp. 89–99. Copyright © 1998 by the Harvard Business
Review School Publishing Corporation; all rights reserved.
172 Chapter 5
Box 5.2
Interview with Marco A. G. Días, Petrobras
1. Besides the United States, Brazil is likely the most popular user of real
options analysis in the world. Why you think is that? What is the role of
instability and uncertainty historically in Brazil? Can you comment on the
adaptability of the Brazilian people and businesses?
Real options (RO) is more popular in Brazil than in most developed

countries. The history of instability and uncertainty obligates both people
and businesses to be more flexible to adapt to the frequently changing
environment. We say that in Brazil even the past is uncertain! So flexibility
is more valuable here than elsewhere.
One example is the flex-fuel car. Here RO started as the villain and ended
up as a hero! Due to the oil price shocks in the 1970s, Brazil initiated the
ethanol-fuel automobile production in the 1980s. But with low petroleum
prices the owners of sugar mills preferred to make sugar instead of ethanol
(switch output option), leaving the service stations without ethanol for
customers. Ethanol car production practically disappeared with the fall of
consumer confidence in the ethanol automobile. But in the 2000s a new
technology appeared in Brazil: the flex-fuel car using either gasoline or
ethanol. The flex-fuel car provided switch-input options for the consumer,
offsetting the fear of the producer switch-output (sugar-ethanol) option.
The flex-car was an immediate success. In the last years almost all auto-
mobiles sold in the Brazilian market are flex-fuel. The best antidote to the
producers’ switch output option was the consumers’ switch input option!
The flex-fuel technology increased consumer confidence and boosted the
automobile market demand, leaving everybody better off: ethanol produc-
ers, automobile producers, and consumers. A real options success story!
2. How, and to what extent, is real options thinking used at Petrobras? Can
you give specific examples of its use and its importance in influencing key
decisions?
There are many examples of application of real options at Petrobras. Some

of these applications are listed below, including several public cases where
Box 5.2
(continued)
the decision of the petroleum regulatory agency (ANP) was often favor-
able to Petrobras.
i. The petroleum sector was opened up in Brazil in the late 1990s. In 1998,
ANP presented for public debate a proposal for the duration of the explor-
atory phase, suggesting only 5 years for deepwater blocks exploration. We
conducted analysis using real options, suggesting between 8 and 10 years.
Subsequently ANP, once it became aware of the results, enlarged the dura-
tion to 9 years. Petrobras thus had more time to discover and appraise new
oilfields; the recent large pre–salt discoveries needed more than 6 years to
be discovered after the auction. RO thus contributed in the public debate
with a lot of success!
ii. In 2000 to 2001, the Brazil–Bolivia gas pipeline became a subject of
litigation between TBG (a pipeline company controlled by Petrobras) and
British Gas (BG) and Enersil for the pipeline free access. BG and Enersil
wanted free access to the pipeline with flexibility to use it or not, while
paying the same tariff as other companies without this flexibility (“take-
or-pay” contracts). We demonstrated to ANP that this flexibility has value
so that the tariff must be higher for BG compared with “take-or-pay”
tariffs. The decision of ANP was to permit free access to the pipeline but
require paying a higher price for the tariff.
iii. In 2005, a biodiesel project was analyzed with real options because of
the “flex” technology for the inputs, namely flexibility to use vegetable oils
from soybean, cotton, castorbean, etc. The RO value was decisive for the
project to get approved by the board of directors.
iv. In 2003, Petrobras International solicited another real options project
named “Strategic Valuation of E&P International at West Africa Off-
shore.” Using RO, we showed the importance to stay in Africa offshore.
Petrobras kept its business there, and nowadays the African production is
very significant for Petrobras’s international operations.
v. We studied GTL (gas-to-liquid) technology using RO (switch-input and
switch-output options) in 2006 to 2008. The study recommended the
project (though the 2008 crisis and other priorities, such as large discover-
ies in pre-salt, put the project in wait mode).
3. Do you see a role for using game theory in conjunction with real options
analysis?
Yes, definitely. At Petrobras game theory is being taught since 2007, but
separate from courses on real options. This course, although recent, moti-
vated three real-life applications already. In the future, I think option
games courses will be offered at Petrobras also and related applications
will follow.
174 Chapter 5
can allow future decisions to be adapted to future market conditions.

Static NPV represents an extreme case where the management commits
at the outset (at t = 0) to a stringent plan of action, as if the utility could
not alter its operational or investment decisions over time.
Here we review basic option valuation principles to help equip those
readers in need of a basic tool kit for valuing the real options an electric
utility or any other firm faces. The two most known option-pricing models
are attributed to Black and Scholes (1973) and Cox, Ross, and Rubinstein
(1979).9 The Black–Scholes (BS) or Black–Scholes–Merton model
involves advanced mathematics and notions of financial theory in con-
tinuous time, while the discrete-time multiplicative binomial model of
Cox–Ross–Rubinstein (CRR) offers a more intuitive introduction to
option pricing.10 Originally these models were designed to price financial
options but have since been extended to valuing real options. Robert C.
Merton discusses the development and impact of continuous-time finance,
option-pricing theory, and the relevance of real options in box 5.3.
The valuation approaches underlying the net-present-value (NPV)
paradigm and real options analysis involve similar assumptions but alter-
native versions of risk adjustment. The traditional approach based on net
present value essentially involves discounting expected cash flows at a
discount rate k that reflects the nondiversifiable risk of the project. An
alternative approach, that is core to option pricing, is to make the adjust-
ment for risk to the expected cash flow rather than to the discount rate:
the resulting certainty-equivalent cash flow can thus be discounted at the
risk-free rate of interest r (instead of k ). Discrete-time and continuous-
time models offer alternative ways to characterize these certainty equiv-
alents. Discrete-time models are generally better suited when one needs
to handle practical or complex valuation problems (e.g., portfolios of real
options). The continuous-time approach assumes instantaneous decision-
making. Discrete-time models are easier to implement, though continu-
ous-time models have an appeal as they help better identify the
theoretical value drivers and examine the underlying trade-offs. We first
present the basic valuation idea in discrete time and later extend it briefly
to the continuous-time context.
9. The Black–Scholes model is also often referred to as the Black–Scholes–Merton model
to pay tribute to Robert C. Merton for developing much of the foundation work in Merton
(1973).
10. The two setups are closely related. The discrete-time CRR model converges to
the continuous-time Black–Scholes model for small time increments or large number of
inbetween steps. In both cases the basic underlying idea is that in a complete capital market
one can replicate over the next time period an asset’s price dynamics by creating a portfolio
that provides the same payoffs in each state of the world.
Box 5.3
Interview with Robert C. Merton, Nobel Laureate in Economics (1997)
1. Did you envision the widespread use or application of options thinking

and tools when you first worked on options and stochastic-calculus applica-
tions? How did you come up with the idea?
I recognized early on that option pricing had a much wider application

than to stock options narrowly, such as using it to develop a unified theory
for pricing the capital structure of the firm. I traded warrants, convertibles,
and OTC options before I ever studied economics. At MIT I worked with
Paul Samuelson in 1968 on warrant pricing, and separately attacked the
intertemporal optimal lifetime portfolio problem with continuous trading
using the Itô calculus as a tool to describe the dynamics of actual sample
paths. When I discussed with Myron Scholes what he and Fischer Black
were doing in discrete-time intervals between trades to find a dynamic
strategy for hedging out the beta risk of an options/stock portfolio, it was
natural to apply this same technique and show in the limit of continuous
trading that one could hedge all (not just beta) risk and thus could repli-
cate the payoffs to any derivative via dynamic portfolio trading in the
underlying asset.
2. Paul A. Samuelson recently passed away. His seminal work spans many
economic fields, including finance. Can you comment on his early contribu-
tion to continuous-time finance?
In his 1965 rational theory of warrant pricing, Paul Samuelson introduced

geometric Brownian motion for underlying stock prices; he generated the
Kolmogorov equations for warrant pricing and with H. P. McKean derived
176 Chapter 5
Box 5.3
(continued)
pricing for the early exercise provision of American-style warrants. In an

attached appendix to Samuelson’s published 12th von Neumann Lecture,
I provided the connection between his warrant pricing model and the
Black–Scholes model.a This was the first time that the Black–Scholes
model appeared in published print.
3. To what extent has continuous-time finance reshaped the theory of pricing

and valuation?
The replication idea has been employed for decades in just about every
venue of financial security pricing; my Nobel Lecture (Merton 1998)
includes a list of various applications of the model methodology, including
real options.
4. What are your views on the usefulness of real options analysis? Is real
options analysis handicapped if the underlying asset (project) is not traded
or portfolio replication of the embedded option is not readily available?
I believe real options analysis is extremely useful. Real options valuation

is no more handicapped than any of the other tools of valuation, such as
NPV, where you need data on an equally risky asset to estimate beta, etc.
Conceptually the model can be adapted to nontrading of the underlying
asset and even to nonobservable interim prices (see Merton 1998, pp.
326–36). Since in all equilibrium asset-pricing models (e.g., the CAPM or
arbitrage pricing theory) assets that have only nonsystematic or diversifi-
able risk are priced to yield an expected return equal to the riskless inter-
est rate, and given that the portfolio tracking error (following a portfolio
strategy that minimizes that error) is uncorrelated with all traded asset
returns, the option pricing formula would apply even in those applications
in which the underlying asset is not traded.
a. Paul Samuelson was John von Neumann Lecturer at the SIAM Annual Meeting
in 1971. This lecture resulted in the article by Samuelson (1973).
5.3.1 Discrete-Time Option Valuation
Assume that a new power plant would generate a stream of cash flows
having present value V today (t = 0). In one period, the plant value can
take one of two possible values: it will move up to V + or down to V −
with real probabilities q and 1 − q, respectively. Figure 5.6 depicts the
underlying asset’s value dynamics in a one-period binomial lattice.
Assume further that this asset is traded in capital markets or that there
V+
V−
t=0 1
Figure 5.6
Binomial lattice for the underlying asset (project) value
is a twin security traded in the market that has the same risk profile as
the asset under consideration.
Under traditional NPV analysis, the future values of the power plant
(V + and V − ) are related to its present value (V ) as a discounted
expectation:
E [V1 ] qV + + (1 − q) V −
V= = . (5.1)
1+ k 1+ k
Suppose that investing in the plant involves capital cost I . Investing
immediately would result in project NPV = V − I . The standard (NPV)
approach, however, is unable to properly value projects involving opera-
tional flexibility, such as the option to delay the investment for a year.11
Real options involve cash flows that are asymmetric on the downside
versus the upside and are contingent on future uncertain events. Risk,
and therefore discount rates, may vary in a complex way over time and
across various future states. Optionality can be properly valued using
option-pricing theory.
The basic idea behind option valuation is that one can replicate an
option by constructing a portfolio consisting of a (long or short) position
in the underlying asset and a (short or long) position in a risk-free bond.
This portfolio can be constructed so as to exactly replicate the future
cash flows or returns of the option in each state of the world.12 Since the
option and its equivalent portfolio would provide the same future returns
in all states, they must sell for the same current value to avoid risk-free
arbitrage profit opportunities. Equivalently, we could create a riskless
replicating portfolio and discount the payoffs from this portfolio at the
11. When we consider a project with differing starting dates as mutually exclusive alterna-
tives, one can capture a form of timing flexibility and act optimally by choosing the alterna-
tive with the highest NPV. This approach based on mutually exclusive alternatives extends
the standard “NPV rule” asserting to invest in positive NPV projects.
12. We assume that the market is complete so that the replication argument holds.
178 Chapter 5
risk-free rate, r.13 To value the project as if in a risk-neutral world, one

needs to utilize the so-called risk-neutral probabilities.14 Alternatively,
the present value of any contingent claim can be obtained from its
expected certainty-equivalent value discounted at the risk-free rate r.
Through the ability to construct a riskless portfolio, investors’ risk atti-
tudes do not matter in valuing the option and need not be explicitly
considered. Therefore, we can equivalently—and more conveniently—
obtain the option value as if we were in a risk-neutral world. In such a
world all assets would earn the risk-free return (r), and so risk-neutral
expected cash flows can be appropriately discounted at the risk-free rate.
Let p denote the risk-neutral probability of an upward move (and 1 − p
the probability of a downward move). The present value of the underly-
ing asset, such as the power plant, in a risk-neutral world is
Eˆ [V1 ] pV + + (1 − p) V −
V= = , (5.2)
1+ r 1+ r
where Ê [⋅] denotes the risk-neutral expectation. The risk-neutral prob-
ability of an up move is then
(1 + r ) V − V −
p≡ . (5.3)
V+ −V−
13. Consider a portfolio made of N shares of the underlying asset Vt and B risk-free
bond(s) that pay €1 next period. Since the bond is risk-free, it yields in each state of
the world a return equal to 1 plus the risk-free return r. Holding B bonds at time t is
worth B (1 + r ) in one period. Consider a portfolio that replicates the payoffs of the option
in each state. To avoid arbitrage opportunities in the capital market, this portfolio must
sell for the same price as the option it replicates, that is, C + = N × V + − (1 + r ) B and
C − = N × V − − (1 + r ) B. This system of two equations with two unknowns gives the following
values for N and B
C+ − C− C
N= and B= (1 − H ) ,
V+ −V− 1+ r
with
⎛ C+ −C− ⎞⎛ V ⎞
H =⎜ + − ⎟⎜ ⎟
⎝ V − V ⎠⎝ C ⎠
being a discrete measure of the elasticity of the option with respect to the underlying asset
value. The position, N , invested in the asset to replicate the option payoff is the option’s
hedge ratio (or option’s delta). In discrete time, it is obtained as the difference (spread) of
the option prices divided by the spread of asset prices.
14. The NPV approach factors investors’ risk-aversion in the risk-adjusted discount
rate k . The ability to construct a replicating portfolio enables the current value of the
option claim to be independent of the actual probabilities or investors’ risk preferences.
Option-pricing theory bypasses risk-aversion by valuing options as if investors were in a
risk-neutral world.
If the underlying asset evolves according to the multiplicative binomial

process with up factor u (where V + = uV ) and down factor d (where
V − = dV), the risk-neutral probability above is given by15
(1 + r ) − d
p≡ . (5.4)
u−d
Consider now a deferral option on the underlying power plant’s value.

Suppose that this real option has value C + or C −, as a function of V + or
V − , respectively, in one period. In a risk-neutral world, the expected
return of this option must also equal the risk-free rate r. This results in
the following fundamental option-pricing formula:16
Eˆ [C1 ] pC + + (1 − p)C −
C= = . (5.5)
1+ r 1+ r
Example 5.1 Option to Invest (or Defer)

Suppose that EDF has the option to build a power plant in Brittany this
year or wait one year until regional elections are settled. EDF has no
fear of preemption and, depending on the party chosen, may gain politi-
cal support through subsidies. By waiting, EDF will forgo one period
of profit but can benefit from the resolution of political uncertainty. If
the plant is built immediately, EDF will receive gross project value
V = C100 million (m) ; net of the capital investment cost I = C80 m,
this results in an NPV of C20 m. Suppose that the plant’s value in one
period will move up by 80 percent (or u = 1.8) or down by 40 percent
(d = 0.6) depending on the outcome of next year’s elections, with each
outcome equally likely (q = 0.5). A year later, the plant will have an
expected value (from subsequent cash flows) of V + = C180 m if the
15. Note that d < 1 < 1 + r < u for the no-arbitrage argument to hold. Alternatively,
formula (5.4) can be obtained by considering returns. In the up case, the return is
R + ≡ V + V − 1 = u − 1. In the down case, it is R − ≡ V − V − 1 = d − 1. The risk-neutral proba-
bility, p, is obtained from the equilibrium condition that the expected return on the asset
in a risk-neutral world must equal the risk-free rate r:
(1 + r ) − d
pR + + (1 − p) R − = r, or p≡ .
u−d
Probability p is lower than the real probability of an upward move, q, since p accounts for
investors’ risk-aversion, giving lower weight to upside events. p is the value probability q
would have in equilibrium if investors were risk neutral.
16. Equation (5.5) provides a formula for the value of the option in terms of V , r and the
asset volatility (u and d ). Effectively, u is the discrete-time equivalent of the continuous-
time volatility parameter eσ h (which is a function of the volatility of the asset σ and the
time step h). In the electricity case we can derive the risk-neutral probability p from the
price dynamics of electricity prices using forward prices for electricity.
180 Chapter 5
outcome is favorable or V − = C60 m in the adverse case. Suppose that the

expected rate of return or discount rate is k = 20 percent and the risk-free
interest rate is r = 8 percent. The risk-neutral probability, obtained from
equation (5.4), is
(1 + r ) − d 1.08 − 0.6
p= = = 0.4 ( < 0.5) .
u−d 1.8 − 0.6
If there are no options creating asymmetry in the payoff profile, the risk-
neutral valuation formula of equation (5.2) would yield the same value
for the plant as traditional DCF valuation based on (5.1):
0.4 × 180 + (1 − 0.4 ) 60
V=
1.08
0.5 × 180 + (1 − 0.5) 60
=
1.20
= C100 m.
The option to defer the investment can be quite valuable, however,
since the firm would invest only if prices and project value rise suffi-
ciently, while it has no obligation to invest under unfavorable develop-
ments. The value of the plant launched one year from now
is C + = max {180 − 80; 0} = 100 in the event of a positive election outcome,
or C − = max {60 − 80; 0} = 0 in the event of a negative outcome. The value
of the option to invest next year, based on equation (5.5), is
0.4 × 100 + 0.6 × 0
C= ≈ C 37 m.
1.08
EDF thus has a very valuable option to defer the investment for a year
(37 > 20), waiting until further information about the outcome of politi-
cal elections and the electricity prices in Brittany is revealed.
Example 5.2 Option to Expand

Alternatively, EDF may install new turbines in one of its wind farms
in Brittany, expanding production scale by making a complementary
investment if the newly elected regional government gives support to
renewable energies. In year 1, EDF can choose to maintain base-scale
operation (receiving project value V − or V + at no extra cost) or expand
operations by 50 percent (e = 0.50) by adding capacity at extra cost
I e = 40. The original investment opportunity can be seen as the
base-scale project plus a call option on future growth, providing
C + = V + + max {eV + − I e ; 0} = max {(1 + e ) V + − I e ; V + } after an up move,
or C − = max {(1 + e ) V − − I e ; V − } in the adverse case. In the case at

hand, EDF will choose to expand in the up case, obtaining
C + = max {1.5 × 180 − 40; 180} = 230, but it will maintain the base scale in
the adverse case earning C − = max {1.5 × 60 − 40; 60} = 60. The expanded
NPV (including the value of the option to expand if the market grows)
based on equation (5.5) is
0.4 × 230 + 0.6 × 60
C= ≈ C118.5 m .
1.08
Example 5.3 Interconnection Line
The Italian electric utility Enel is considering installing an interconnec-
tion line with France that would enable it to benefit from electricity price
differentials between the two countries. Suppose that the electricity price
in France is constant at PF = 1 due to reliable nuclear power technology.
The Italian electricity price, being PI = 1 today, will move up by 50 percent
to PI+ = 1.5 (u = 1.5) or down by 33 percent to PI− = 0.67 (d = 2 3) with
equal probability (q = 0.5) each year. If the Italian electricity price rises
next year, Enel can take advantage of the transmission line importing
cheaper electricity from France by buying at the fixed French price
PF = 1 and receiving the higher Italian selling price PI+ = 1.5. This is analo-
gous to the previous option to expand with payoff max {PI+ − PF ; 0} = 0.5.
In the adverse case, if Italian prices drop to PI− = 0.67 next year, Enel can
export electricity to France receiving the higher French price PF = 1; the
option payoff is then max {PF − PI− ; 0} = 0.33. This option is analogous to
a put that allows to receive the French price (strike price) of C1 by paying
the lower Italian electricity price (underlying asset) of PI− = 0.67. The
interconnection line thus provides Enel with two valuable options: one
creating an upside potential to sell more electricity in Italy by importing
cheaper nuclear power from France (a call option), and another limiting
the downside risk to Enel by selling in France rather than in Italy if local
prices drop (a put option). The price received by Enel will be
P + = max {PI+ ; PF } or P − = max {PI− ; PF }.

If local prices move up next year, Enel will charge P + = max {1.5; 1} = 1.5.
If they move down, it will obtain the guaranteed (French nuclear) price
P − = max {0.67; 1} = 1. Without the transmission line, Enel could only sell
at local prices, being exposed to the full price fluctuation risk, receiving
PI+ = 1.5 or PI− ≈ 0.67. The average (next-year) price in Italy would have
been E [ PI ] = qPI+ + (1 − q) PI− = 0.5 (1.5 + 0.67 ) ≈ 1.1. With the transmission
182 Chapter 5
line, however, the average price is E [ PI ] = 0.5 (1.5 + 1) = 1.25 ( > 1.1). Thus
the transmission line allows to sell at higher prices on average. The trans-
mission line would be mispriced if managers ignore the embedded
switching flexibility value and base their investment decision on the
future average price, max {E [ PI ]; PF } = 1.1. Real options analysis, by con-
sidering the optimal switching decision at each period in each state,
makes it possible to circumvent this “flaw of averages.”17 What is the
correct “average” price discounting for the value of the transmission
line? From equation (5.4), the risk-neutral probability of an up move
(with risk-free rate r = 0.05) is p ≡ (1.05 − 0.67) (1.5 − 0.67) = 0.46. From
equation (5.5) the value of the merchant interconnection line per unit of
output is
0.46 × 1.5 + 0.54 × 1
≈ 1.17 .
1.05
Outside Europe, Hydro-Québec, a state-owned corporation in Canada

with large production capacity in hydro (95 percent), is profitably exploit-
ing such transmission lines. Hydro reservoirs are very flexible resources,
so that Hydro-Québec can increase or decrease output at very low cost
almost overnight. In contrast, Ontario and the northeastern states of the
United States rely mainly on nonflexible thermal power plants that virtu-
ally have a constant output, explaining why prices there are very sensitive
to changes in demand patterns. At night, Hydro-Québec buys electricity
from Ontario and the NE-US at very low prices (due to low local
demand), downscaling its own production. During the day, it raises own
production and sells them back electricity at high prices (high local
demand).18
One can extend the above one-period binomial analysis to a larger
number of steps though a repetitive process. This is discussed in appendix
5A and illustrated briefly in example 5.4 below for two steps.
Example 5.4 Option to Invest or Defer (Two Steps)

Consider a situation analogous to example 5.1, where Enel of Italy has
the option to enter the Russian electricity market in two years’ time.
Suppose again that the market value, currently C150 m (V = 150), follows
a binomial process with an upward multiplicative factor u = 1.5 and
17. We can characterize this value difference by applying Jensen’s inequality to convex or
concave functions. The payoff function f (⋅) of the call option is convex in the underlying
factor X , such that E [ f ( X )] ≥ f ( E [ X ]). On the converse, a put has a concave payoff func-
tion, so that the opposite inequality holds. Savage (2009) applies Jensen’s inequality to
challenge certain managerial practices based on the “flaw of averages.”
18. We thank Marcel Boyer for suggesting this example.
downward factor d = 1 u ≈ 0.67 in each period. Enel must incur an infra-

structure investment cost of I = C80 m to enter this geography at T = 2
years. The risk-free interest rate is r = 0.04.
In the scenario following two consecutive up moves, the gross market
value, V ++ = uuV = 1.5 × 1.5 × 150 ≈ C 338 m, exceeds the investment cost,
I = C80 m. Enel will then enter the market, receiving a net (forward)
investment opportunity value of C + + = max {338 − 80; 0} = C 258 m.
In the intermediary state (that occurs after a downward move
following an up move or inversely), the gross market value is
V +− = udV = 1.5 × 0.67 × 150 = C150 m. If Enel invests, it receives
V +− − I = 150 − 80 = C 70 m. It will thus again exercise its investment
option at maturity, receiving C +− = C70 m. In the down state, after
two consecutive down moves, the gross market value is
V − − = ddV = 0.67 × 0.67 × 150 ≈ C 67 m. Enel will not invest I = C80 m for
a negative NPV (67 − 80 = −13). It will instead abandon the investment
option, receiving C − − = 0. Figure 5.7 shows the market value evolution
and the investment option’s payoffs at maturity.
The current investment option value is assessed by a backward process
using risk-neutral valuation along the two-step binomial tree. The risk-
neutral probability of an up move, determined from equation (5.4), is
p = 0.45. Going backward to t = 1, in the up state the investment option
value is given by equation (5.5) as
Binomial tree representing Option

Option tree
market value evolution payoff
338 C ++ = 338 − 80 = 258 C ++ = 258

p
225 C + = 148
p
1−p
150 C = 80
150 C +– = 70 C +– = 70
1−p p
100
C – = 30
1−p
67 C –– =0 C –– = 0
t=0 1 2 t=0 1 2
Figure 5.7
Binomial tree evolution and payoff for the option to defer (2 steps)
184 Chapter 5
pC ++ + (1 − p)C +− 0.45 × 258 + 0.55 × 70

C+ = = ≈ C148 m.
1+ r 1.04
In the down state, the option has (time-1) value
0.45 × 70 + 0.55 × 0
C− = = C 30 m.
1.04
Finally, one step earlier, the present value (t = 0) of the investment option
for Enel is
pC + + (1 − p)C − 0.45 × 148 + 0.55 × 30

C= = ≈ C 80 m.
1+ r 1.04
Alternatively, using the t = 2 expectation, based on applying the equation
from appendix 5A for the binomial distribution with n = 2 steps:
p2C + + + 2 p (1 − p) C + − + (1 − p) C −−
2
C=
(1 + r )2
0.45 × 258 + 2 × 0.45 × 0.55 × 70 + 0.552 × 0
2
=
1.04 2
≈ C 80 m.
That is, the current value of the investment opportunity for Enel to enter
the Russian market in two years is &80 m, which is more that the value
to enter it today. The net present value of entering the market immedi-
ately (at t = 0) is NPV = V − I = 150 − 80 = C 70 m.
5.3.2 Continuous-Time Options Analysis
Real options analysis can be either dealt with in discrete or in continuous

time. Each approach has its own merits. The continuous-time approach
is more helpful to derive basic investment principles.19 The CRR dis-
crete-time analysis rested on the assumption that the underlying
asset, Vt, follows a multiplicative binomial process. In continuous time
this corresponds to assuming that the underlying asset follows the geo-
metric Brownian motion (GBM)
dV = ( gV ) dt + σ V dz, (5.6)
where g denotes the actual growth trend of the process, σ 2 its variance
and z is a standard Brownian motion.20
19. Continuous-time models are useful when model assumptions enable the derivation of
analytical solutions.
20. See the appendix of the book for detail on the GBM.
Black and Scholes (1973) use this process to derive their famous
formula for pricing European call options. At maturity T , a European
call option pays off the greater of the net value VT − I or zero, meaning
CT = max {VT − I ; 0}. Under risk-neutral valuation, the call option at
time t = 0 is worth C = e − rT Eˆ [CT ], where r is the continuously com-
pounded risk-free interest rate.21 The Black–Scholes (BS) formula for
the value of a European call option (on a nondividend-paying asset) is
C = V N( d1 ) − Ie − rT N(d2 ), (5.7)
where N (⋅) is the cumulative standard normal distribution.22 Parameters

d1 and d2 are given by
ln (V I ) + [ r + (σ 2 2)]T
d1 = ,
σ T (5.8)
d2 = d1 − σ T .
This formula is a cornerstone in option-pricing theory. One can obtain it
based on the replicating portfolio argument as in Black and Scholes
(1973) and Merton (1973).23
The discrete-time and continuous-time approaches are not really com-
peting paradigms; they view the same problem from different mathemat-
ical angles. The multistep Cox–Ross–Rubinstein (CRR) option-pricing
formula is derived in appendix 5A. For a given maturity, T , as the time
21. Under the risk-neutral probability measure, the asset price does not exactly follow
the GBM of equation (5.6), but an adjusted GBM involving a “risk-neutral drift,” ĝ , equal
to r in the Black and Scholes model.
22. Let p (·) denote the probability density under the risk-neutral measure. By decompos-
ing C , we obtain
∞
C = e − rT ∫ max {VT − I ; 0} p(VT ) dVT
0
∞
= e − rT ∫ (VT − I )p(VT ) dVT
I
= e − rT × ξ − e − rT I × θ ,
where θ ≡ Pr (VT ≥ I ) and ξ ≡ Eˆ [VT | VT ≥ I ] are, respectively, the probability that the option
ends up “in the money” and gets exercised at maturity, and the expected value of the asset
when it does. From equations (A.16) and (A.19) in the appendix of the book, θ = N ( d2 )
and ξ = Ve rT N ( d1 ) . We employ the risk-neutral drift term r, here, instead of g.
23. Our derivation of BS in note 21 rests on probabilistic properties of the European call
option and of geometric Brownian motion. The replicating-portfolio approach generalizes
to a larger family of processes (Itô processes) and can accommodate other payoff functions.
As noted, under mild conditions, it is possible to create a portfolio replicating the payoff
to a call option. This portfolio consists of N shares of the underlying asset and a
short position, B, in a risk-free bond. In continuous time, N = CV (V ) and B = e − rtC (1 − ε ) ,
with ε ≡ CV (V ) × V C . In the BS case involving geometric Brownian motion, the
hedge ratio (position in the underlying asset) used in the replicating portfolio is
N = CV (Vt ) = N( d1 ) .
186 Chapter 5
step, h ≡ T n, becomes increasingly smaller (as h approaches 0 or the

partition of the time interval becomes finer with n going to infinity),
continuous replication is approximated and the multiplicative binomial
process converges to the geometric Brownian motion. In the binomial
model the parameters u, d , and p are consistent with their continuous-
time counterparts if 24
1
u = eσ h
and d = . (5.9)
u
Under these conditions the multistep CRR binomial option-pricing
formula, discussed in appendix 5A, converges to the BS formula in
(5.7).25
Example 5.5 Option to Invest (Black–Scholes)

Let us revisit example 5.4 above. Enel may delay investment in the
Russian electricity market for two years until the true market develop-
ment is revealed. Underlying project value is V = 150. Suppose that this
value fluctuates continuously over time (driven by global energy supply
and demand factors) with volatility σ = 40%.26 The risk-free interest rate
is r = 4%. The investment outlay for the power plant is I = 80. From equa-
tion (5.8),
ln (150 80 ) + [ 0.04 + ( 0.4 2 2)] 2
d1 = ≈ 1.54,
0.4 2
and d2 ≈ 1.54 − 0.4 2 ≈ 0.97. From the cumulative standard normal dis-
tribution, N (d1 ) ≈ 0.94 and N (d2 ) ≈ 0.84. From the Black–Scholes formula
of equation (5.7), the investment option value is
C = 150 × 0.94 − 80 × e −0.04 × 2 × 0.84 ≈ C 79 m.
This is close to the value obtained in example 5.4 above using the CRR
binomial model (C80 m) with only two steps (n = 2).
24. The probability of an up move is given by
1 1 αˆ ′
p= + h,
2 2 σ
where αˆ ′ ≡ ln r − (σ 2 2) . Cox, Ross, and Rubinstein (1979) show that, in the limit, the
complementary binomial distribution function B used in appendix 5A converges to the
cumulative standard normal distribution function N(⋅).
25. The CRR formula converges to the BS formula if h ≤ σ 2 αˆ 2 , with αˆ ≡ r − (σ 2 2).
26. This volatility value, σ = 40 percent, is close to u = 1.5 in example 5.4, as given
by u = eσ h .
The Black–Scholes formula of equation (5.7) deals with a relatively

simple situation where a single risk factor evolves stochastically. In
reality, several risk factors may affect firm value. Margrabe (1978) exam-
ines a more general situation where a firm can exchange one (nondivi-
dend-paying) stochastic asset (I) for another (V). For example, the capital
investment cost as well as the project value may evolve stochastically.
Suppose that both project value, Vt, and investment cost, I t, follow cor-
related geometric Brownian motions
dV = ( gV V ) dt + σ V Vdz,
(5.6′)
dI = ( g I I ) dt + σ I I dz′.
These factors are assumed correlated with correlation coefficient ρ. We

want to value a European call option giving the right to receive at matu-
rity uncertain project value VT by paying uncertain investment cost IT ,
i.e., C (V , I ) = e − rT Eˆ [max {VT − IT ; 0}]. One way to simplify the problem
is to define project value, V , in units of investment outlay, I , thereby
reducing the problem dimensionality by one dimension (from two to
one). Let X ≡ V I be this composite (relative) stochastic factor, with
relative (instantaneous) variance given by
σ X 2 = σ V 2 + σ I 2 − 2 ρσ V σ I . (5.10)
The value of the investment outlay I in terms of itself is 1 and the interest
rate on a riskless loan (paying no dividend) in units of I becomes 0. The
Black–Scholes formula still applies, with two needed adjustments:
(1) r = 0 and (2) σ 2 becomes σ X 2 as given by equation (5.10).27 This
results in Margrabe’s (1978) extension for the European option to
exchange stochastic cost I for V at maturity T :
C(V , I ) = V N(d1 ′ ) − I N(d2 ′ ), (5.11)
where
1
ln (V I ) + σ X 2T
d1 ′ = 2 , (5.12)
σX T
d2 ′ = d1 ′ − σ X T .
27. Given these adjustments and the homogeneity of the option value function, we obtain
from Black–Scholes formula (5.7) that
C (V , I )
= X N ( d1′ ) − 1e −0 T N ( d2 ′ ) .
I
188 Chapter 5
Example 5.6 Option to Temporarily Shut Down Operations28

The Italian electric utility is equipped with CCGT technology. The gen-
eration cost, Ct , is driven by two factors: the input gas price, PtG, which
evolves stochastically according to
dPtG = (rPtG ) dt + σ G PtG dzt,
and technological efficiency, measured by a constant heat rate H.29 The

output electricity price, Pt E, follows the geometric Brownian motion,
dPt E = (rPt E ) dt + σ E Pt E dzt.
Electricity and gas prices are correlated with coefficient ρ . The electric
utility is not compelled to operate the CCGT plant at any time t if vari-
able costs are not covered. The contingent profit stream at time t is thus
π t ≡ max {Pt E − Ct ; 0}, where the generation cost, Ct = H × PtG, where H is
the efficiency coefficient, is the exercise price of this European call option.
The present value of the time-t contingent profit π 0(t ) can be valued (as
of time 0) using Margrabe’s formula from (5.11) with maturity t. From
equation (5.11) the expected present value of π 0( t ) = C( P0E , P0G ) is
C( P0E , P0G ) = P0E N( d1′ ) − H × P0G N( d2 ′ ), (5.11′)
where H × P0G is the present value of the (time-t) exercise price. The
parameters d1’ and d2’, obtained from equation (5.12), are given by
1
ln ( P0E ( H × P0G )) + σ X t
d1′ = 2 (5.12′)
σX t
and d2 ′ = d1′ − σ X t with σ X2 = σ E2 + H 2 × σ G2 − 2ρHσ E σ G following
(5.10).30 Suppose that the current prices of electricity and gas are
P0E = C12 and P0G = C10, with efficiency coefficient H = 1. Electricity
and gas prices have volatility σ E = 30 percent and σ G = 20
percent, with correlation coefficient ρ = 0.40. From equation (5.10),
σ X2 = 0.32 + 12 × 0.2 2 − 2 × 0.4 × 1 × 0.3 × 0.2 ≈ 0.08. For a two-year horizon
(t = 2) we have
28. The present example is adapted from McDonald (2006, ch. 17).
29. The heat rate H corresponds to the number of British thermal units necessary for the
generation of one MWh of electricity.
30. McDonald and Siegel (1985) derive the closed-form solution for this problem. Assum-
ing that the two assets pay no dividends, the general solution in McDonald and Siegel
(1985) obtains as Margrabe’s (1978) formula for the option to trade one risky asset for
another.
ln (12 (1 × 10)) + (0.08 2 2) × 2

d1′ = ≈ 1.67 ,
0.08 2
d2 ′ = 1.67 − 0.08 2 ≈ 1.55,
so N (d1′ ) ≈ 0.95 and N (d2 ′ ) ≈ 0.94. Having flexible operations with the
possibility to shut down operations in two years results in a value, based
on equation (5.11), of π 0 ( 2 ) = C(12, 10 ) = 12 × 0.95 − 1 × 10 × 0.94 ≈ 2.0.
Assuming the CCGT plant will be decommissioned in T years, the power
plant that embeds such operational flexibility in each year t has total
value ∑ t = 0 π 0( t ).
T
Conclusion
We discussed multiple sources of risk affecting companies in the energy

sector and the breakthrough innovation of real options analysis. Option-
based valuation is a useful tool to corporate managers and strategists,
providing a consistent and unified approach toward incorporating the
value of real options associated with the investment decisions of the firm.
We discussed how to quantify in principle the value of various types of
operating options embedded in capital investments with applications in
the energy sector. Some of these options enhance the upside potential
(e.g., options to defer or expand), while others reduce downside risk (e.g.,
options to contract, switch use, interconnect or default on staged planned
outlays). This valuation approach serves as foundation for the option
games approach developed later in the book.
Selected References
The International Energy Agency (2007) identifies various challenges

ahead for companies in the energy sector and suggests possible ways to
tackle the business risks involved. Trigeorgis (1996) offers a broad over-
view on real options. Dixit and Pindyck (1994) discuss various real
options in continuous time. Cox, Ross, and Rubinstein’s (1979) binomial
model is widely used for pricing options in discrete time. Black and
Scholes (1973) and Merton (1973) derive the key properties and formula
for valuing European call options.
Black, Fischer, and Myron S. Scholes. 1973. The pricing of options and
corporate liabilities. Journal of Political Economy 81 (3): 637–54.
190 Chapter 5
Cox, John C., Stephen A. Ross, and Mark E. Rubinstein. 1979. Option
pricing: A simplified approach. Journal of Financial Economics 7 (3):
229–63.
Dixit, Avinash K., and Robert S. Pindyck. 1994. Investment under Uncer-
tainty. Princeton: Princeton University Press.
International Energy Agency. 2007. Tackling Investment Challenges in
Power Generation. Paris: IEA Publications.
Merton, Robert C. 1973. Theory of rational option pricing. Bell Journal
of Economics and Management Science 4 (1): 141–83.
Trigeorgis, Lenos. 1996. Real Options: Managerial Flexibility and Strategy
in Resource Allocation. Cambridge: MIT Press.
Appendix 5A: Multistep Cox–Ross–Rubinstein (CRR) Option Pricing
Consider a European call option that gives the right—but not the obli-
gation—to receive at maturity the underlying asset value VT by paying
the exercise price or investment cost I . This call option pays off at matu-
rity (T ) the greatest of VT − I and 0, or CT = max {VT − I ; 0}. Suppose that
the time to maturity T is divided into n time steps, each of equal length
h ≡ T / n, and let j be the number of up moves in n time steps. At maturity
in the last period n, after j up moves, the call option pays off
C n = max { u j d n− jV − I ; 0}.
The risk-neutral probability of an up move, p, over an interval is given

in equation (5.4).31 We can generalize equation (5.5) to obtain a binomial
option pricing formula for n periods
Eˆ [CT ] 1 ⎡ n ⎛ n⎞ j ⎤
T ⎢∑ ⎜ ⎟
p (1 − p) max {u j d n − j V − I ; 0}⎥,
n− j
C= = (5A.1)
(1 + r )T (1 + r ) ⎣ j = 0 ⎝ j ⎠ ⎦
where
⎛ n⎞ n! ⎛ n⎞ j
⎜⎝ j ⎟⎠ ≡ (n − j )! j ! and ⎜⎝ j ⎟⎠ p (1 − p)
n− j
denotes the binomial distribution giving the probability that the asset
will take j upward jumps in n steps, each jump occurring with risk-neutral
31. As discussed elsewhere, in equation (5.9), for consistency the value of parameters u
and d should be related to the time increment, h.
probability p. The summation of all possible (from j = 0 to n) option

values at expiration, multiplied by the state probability that each sce-
nario will occur, gives the expected option value at maturity T ( n) . This
expected option value, Ê [C ], is discounted at the risk-free rate r over
the n time periods. If we let m be the minimum number of up moves
(over n periods) “triggering” call option exercise (above which V > I ),
the binomial option-pricing formula in (5A.1) becomes
I
C = VB ( m, n, p′ ) − B (m, n, p), (5A.2)
(1 + r )n
where B( ) is the complementary binomial distribution function that
gives the probability of at least m up moves in n periods
n
⎛ n⎞
B ( m, n, p) ≡ ∑ ⎜ ⎟ p j (1 − p) ,
n− j
j=m
⎝ j ⎠
with
u
p′ ≡ p.
1+ r
II OPTION GAMES: DISCRETE-TIME ANALYSIS
In the first part of the book, we introduced basic principles of strategic

management and real options, and discussed how an industrial organiza-
tion perspective may provide useful insights to managers about how to
behave vis-à-vis rivals under certain business conditions. Our belief is
that these separate approaches should be combined, leveraging the
strengths of each discipline to provide enhanced managerial guidance,
dealing concomitantly with both market and strategic uncertainties. In
part II of the book, we put these perspectives together, discussing some
useful models at the interface between game theory and real options as
part of a unified, discrete-time analysis. Discrete-time option games are
more suitable to help explain intuitively the basic concepts and logic
behind the timing and interactions of real investment decisions and
determining optimal investment strategies to guide the behavior of ratio-
nal option holders.
In what follows we introduce concepts and tools gradually in terms of
increasing complexity, starting first with a simple “equilibrium selection
procedure” and building up in terms of complexity over subsequent
chapters. We illustrate the simple idea behind option games via illustra-
tive examples in chapter 6. In subsequent chapters we analyze how
strategic interactions among rivals may alter the firms’ behavior in cases
where the investment opportunity is analogous to a shared European
call option, circumventing the issue of optimal timing under rivalry.1
We base much of this analysis on Smit and Trigeorgis’s (2004) extension
1. Investment opportunities are often viewed as being analogous to American call options.
To simplify, we start with the simpler case of European options that give the option holder
only one investment exercise possibility, at maturity. Using European options has two main
advantages. First, it allows circumventing the problem of optimal timing in multiplayer
settings, thereby precluding preemption or war of attrition effects. Second, for discrete-time
analysis with finite horizons, it enables us to have investment triggers that are independent
of the time or stage considered. Here the investment trigger is fixed and prescribes the
investment decision at the end period (maturity).
194 Part II
of Fudenberg and Tirole’s (1984) framework for analyzing business strat-

egies under uncertainty in light of whether firms react in a reciprocating
or contrarian manner. Exogenous demand uncertainty is modeled via
discrete-time multiplicative binomial models, as in Cox, Ross, and Rubin-
stein (1979). Uncertainty arising from strategic interactions at each end
demand node is modeled via two-by-two matrices (in strategic form),
whose equilibrium payoff replaces the node payoffs in the standard
binomial tree. The cases of Cournot quantity and Bertrand price compe-
tition are analyzed in discrete time, both in the context of a proprietary
R&D investment and when there are spillover effects (shared benefits).
An extension and application in case of two-stage R&D investment
games is also provided. In chapter 7 we discuss how the above principles
can be applied in the context of Cournot quantity and Bertrand price
competition. In chapter 8 we describe how commitment and early invest-
ment in two-stage games (e.g., in R&D or advertising campaigns) may
alter the strategic value of an investment opportunity. Whether the first-
stage commitment investment increases or decreases the option value
depends on the effect of the commitment (tough or soft) and on the
reactions of competitors (strategic substitutes or complements). The
analysis is extended to derive optimal investment strategies under uncer-
tainty, providing new insights about R&D investment, spillover effects,
goodwill building, and patent strategies.
An Integrative Approach to Strategy: Option Games
6
In part I we discussed basic approaches providing insights about how to

behave in an uncertain competitive environment. We reviewed strategic
management, industrial organization, and real options as separate, stand-
alone disciplines. Each approach can separately bring about useful
insights in analyzing business situations. Nonetheless, each discipline,
taken separately, also has drawbacks. Standard game theory has not dealt
so far with stochastic dynamics; static games by their very nature do not
involve such a problem, while dynamic games are mostly cast in a steady
or deterministically evolving environment. Real options analysis, while
suitable to account for stochastic uncertainty, often makes the simplify-
ing assumption that strategic interactions do not materially affect the
investment decisions or project values of firms. Strategic management
has a lot to benefit by more explicitly incorporating the trade-off between
the value of flexibility and commitment. The best way to overcome these
drawbacks is to follow an integrative approach using the combined tools
and concomitant insights of game theory and real options. This is what
“option games” is all about, standing at the intersection between the
theory of investment under uncertainty (real option analysis) and the
game-theoretic analysis of strategic investments.
In section 6.1 we discuss how option games can provide useful insights
to management faced with conflicting strategic choices. We discuss two
prominent issues here: optimal investment timing, and the trade-off
between flexibility and commitment.1 We elaborate on these issues
further in upcoming chapters. Section 6.2 provides a simple illustration
to help figure out the logic behind option games. Sections 6.3 and 6.4 go
deeper and discuss applications to R&D and the mining/chemicals indus-
try, respectively.
1. These two issues are not really that distinct. Optimal timing is concerned with the choice
of the right moment at which to incur a sunk investment cost, which is a form of commit-
ment. Thereby the firm kills the option to delay further, losing valuable flexibility.
196 Chapter 6
6.1 Key Managerial Issues: Optimal Timing and Flexibility versus

Commitment
6.1.1 Optimal Investment Timing under Uncertainty
Consider the example of a multinational financial institution, such as

Deutsche Bank, contemplating investing in China where profits have
been growing and prices escalating. Deutsche Bank ponders whether to
acquire a stake in a local bank at the earliest opportunity or wait to see
if prices subside as the hype diminishes. Many international organiza-
tions face such a dilemma. The market in China is not fully liberalized
and administrative barriers have long blockaded entry by foreign finan-
cial institutions. These foreign institutions are faced with a trade-off
between investing now incurring a large investment outlay or waiting for
the liberalization of the market in the wake of WTO negotiations.2 A
good understanding of investment timing requires a simultaneous assess-
ment of both market uncertainty and the anticipated reactions of com-
petitors eager to seize their slice of the pie.
Should the firm invest now? Invest later? Abandon the project
altogether? If the market develops favorably, investing can prove
quite valuable. But if the market flops, investing prematurely may prove
a regrettable mistake, especially when investment costs are sunk.
To protect itself from adverse market developments, a firm that has
the flexibility to wait will require a delay investment premium until
the market is sufficiently mature to compensate for the risk. Real
options analysis can provide valuable insights concerning the optimal
timing decisions of firms under uncertainty. Investing when the project
NPV is positive is inferior to selecting optimally the time at which the
project value is maximal, with due accounting for the time value of
money.
Optimal investment timing under uncertainty is a key challenge. In
competitive settings, the optimal timing policy may differ substantially
from that of a monopolist. Rivals may preempt, eroding the incentive to
defer the decision. In other situations, rivals may prefer to wage a war
of attrition in the hope that their rival will retreat sooner. In these set-
tings the optimal timing decisions, as the result of a multiplayer problem,
2. Deutsche Bank actually decided not to wait, acquiring several local banks such as
Harrest Fund Management and Huaxia Bank. In their decision-making, Deutsche Bank
took into account the risk of international rival banks preempting it.
An Integrative Approach to Strategy 197
must form an industry equilibrium. In such investment problems the

presence of competition generally leads firms to invest earlier than a
monopolist and erodes the deferral option value of the firm.
6.1.2 The Trade-off between Flexibility and Commitment
In an uncertain competitive environment, any company considering a

capital-intensive decision, like whether to invest in a new technological
process to develop a new product, faces a trade-off between investing
early to build up competitive advantage over rivals versus delaying
investment to acquire more information and mitigate the potentially
unfavorable consequences of market uncertainty.
At the heart of this trade-off between commitment and flexibility are
two conflicting value drivers: (1) exogenous uncertainty in the form of
fluctuating demand, prices, or input costs may restrain a firm from com-
mitting early, and (2) in the face of competitive threat or pressure, a firm
might be better off to build first-mover competitive advantage. The value
of commitment as discussed in industrial organization challenges the
belief that flexibility is always valuable.3 One thus needs to weight the
relative merits of commitment versus flexibility, providing a balancing
act between the two. This trade-off can be addressed by combining real
options analysis and game theory. In boxes 6.1 and 6.2 senior consultants
from BCG and McKinsey & Company discuss the usefulness of real
options analysis for management practice and the prospects offered by
taking a game-theoretic perspective.
6.2 An Illustration of Option Games
Viewed in discrete time, an option game is an overlay of a binomial tree

onto a payoff matrix.4 A binomial tree, as the one shown in figure 6.1, is
3. The reader may recall that chapter 4 dealt with the value of early commitment (indus-
trial organization), while chapter 5 focused on the flexibility value via real options
analysis.
4. In real options analysis, two approaches are commonly used: (1) the discrete-time
approach, using binomial trees depicting the evolution of the demand state, and (2) the
continuous-time approach, using stochastic processes to model the underlying variables. In
chapter 5 we described how project value dynamics can be modeled based on a binomial
tree lattice, how risk-neutral probabilities are derived, and how the current value of an
investment option can be determined using the backward risk-neutral valuation principle.
Smit and Ankum (1993), Smit and Trigeorgis (2001, 2004), and Ferreira, Kar, and Trigeorgis
(2009) discuss option games in discrete time. This approach enables deriving key insights
by use of simple numerical examples.
198 Chapter 6
Box 6.1
Interview with Rainer Brosch and Peter Damisch, Boston Consulting Group
1. In what ways do you believe real options thinking can contribute to

strategy development? How useful have you found real options thinking in
your consulting practice?
We believe that real options thinking can contribute to strategy develop-

ment in a very powerful way: it helps to analytically support strategic
decision-making, especially in environments that are complex and exposed
to many sources of uncertainty. The approach provides structural elements
and a “vocabulary” that can be very valuable in strategy discussions that,
by definition, center around managerial flexibility, options, and contingent
decisions. A question like “how would the exercise price of a strategic
option be affected by a specific managerial action?” could very well
uncover a key issue. In many contexts a detailed valuation of business
cases or strategies is an important element of our work; this typically can
be achieved with much precision by an in-depth DCF and scenario analy-
sis. However, in settings where significant uncertainty and managerial
flexibility is involved, such as flexibility to change trajectory, abandon, or
accelerate, the value of such optionality must be considered explicitly: this
flexibility possibly allows capitalizing on positive market developments or
reducing the impact of negative market developments, and thus impacts
strategic choices. In every practical setting it is important to rigorously
assess possible sources of optionality and decide how to best capture them.
2. Would you envision extending BCG matrix thinking using options and
games for competitive analysis?
Portfolio thinking is inseparably connected to strategy and is among the

most challenging—and rewarding—aspects of management. Looking at a
company as a portfolio of businesses opens up an important perspective,
enabling to actively realize value which is above and beyond the sheer
Box 6.1
(continued)
sum of the parts. At the same time, this lens requires to actively address
trade-offs within the portfolio, namely to tackle portfolio effects and syn-
ergies that are the basis of the portfolio perspective. From its first days
BCG has pioneered strategy through portfolio analysis. The BCG Portfo-
lio Matrix is one well-known example, capable of providing awareness and
tremendous insight. Over the years we have continued to develop strategy
and portfolio analysis in many directions, such as by integrating additional
parameters, including among these strategic fit, value creation potential,
role-based views, dynamic paths and trajectories, options, and competitive
interaction. Today’s portfolio manager can rely on very advanced
approaches, consolidating various views which are inseparably connected
to options thinking and competitive analysis. Admittedly, it is always a
challenge to highlight competitive interaction and even more so when
options are involved. This is exactly what option games is about. Option
games thus make a very important and directional contribution to strategy,
tying together game theory and options thinking into a joint, analytically
rigorous framework.
Box 6.2
Interview with Eric Lamarre, McKinsey & Company
1. In your corporate finance and risk management practice with clients at

McKinsey & Company, how, and to what extent do you believe real options
analysis offers better guidance to your clients than traditional capital bud-
geting techniques?
200 Chapter 6
Box 6.2
(continued)
There is no doubt that real options analysis generates a more insightful

dialogue among senior managers. It helps uncover additional value not
fully recognized by traditional NPV techniques and, more important,
creates a structured conversation around the sources of risk and how a
company plans to respond to these risks. While a typical investment busi-
ness case merely lists potential risks, RO techniques place much greater
emphasis on these risks, as well as on the managerial flexibility to react.
2. How did you first come up with or run into the option games concept?
We first came across this concept in the mining industry. Option games are
particularly helpful for a special class of strategy problems where uncer-
tainty is high and a company’s actions or those of competitors can shape
industry dynamics. This is sometimes the case in mining when major capac-
ity expansions can materially impact the supply/demand balance. The first
mover in adding capacity will hold an advantage, but must also take on
more risk because future demand is uncertain. Managers intuitively under-
stand this dynamics, but they may find that quantifying the value is difficult
with standard DCF methodologies.
3. How useful have you found real options analysis in your consulting
practice? Have your clients shown interest in this approach?
Despite its compelling benefits, clients have been slow to adopt the RO
approach for three reasons. First, often too much focus is placed on analyt-
ics and not enough on the organizational changes required to generate
broad adoption inside a corporation. Second, having received little train-
ing on RO techniques, senior managers often revert to familiar methods
despite the shortcomings these methods present in certain situations.
Finally, poor execution during first experimentations often leads to disap-
pointing results. There is sometimes too much focus on computer simula-
tions and not enough on structuring the risk problem properly. If properly
used, this new methodology can be a real source of competitive advantage,
even more so when integrated within the organizational and strategy
processes.
State value Cumulative probability
p
V ++ pp
p V+
V 1− p
V +− = V −+ 2 p (1 − p )
p
1− p
V−
1− p
V −− (1 − p )
2
Figure 6.1
Binomial tree representing evolution of market uncertainty and associated probabilities
used to model the stochastic evolution of project value V , while two-by-

two matrices are used to capture the competitive interactions among
players. Suppose that p is the risk-neutral probability of an up move per
period. To each scenario at the end node in the binomial tree of figure
6.1 corresponds the cumulative risk-neutral probability shown in the
right column after two steps: pp for the high demand state, 2 p (1 − p)
for the intermediary demand state, and (1 − p) for the low demand
2
state.
Consider a duopoly consisting of firms i and j sharing a European
option to invest in an emerging market within two years. The annual
risk-free interest rate is 4 percent (r = 0.04). Firms i and j can both invest
now, wait and invest later (at maturity in year 2), or let the option expire.
If none invests now, at the end node in year 2 the firms’ strategic choices
(represented in two-by-two payoff matrices) are: invest or do not invest
(abandon). At maturity both firms can invest, both can abandon, or only
one invests (potentially involving a coordination problem). The basic
structure of this option game in discrete-time is depicted in figure 6.2.
Once the binomial tree charts the evolution of potential demand sce-
narios until maturity (year 2), in each end node a two-by-two payoff
matrix depicts the resulting competitive interaction. The resulting equi-
librium outcome (*) and corresponding player payoffs can be anticipated
for each of the three payoff matrices. Once the equilibrium (*) strategic
option values are obtained in each end state (C*++, C*+−, C*−−), working the
tree backward enables the firm to assess the value each strategy creates
under rivalry. The analysis reveals the benefits to each player from
202 Chapter 6
Binomial tree representing Payoff matrix for Strategic option

market uncertainty strategic uncertainty value
Firm j
Invest Abandon
Invest
High demand
C*++
Firm i
++
V
Abandon
V+ Invest Abandon
Invest
V V +− C*+ −
Abandon
V−
Invest Abandon
V −− Invest
Abandon C*−−
Low demand
t=0 1 2
Figure 6.2
Structure of an option game involving both market (demand) and strategic (rival)
uncertainty
pursuing a given strategy and enables management to determine how

these benefits might change if certain key variables, such as growth or
volatility, would change.
Let us put this in a concrete context from the electricity sector (see
example 5.4). Suppose that the Italian utility Enel and EDF of France
both possess the option to enter the Russian electricity market in two
years’ time.5 This investment option is analogous to a shared European
call option with maturity two years, with the underlying market value
following a multiplicative binomial tree process. Suppose that the market
is currently worth C150 m (V = 150) and evolves with an upward multi-
plicative factor u = 1.5 and downward factor d = 1 u ≈ 0.67 in each period.
If only one firm invests when the market is mature in year 2, that firm
would seize the entire market pie (in effect will be a monopolist). If both
utilities invest at t = 2, we assume that the market will be divided among
the two firms relative to their market power. Suppose that the Italian
5. The intent here is to value, for each firm, the option to invest in this market as incorpo-
rated in the firm market value. A different issue might be of interest as well. Suppose the
Russian government is selling two options to invest, with Enel and EDF as bidders. What
will they bid? This analysis should include the possibility that one of the utilities may find
it optimal to buy up both options and then exercise only one (if the rules and regulations
made by the Russian government permit this). Such a problem might have a different
answer.
utility (Enel) has a comparative advantage enabling it to acquire a higher

slice of the market pie (s = 0.60), with its French rival obtaining the
remainder (40 percent). Each firm must incur an infrastructure invest-
ment outlay of I = C80 m to enter the Russian market. At maturity in
year 2, each firm will either invest (receiving the net project value at that
time) or abandon the investment (receiving nothing). The values obtained
by each firm in each competitive scenario are presented in two-by-two
matrices; each of the tree end nodes of demand has a corresponding
two-by-two matrix.
Consider first the upper demand state in figure 6.3 that occurs after
two consecutive demand up moves. In this case, the gross market value
is V ++ = uuV = 1.5 × 1.5 × 150 ≈ C 338 m. In the event where only one firm
(Enel or EDF) enters the market, it gets the full gross market value V ++
incurring the entry cost of I = C80 m, receiving a net (forward) value of
V ++ − I = 338 − 80 = C 258 m. If the firm does not enter the market, letting
its investment option expire, it receives nothing (0). If both firms invest
at maturity (invest, invest), they split the market as follows: Enel obtains
60 percent of the gross market value (338) at the cost of I = C80 m,

Firm j
Invest Abandon
Invest
High demand (123, 55) (258, 0)

Firm i
338 C*++ = (123, 55)

Abandon
(0, 258) (0, 0)
225
Invest Abandon
Invest
(70, 0)
150
(10, –20)
150 C*+− = (70, 0)
Abandon
(0, 70) (0, 0)
100
Invest Abandon
Invest
(–40, –53) (–13, 0)

67 C*−− = (0, 0)
Abandon
Low demand
(0, –13) (0, 0)
t=0 1 2
Figure 6.3
Binomial tree and equilibrium end-node payoff values in the Enel versus EDF rivalry over
the Russian market
The first element in (·, ·) represents firm i ’s (Enel’s) net value or payoff, while the second
entry denotes the net value or payoff to firm j (EDF).
204 Chapter 6
Firm j (EDF)
Invest Abandon
Invest
Firm i (Enel)
(123, 55) (258, 0)

Abandon
(0, 258) (0, 0)
Figure 6.4
Two-by-two matrix in the upper demand node
The first element in (·, ·) represents firm i’s (Enel’s) net value or payoff, while the second
entry denotes the net value or payoff to firm j (EDF).
receiving net (forward) value: s × V ++ − I = 0.6 × 338 − 80 = C123 m; EDF

gets 0.4 × 338 − 80 = C 55 m. These competitive situations are summarized
in the two-by-two matrix of figure 6.4. The first number in each pair of
payoff values (in parenthesis) represents the payoff to Enel (firm i), and
the second to EDF (firm j).
We next determine which competitive outcome is more likely to occur
as a stable solution, applying the Nash equilibrium concept. Whatever
EDF chooses, Enel earns a higher payoff by investing than by abandon-
ing the project: if EDF invests, Enel receives C123 m when investing
and 0 otherwise; if EDF abandons the option, Enel is better off investing
obtaining net value C258 m rather than 0. Enel thus has a dominant
strategy to invest. EDF also has a dominant strategy to invest, earning
!55 m if Enel invests or C258 m if Enel lets its option expire. The resulting
Nash equilibrium in the upper end node is for both firms to invest, with
Enel receiving C123 m and EDF !55 m. The equilibrium payoffs,
C*++ = (123, 55), are shaded or shown with *.
The case arising in the medium demand state (occurring after a down-
ward move following an up move or inversely) can be analyzed similarly.
Here the gross market value is V − + = udV = 1.5 × 0.67 × 150 = C150 m.
In the intermediate demand state there is room for only one
firm to operate profitably in the market (150 < 2 × 80). If Enel or
EDF ends up in a monopoly, it receives V − + − I = 150 − 80 = C 70 m.
If the firm abandons, it receives nothing (0). If both firms invest,
Enel receives s × V − + − I = 0.6 × 150 − 80 = C10 m, while EDF obtains
0.4 × 150 − 80 = − C 20 m. Again, Enel has a dominant strategy to invest,
receiving a positive value in both situations. Given that Enel has a domi-
nant strategy to invest, the best response of EDF is to abandon the
market, receiving 0 rather than a negative payoff (−C20 m). Given that
each firm plays its best response to its rival’s actions, the Nash equilib-
rium payoff in the intermediate demand state is C*+− = ( 70, 0 ).
In the down state (after two consecutive down moves), the gross
market value is V − − = ddV = 0.67 × 0.67 × 150 ≈ C 67 m, which is lower
than the needed investment outlay of I = C80 m. Neither firm therefore
has an incentive to invest, since whatever the resulting competitive
outcome, the firm would incur losses. Both firms thus have a dominant
strategy to abandon the project, receiving 0. The resulting Nash equilib-
rium payoff is C*−− = ( 0, 0 ). The binomial tree and resulting Nash equilibria
(highlighted) in each of the three demand states are shown in figure 6.3.
The next step is to substitute these equilibrium payoff or strategic
option values in the end nodes of the binomial tree, and determine for
each firm the investment option value by backward valuation along the
binomial tree. For this, we need to assess the risk-neutral probabilities
of each end node that will allow determining the present value of the
strategic option. Following the discussion in chapter 5, the risk-neutral
probability of an up move is given by equation (5.4). In the present case
with r = 0.04, u = 1.5, and d ≈ 0.67, the risk-neutral probability of an up
move is
(1 + 0.04) − 0.67
p= = 0.45.
1.5 − 0.67
Going backward along the binomial tree at t = 1, in the up state the
investment option for Enel is worth
pC ++ + (1 − p)C +− 0.45 × 123 + (1 − 0.45) × 70

C+ = = ≈ C 90 m.
1+ r 1.04
The (time-1) value for Enel in the down state is
0.45 × 70 + 0.55 × 0
C− = ≈ C 30 m.
1.04
Finally, one step earlier, the present value (t = 0) of the strategic invest-
ment option for Enel is
pC + + (1 − p)C − 0.45 × 90 + 0.55 × 30

C= = ≈ C 55 m.
1+ r 1.04
That is, the current value of the investment opportunity for Enel to enter
the Russian market in two years, accounting for strategic interactions
with European rival EDF in each possible state of market demand evolu-
tion, is C55 m.
206 Chapter 6
The value of the investment opportunity for EDF is similarly obtained

to be 10 m.6 This basic valuation procedure is a cornerstone for the
discrete-time analysis of option games. It will be used again in the exam-
ples in the rest of this chapter and in subsequent chapters. The next
section provides an illustration of option games in the case of patent-
leveraging strategies. Section 6.4 provides a case application in the
context of mine investments.
6.3 Patent-Fight Strategies
As another illustration of the usefulness of simple option games, Trigeor-

gis and Baldi (2010) consider different patent-leveraging strategies
among two patent-holding firms in a duopoly. The setup of their problem
together with the payoff matrices at maturity are depicted in figure 6.5.

Firm j
Sleep Invest
Sleep
High demand (98, 33) (68, 152)
C *++ = (92, 31)

Firm i
324 Sleeping Wall

Invest
(220, 8) (92, 31)

Wall Bracketing
180
Sleep Invest
Sleep
(9, 3) (–29, 33)

100
108 C *+– = (34, 0)
Sleeping Wall
Invest
(34, 0) (3, –17)

Wall Bracketing
60
Sleep Invest
Sleep
(9, 0) (–14, –1)

36 Sleeping Wall
C *–– = (9, 0)
Low demand
Invest
(–5, 0) (–20, –7)

t= 0 1 2 Wall Bracketing
Stage I Stage II
Patent acquisition for firm i Choice of patent fighting strategy

(old technology for firm j )
Figure 6.5
Binomial tree and equilibrium end-node payoffs for patent fighting strategies where firm
i has a strong patent advantage
6. At time t = 1 in the up node, EDF will receive 55 m in the up state or 0 in down state,
worth C + = (0.45 × 55 + 0.55 × 0 ) 1.04 = C 24 m. At t = 1 in the down state, EDF’s investment
opportunity is worth zero. Going back one step earlier, the current ( t = 0 ) value of EDF
is C = (0.45 × 24 + 0.55 × 0 ) 1.04 = C10 m.
At time t = 0 (or at the beginning of stage I), firm i innovates and acquires
a new core patent that is superior to the old patented technology used
by rival firm j. At time t = 2 (or at the beginning of stage II), each firm
decides on its best patent-leveraging strategy, whether to fight, cooperate,
or wait, depending on firm i’s cost advantage and the state of demand
(high, intermediate, or low).
The weaker rival, firm j, believing it has a fighting chance, may go
on the offensive to identify and exploit gaps around firm i’s core
patent. Firm i may pursue a similar offensive strategy, resulting in a
patent-bracketing war. When both firms attack each other via patent
bracketing, they share a reduced market value reflective of their
respective market power. Alternatively, firm i can solidify its large
advantage building a defensive patent wall around its core patent in
the hope of driving the rival out. When one firm invests while the rival
waits, it captures full monopoly NPV.7 Last, each firm can “wait and
see,” virtually putting its patent in a “sleep mode.” When both firms
sleep (wait) and postpone their fighting decision, firm i has an advan-
tage (capturing more of the option value according to its higher market
power).
The type of competition depends in part on the size of the cost advan-
tage resulting from the patented innovation. Absence of such advantage
is likely to induce symmetric rivals to cooperate, while a large cost advan-
tage by firm i will favor a fight mode instead. In case of a large cost
advantage, different types of fight mode may result, depending on real-
ized demand.
Figure 6.5 focuses on the case where firm i has a strong advantage
resulting from the innovation. This situation will result in patent fighting.
In the two-by-two matrices under high, intermediate, or low demand,
different types of fighting equilibria may result:
• Under high demand, each firm should invest regardless of the oppo-
nent’s decision (for firm i, 220 > 98 and 92 > 68; for firm j, 152 > 33 and
31 > 8). Invest is a dominant strategy for both. The resulting equilibrium
strategies are for both firms to invest, ending up in a bracketing war with
bottom-right payoffs C*++ = ( 92, 31). Under asymmetric reciprocating
competition with high demand, both firms feel induced to fight via
7. Firm i has an incentive to fortify and exploit its large cost advantage to drive the rival
out of the market. The rival will be inclined to fight (even attack) if demand or volatility
is high. Entering a reciprocating fight is costly and erodes profit margins for both firms,
reducing total market pie (to 70 percent)—except when one firm ignores its fighting rival
and lets its patent sleep.
208 Chapter 6
reciprocal patent bracketing—even though they would be better off to

let their patents sleep, obtaining ( 98, 33).8
• Under intermediate demand, firm i should invest, regardless of its
rival’s decision (34 > 9 and 3 > −29), a dominant strategy. Knowing that
firm i will invest and fight, firm j prefers to wait (sleep) rather than
engage in a costly bracketing fight (0 > −17), resulting in patent walls with
Nash equilibrium payoffs C*+− = ( 34, 0). Firm i will invest building a defen-
sive patent wall around it, with firm j waiting (sleeping).
• Under low demand, each firm has a strictly dominant strategy to let its
patent sleep (for firm i, 9 > −5 and −14 > −20; for firm j, 0 > −1
and 0 > −7). Given the low level of demand, both firms would actually
lose value by fighting each other. The equilibrium strategy is for both
firms to “sleep.” Firm i lets its superior patent sleep, maintaining its
option to become a monopolist should the market recover in the future
(with continuation value 9). This amounts to the disadvantaged firm
abandoning the market. The Nash equilibrium for the upper-left game
payoff is C*−− = ( 9, 0 ).
In the problem above the risk-free interest rate is r = 0.08 and the risk-
neutral probabilities for an up or down move are p = 0.4 and 1 − p = 0.6 .
Given that the equilibrium investment option values at maturity (t = 2)
for firm i are C*++ = 92, C*+− = 34, and C*−− = 9, in the high, medium,
and low demand states, with associated probabilities pp = 0.16,
2 p (1 − p) = 0.48, and (1 − p) = 0.36, respectively, the current (t = 0)
2
value of the strategic investment opportunity for firm i is

p2C*++ + 2 p (1 − p)C*+− + (1 − p) C*−−
2
C=
( 1 + r )2
0.16 × 92 + 0.48 × 34 + 0.36 × 9
= = 29.
(1.08)2
This yields an expanded net present value for the patent fight strategy of
firm i of 29 m in case of a large cost advantage. Firm j’s value of the
investment opportunity obtains similarly as C4 m.9
8. The fear of the rival investing in a patent wall and strengthening their position if they
let their own patent sleep puts pressure on both firms to invest aggressively bracketing
each other’s patent, a situation analogous to the prisoner’s dilemma.
9. Firm j obtains in each demand state C*++ = 31, C*+− = 0 , and C*−− = 0 , respectively. Firm
j’s investment opportunity is worth
0.16 × 31 + 0.48 × 0 + 0.36 × 0
C= = C 4 m.
(1.08)2
6.4 An Application in the Mining/Chemicals Industry
Ferreira, Kar, and Trigeorgis (2009) present an actual application of

option games in the mining/ chemicals industry.10 Deciding when to add
capacity in the face of rivals is a challenging problem for any industry.
This approach involves American-type real options and games and is
solved backward by use of numerical analysis.
Between 1995 and 2001 annual revenues for the US commodity chemi-
cals industry fell from $20 bn to $12 bn, while companies’ operating
profits fell on average by 26 percent a year. The collapse was in large
measure caused by a tight economic environment and a rising dollar. But
outside forces were only part of the story—industry players also made
some very poor decisions. . . . It’s a story that regularly plays out in many
industries. Indeed any company making big-budget investment decisions
faces the same basic dilemma. On the one hand, it must make timely,
strategic investments to prevent rivals from gaining ground. On the
other, it must avoid tying up too much cash in risky projects, especially
during times of market uncertainty. Using game theory models, managers
can incorporate the collective effect on market-clearing prices of other
companies that are expanding their capacity at the same time. Typically
the way to do this is to create a payoff matrix, which compares your
payoffs with those of your competitor under different scenarios. Unfor-
tunately, the standard calculation of payoffs does not allow managers to
factor in uncertainty for key market variables such as prices and demand,
nor does it assign any value to flexible investment strategy. To get around
this problem, we use a hybrid model that overlays real options binomial
trees onto game theory payoff matrices.
To Mine or Not to Mine?

MineCo is planning to open a new mine to expand its capacity to produce
minerals for its regional market. In this market, if demand exceeds local
supply, customers will import from foreign sources, which effectively sets
a cap on prices. From MineCo’s perspective there are two key sources
of uncertainty: the growth rate of local demand, which has varied in
recent years with shifts in the country’s political economy, and the risk
that CompCo, its largest competitor, will invest in a similar project first.
10. This section is an excerpt from “Option games: The key to competing in capital-
intensive industries” by Nelson Ferreira, Jayanti Kar, and Lenos Trigeorgis, Harvard Busi-
ness Review, March 2009. It is reprinted by permission of Harvard Business School
Publishing.
210 Chapter 6
The current demand is 2,200,000 tons and the current price (set by
imports) is $1,000 per ton.
The MineCo project involves adding 250,000 tons of capacity at a cash
operating cost of $687 per ton (incurred each year the project is up and
running) and a capital expenditure of $250 per ton, spread over three
years. The Comp Co project faces cash operating costs of $740 per ton
annually, projected capacity of 320,000 tons, and a capex of $150 per ton,
also spread over three years. The investments take three years to com-
plete, and both new mines have a lifespan of 17 years. For the purposes
of simplicity, we assume that each firm can decide to invest in Y0 (with
capex in Y0, Y1, and Y2 and production starting in Y3) or in Y3 (with
capex to be invested in Y3, Y4, and Y5 and production starting in Y6).
We begin by calculating the inputs that will serve as the basis for
determining payoff values for each of the scenarios: demand evolution
and the probabilities of upward and downward shifts in demand. We
assume that demand will go up or down by a fixed multiple in each period
(in this case the period is a year). Using historical data and surveys of
the company’s managers, we predict demand will move up or down by
about 5 percent in each period. We estimate the risk-adjusted probability
of an upward shift in each period at 30 percent (therefore, a 70 percent
probability of a downward shift in each period). Next we input these data
into a binomial tree that tracks the evolution of demand over the next
six years and overlay it with a tree that tracks the cumulative probabili-
ties at each node in the demand tree (see figure 6.6). We will refer to this
tree throughout the analysis in this section.
Now let’s calculate the payoffs for MineCo and CompCo for each of
the four scenarios arising from their decisions to invest now or wait until
year three to decide.
Scenario 1: Both Companies Invest Now

If both firms decide to invest now, they will incur capital expenditures in
Y0, Y1, and Y2, and both projects will start producing in Y3. Given this,
we can model how evolution in demand and capacity will affect prices
and thereby revenues and profits for each of the two companies.
First, we create a binomial tree showing how market prices might
evolve (see figure 6.7). The price at each node is determined by demand
and supply, driven by the cash operating cost of the marginal producer
(the producer just barely able to remain profitable at current levels of
price and demand). If demand rises and MineCo or its competitor adds
capacity at a higher marginal operating cost, local prices will rise.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
2970
2825 0.1%
2687 0.2% 2687
2556 1% 2556 1.0%
2431 3% 2431 2.8% 2431
2313 9% 2313 8% 2313 6.0%
2200 30% 2200 19% 2200 13.2% 2200
100% 2093 42% 2093 26% 2093 18.5%
70% 1991 44% 1991 30.9% 1991
49% 1894 41% 1894 32.4%
34% 1801 36.0% 1801
24% 1713 30.3%
16.8% 1630
11.8%
Figure 6.6
Demand evolution and probability tree
To calculate the annual operating profits at each node for each firm,
we subtract that firm’s estimated annual cash operating costs per ton
from the prices at each node for each operating year and multiply that
number by the demand filled by the added capacity, estimated over the
remaining life of the project. To illustrate, at the upper demand node in
Y5, MineCo gets a margin of 313 (the 1,000 price less its cost of 687) per
ton, which for 250, 000 tons of added capacity represents $78,250,000. In
Y6 nodes, we have to add in the terminal value, which is an estimated
present value of cash flows for the remaining 14 years of the mine’s useful
life. To calculate this, we assume that price and demand remain constant
subsequently and apply the standard discounting formula, which gives
us a terminal value of $774,569,000. We add that to the Y6 annual operat-
ing profit (again, $78,250,000), and get a total value for the upper node
in Y6 of $852,819,000. The resulting tree for MineCo (with the added
capacity of 250,000 tons) is shown in the lower panel of figure 6.7. The
tree for CompCo is similar (but not shown here)—the numbers are a
little higher on the upside and more negative on the downside.
Our final step is to weight the numbers at each node by the corre-
sponding risk-adjusted probability (from the demand tree) and discount
those expected payoff values by 5 percent per year (the risk-free interest
rate) back from the position of the node to the present. We then sum up
these numbers—the weighted, discounted annual operating profits at
each node plus the terminal value—and subtract from that sum the
212 Chapter 6
Market-clearing Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

prices (in US$/ton)
1,000
1,000
1,000 1,000
1,000 1000
1,000 740 740
1,000 700 700
1,000 1,000 700 700
1,000 700 700
1,000 687 687
685 685
685 685
685
680
Payoffs for Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

MineCo
(in US$ thousands) 852,819
78,250
78,250 852,819
78,250 78,250
(20,833) 13,250 144,407
(20,833) 3,250 3,250
(20,833) (20,833) 3,250 35,421
(20,833) 3,250 3,250
(20,833) 0 0
(500) (500)
(500) (5,449)
(500)
(19,073)
Figure 6.7
Scenario 1: Both companies invest now
present value of the annual capex investments made by each company.

This gives us the net current payoff value, or final payoff value, for each
company under scenario 1: For MineCo the expected payoff in Y0 is
−$36 m; for CompCo, −$195 m. If both firms invest now, both lose money.
Scenario 2: MineCo Invests Now, While CompCo Waits

In this scenario MineCo invests first, giving it the advantage of being the
sole producer from Y3 to Y6, while CompCo waits until Y3 to decide
whether to invest. If demand evolves favorably, CompCo enters in Y3; if
not, it abandons the project.
We begin the valuation by calculating the market-clearing prices from
Y0 through Y3, using the demand tree and given the fact that MineCo
has invested in extra capacity and CompCo so far has not. Next, we
calculate how prices will evolve from Y3 through Y6. There are four
possible Y3 scenarios, each with an associated probability of occurrence
(see demand tree in figure 6.8). At each of the nodes, we determine the
market-clearing prices, operating profits, and terminal value for each firm
Expected value
Probability of Competitor’s of payoffs
Evolution of demand till year 3 reaching node (Y3) decision (Y3) (in US$ million)
Y0 Y1 Y2 Y3
3% • CompCo • MineCo = 328

decides to • CompCo = 71
Up
invest
Do
Up
wn
19% • MineCo = 263

• CompCo = ∅
Do
Up
Up
wn
Do
Do
wn
wn
44% CompCo • MineCo = -6

Do
• CompCo = ∅
Up
abandons
wn
project
Do
wn
34% • MineCo = -64

• CompCo = ∅
Figure 6.8
Scenarios 2 and 3: One company invests, the other waits
assuming that CompCo does invest in Y3. In other words, for each of the
four scenarios, we create a three-year binomial tree (Y4, Y5, and Y6)
showing what the annual operating profits plus terminal value would
look like at each node if CompCo were to invest then.
Next for each Y3 scenario we weight the node values by the demand
probabilities for Y4, Y5, and Y6 and discount the values back to Y0,
taking into account the NPV of CompCo’s investment costs (Y3 through
Y5) and MineCo’s (Y0 through Y3). The result is four pairs of expected
Y0 net payoff values: $71 m for the upper demand node in Y3, and
–$114 m, –$169 m, and –$185 m for the other three nodes.
As a rational investor, CompCo will not invest in Y3 unless its payoff
value is positive, which is only the case in the top node where demand
evolution from Y3 is high enough to accommodate a second entrant. At
all the other demand nodes, CompCo will abandon the project, prefer-
ring a payoff of zero to losing money.
We thus recalculate the operating profits plus terminal value for both
companies, based on the assumption that CompCo will not invest in any
but the top demand node. These expected net Y0 payoffs for MineCo
and CompCo (taking into account the investment costs incurred in Y0
214 Chapter 6
through Y2 for MineCo in each subscenario and in Y3 through Y5 for

CompCo in the uppermost subscenario) are shown in the last column in
the figure.
We finally weight these four pairs of Y0 payoff values according to the
probabilities associated with the Y3 demand nodes. We arrive at the final
payoff for each company by summing up the four weighted, discounted
payoff numbers. For MineCo, the expected final payoff at Y0 is ($328 m
× 3%) + ($263 m × 19%) + (−$6 m × 44%) + (−$64 m × 34%), which
yields $35 m. For CompCo, the expected final payoff at Y0 is ($71 m ×
3%) + ($0 × 19%) + ($0 × 44%) + ($0 × 34%), which yields about $2 m.
Scenario 3: CompCo Invests Now, While MineCo Waits

This is estimated in the same way as scenario 2, but with MineCo as the
follower. The final payoffs are $4 m for MineCo and −$83 m for CompCo.
Scenario 4: Both Companies Wait

In the last scenario, where both firms wait until Y3 to decide whether to
invest, we start by looking at the four possible demand nodes in Y3 (see
figure 6.9). For each, we need to consider four subscenarios: both firms
Probability of Expected value of

CompCo reaching node payoffs
Invest Abandon
(in US$ million)
Evolution of demand till Y3
Abandon Invest
3% Dominant strategy
MineCo
Y0 Y1 Y2 Y3 (143, 71) (410, 0)

• MineCo = 143
(0, 405) (0, 0) • CompCo = 71
Up
CompCo
Invest Abandon
Abandon Invest
Up
Do
19% Mixed strategy (average)

(–2, –114) (87, 0)
MineCo
wn
• MineCo = 43.5
(0, 71) • CompCo = 35.5
Up
(0, 0)
Do
Up
wn
CompCo
Do
Do
wn
wn
Invest Abandon
Abandon Invest
(–45,
MineCo
(–11, 0) 44% Dominant strategy

Do
Up
–169)
• MineCo = ∅
wn
(0, –102) (0, 0) • CompCo = ∅

Do
wn
CompCo
Invest Abandon
Abandon Invest
(–57, 34% Dominant strategy

MineCo
–185) (–55, 0) • MineCo = ∅

• CompCo = ∅
(0, –158) (0, 0)
Figure 6.9
Both companies wait to decide
investing in Y3, only MineCo investing in Y3, only CompCo investing in

Y3, and both abandoning. We thus have 16 subscenarios, each with its
own three-year market-clearing price evolution tree. The price at each
node, as ever, is based on the demand evolution (captured by the demand
tree) and on total industry capacity, which varies depending on the Y3
investment decisions of MineCo and CompCo.
Let’s take the upper demand node in Y3 as an example. In the first
subscenario, both firms invest from Y3 to Y5 and enter in Y6. We calcu-
late the expected net Y0 payoffs in the same way we did in scenario 1
but with a three-year tree, weighting annual operating profit plus termi-
nal value, discounting back to Y0, and subtracting net present capex
costs. For the upper demand node, this results in Y0 net expected payoffs
of $143 m for MineCo and $71 m for Comp Co. We perform similar
exercises to calculate the expected net Y0 payoffs in the remaining three
subscenarios, with the firm not investing receiving a zero payoff and the
firm investing receiving payoffs determined by demand evolution and
industry capacity. This exercise is then repeated for the remaining three
sets of subscenarios.
We present all expected net Y0 payoffs in a series of two-by-two game
matrices, one for each demand node in Y3, which is when decisions are
made. We then identify the Nash equilibria—outcomes from which
neither player has an incentive to deviate. In the top demand node, for
example, we see that both MineCo and CompCo will find it optimal to
invest in that year (receiving $143 m and $71 m, respectively). MineCo
cannot do better since the alternative (abandoning) would entail a lower
(zero) payoff whatever CompCo does; CompCo reaches the same con-
clusion. The remaining three two-by-two matrices are similarly analyzed
to find Nash equilibria.
At three nodes (the top and the lower two) there is a single (pure)
equilibrium. In one (the second), we have two. There are theories about
how to determine which of two equilibria one should favor, but suppose
here that the companies are roughly symmetrical such that there is an
equal chance that either equilibrium will prevail; in other words, each
player will choose one strategy 50 percent of the time and the other the
remaining 50 percent. The resulting expected payoffs from the two mixed
equilibria therefore are simply the average of the payoffs associated with
each equilibrium for each player. For MineCo, the expected net Y0
payoff for the node is (0.5 × $87 m) + (0.5 × $0), which yields $43.5 m.
Finally, we weight these four pairs of net Y0 payoff values according
to the probabilities associated with the Y3 demand nodes. We arrive at
216 Chapter 6
the final payoff for each company by summing up the four weighted,
discounted payoff numbers. This yields an expected net Y0 payoff value
for MineCo of $12 m [($143 m × 3%) + ($43.5 m × 19%) + ($0 × 44%)
+ ($0 × 34%)]. For CompCo the payoff is $8 m.
How Do the Results Stack Up?

Having analyzed the four different strategic scenarios one at a time, we
now put them together into a time-zero payoff matrix for a final decision,
as shown in figure 6.10. We see that scenario 2 (MineCo invests now and
CompCo waits) is a Nash equilibrium scenario, as no player has an incen-
tive to deviate from the associated strategy choices. MineCo cannot do
better (if it decides to wait as well, moving to scenario 4, it will get $12
m instead of $35 m). The optimal decision for MineCo therefore is to
invest at once.
How does this recommendation compare with the traditional valua-
tion methods? Given the data, a standard NPV analysis (assuming
MineCo invests now and the competition never enters) would have
indicated values for the project of $41 m for MineCo and $13 m for
CompCo. This would suggest that both companies should invest imme-
diately, with disastrous results. A conventional real options calculation
using the same data would have indicated that delaying the project
would add $8.5 m in flexibility value to the NPV number for MineCo
CompCo
Invest Wait
Scenario 1 Scenario 2
Invest
(–36, –195) (35, 2)

MineCo
Scenario 3 Scenario 4
Wait
(4, –83) (12, 8)
Note: Current value of payoffs in each strategic scenario (in US$ million)
Figure 6.10
Comparing strategic scenario payoffs for a final time-0 decision
and $5 m for CompCo. This would suggest that both should delay, which,
although not disastrous, would still misrepresent value for both players.
With the benefit of an option games analysis, each player can see how
the flexibility and commitment tradeoff works out for it. In MineCo’s
case, the flexibility value from delaying is more than outweighed by the
commitment value created by investing now, whereas CompCo is better
off waiting.
Conclusion
In this chapter we illustrated via simple numerical examples the benefits

of an integrative approach to strategy, deriving fruitful insights into
when and how firms should invest in uncertain environments when they
also face strategic interaction. Option games give valuable guidance as
to when to pursue different investment strategies and how to assess the
trade-off between flexibility and strategic commitment. In the next two
chapters we elaborate further on option games in discrete-time settings.
We first consider the option to invest in a new market in different com-
petitive situations. Chapter 7 discusses this investment option, consider-
ing models of quantity or price competition. In Chapter 8, we extend
our tool kit to quantify the trade-off between flexibility and commit-
ment, examining when early commitment might be worthwhile in
an uncertain environment in the context of R&D and advertising
strategies.
Selected References
Smit and Ankum (1993) and Trigeorgis (1996) discuss related issues of
market structure under uncertainty. Smit and Trigeorgis (2004) develop
the option games approach in discrete time and give a number of case
applications. Ferreira, Kar, and Trigeorgis (2009) present a concrete,
actual application and discuss the insights offered by option games, high-
lighting their relevance for strategic management practice. Trigeorgis and
Baldi (2010) discuss an application of the aforementioned methodology
in the context of patent games.
Ferreira, Nelson, Jayanti Kar, and Lenos Trigeorgis. 2009. Option games:
The key to competing in capital-intensive industries. Harvard Business
Review 87 (3): 101–107.
218 Chapter 6
Smit, Han T. J., and L. A. Ankum. 1993. A real options and game-theo-
retic approach to corporate investment strategy under competition.
Financial Management 22 (3): 241–50.
Smit, Han T. J., and Lenos Trigeorgis. 2004. Strategic Investment: Real
Options and Games. Princeton: Princeton University Press.
Trigeorgis, Lenos. 1996. Real Options: Managerial Flexibility and Strategy
in Resource Allocation. Cambridge: MIT Press.
Trigeorgis, Lenos, and Francesco Baldi. 2010. Patent leveraging strate-
gies: Fight or cooperate? Working paper. University of Cyprus.
7 Option to Invest
This chapter describes a simple framework—based on the combined

insights from real options and game theory—that enables managers to
analyze strategic investment and quantify flexibility in a competitive
setting in relatively simple terms. Encompassing more aspects of reality
would involve more complications to the modeling of option games. The
simple models presented herein offer pedagogical value and make easier
the understanding of subsequent chapters.
The chapter is organized as follows. In section 7.1, we present a bench-
mark model for later analysis, focusing on a monopolist’s option to
invest. In section 7.2, we discuss quantity competition models and
examine the importance of having a cost advantage from a dynamic
perspective. In section 7.3, we analyze investment settings in which, upon
market entry, firms compete in price. Chapter 8 then builds upon these
two benchmark duopoly models and puts them in dynamic perspective
in light of earlier-stage commitment decisions.
7.1 Deferral Option of a Monopolist
Suppose that in the discrete-time model of Smit and Trigeorgis (2004)

the demand intercept in the linear market demand function of equation
(3.1) follows a multiplicative binomial process. That is, the inverse (sto-
chastic) demand function is given by
p ( X t , Q) = aX t − bQ, (7.1)
where X t follows a multiplicative binomial process, a and b are constant

parameters, and Q is the total output (capacity) offered in the market-
place.1 The binomial stochastic process followed by X t is shown in
1. Throughout part II we assume a linear market demand function. Most of the results and
insights from the models developed here would carry over to other types of inverse demand
curves.
220 Chapter 7
~
X2++
~
X1+
X0 ~
X2+ −
~
X1−
~
X2−−
Figure 7.1
Multiplicative binomial process followed by demand (intercept)
X t is the underlying asset (stochastic market demand) at time t.
figure 7.1 for two periods: after each up move, X t is multiplied by u,

while after each down move by d (d = 1 u).2
Consider a European option held by a monopolist to invest at
maturity t = T ( = 2 ).3 At each end state or node in the binomial tree, the
monopolist can choose at maturity between investing or abandoning
the investment. When the monopolist decides to invest, it chooses its
strategic variable (output) to maximize its payoff; that is, it selects the
monopoly profit-maximizing output QM ( X T ). Under market demand
uncertainty the firm has an option to invest but can wait until new infor-
mation is revealed, deferring the investment decision until maturity.
Suppose that the monopolist’s cost function is linear and given by
C ( q) = cq (where variable cost c is lower than the demand intercept). As
seen in chapter 3, equation (3.4), the equilibrium profit for a monopolist
in the deterministic case (if X t were constant over time and equal to 1) is
(a − c )2
πM = .
4b
2. The binomial lattice, developed by Cox, Ross, and Rubinstein (1979), is meant as a
discrete-time equivalent of the geometric Brownian motion. Many of the models used in
the continuous-time part assume that X t follows a geometric Brownian motion. These
assumptions used in the discrete-time and continuous-time parts are compatible.
3. We here focus on European options to simplify the problem structure and derive better
intuition concerning the strategic interactions taking place at maturity among the option
holders. We could also consider American-type options, but these models are more demand-
ing mathematically. To solve this problem, we would need to resort to numerical analysis,
for example, as in Smit and Trigeorgis (2004). Part II focuses on European options in
discrete time due to their relative simplicity, while part III discusses perpetual American
options in continuous time that may admit closed-form solutions.
Option to Invest 221
Given the stochastic uncertainty about the demand parameter X t , the

equilibrium profit for the monopolist at maturity T now is
(aX − c)
2
π M ( X T ) =
T
, (7.2)
4b
provided that the firm invests, and π M ( X T ) = 0 otherwise.4

Suppose the monopolist firm invests amount I at time t = T , receiving
at the end of the year the equilibrium profit π M ( X T ) that grows there-
after in perpetuity at an average annual growth rate g . The appropriate
risk-adjusted discount rate is k (k > g ). The monopolist’s net project
value at the end node (at maturity T ) is given by
NPV M ( X T ) =
π M
( X ) − I,
T
(7.3)
δ
where δ ≡ k − g ( > 0 ) represents some form of dividend yield or
opportunity cost of waiting.5 Assuming after maturity T the project
enters steady state (with g = 0 subsequently), the expression above
(with δ = k) simplifies to
π M ( X T )
NPV M ( X T ) = − I.
k
The firm cannot delay the investment decision beyond maturity. At

maturity it must decide either to invest or abandon. If the monopolist
firm invests, it becomes committed to the project and receives the NPV
of the investment as given in equation (7.3). In this sense the classical
NPV rule holds at maturity because the monopolist is then faced with
a now-or-never decision. The firm will decide to invest at maturity T if
and only if NPV M ( X T ) ≥ 0. This occurs when the random demand
reaches or exceeds a specified trigger X M , or X T ≥ X M , provided that
aX T ≥ c. The monopolist’s investment trigger, X M , is given by
4. The firm will not invest if aX T < c since demand would not cover marginal production
costs.
5. The perpetuity formula above (used as the present value) is often referred to as
the Gordon formula. It equals the infinite sum of subsequent cash flows beginning
with π M ( X T ) starting in one period (end of the year) and growing in perpetuity at a
rate g per year, namely
1 ⎡ ∞ M ⎛ 1 + g ⎞ ⎤ π ( X T )
t M
⎢ ∑ π ( XT ) ⎜ ⎟ ⎥ = ,
1 + k ⎣ t =0 ⎝ 1+ k⎠ ⎦ δ
provided that δ ≡ k − g > 0.
222 Chapter 7
Binomial tree evolution Threshold Investment decision Payoff value
High
~
XT ≥ X M Invest ~
( )
NPVM XT ≥ 0
~ XM
X0 XT
~ Do not invest
XT < X M (abandon) 0
Low
Figure 7.2
Critical threshold, investment decision and payoff for the monopolist at maturity
X M = (2 bδ I + c) a is the monopolist’s fixed investment trigger (critical threshold).
2 bδ I + c
XM ≡ . (7.4)
a
Since all parameters (k , g , a, b, c, and I ) determining the investment

trigger of the monopolist X M are constant and known at the outset, the
optimal investment decision of the monopolist depends solely on whether
the value of X T at maturity exceeds the fixed investment trigger X M .
Figure 7.2 illustrates the payoff and investment decision of the monopo-
list at maturity, T , depending on the random value of X T exceeding or
being below the specified fixed critical threshold X M .
Example 7.1 Investment Trigger for a Monopolist

A decade ago the Italian public electric utility Enel had an option to
invest in a new power plant involving a capital expenditure of I = 250.
At the time the unit variable cost for the monopolist was c = 15. The
appropriate discount rate for the firm was 10 percent or k = 0.10. The
demand parameter X t evolved stochastically with a = 5 and b constant
and equal to 1. The market growth ( g ) was 0 percent p.a. Note that
δ = k − g = 0.10 − 0 = 0.10. The investment trigger for the monopolist,
based on equation (7.4), is
2 1 × 0.10 × 250 + 15
XM = = 5.
5
NPVM at maturity
(in thousands)
30
20
10
0
0 5 10 15 20 25
XM End-node value XT
~
Figure 7.3
Payoff value ( NPV M) at maturity for the monopolist’s option to invest
We assume linear demand with a = 5 and b = 1. Unit variable cost is c = 15. I = 250,
k = 0.10 , and g = 0 .
The payoff function for the monopolist option holder at maturity,

NPV M ( X T ), is shown in figure 7.3. The payoff at maturity (as a function
of end-node value X T ) increases at an increasing pace beyond the trigger
point X M = 5.6
Once the optimal investment trigger level X M has been determined as
per equation (7.4), the resulting payoff values at maturity T can be easily
derived based on equations (7.2) and (7.3). The maximal value of the
investment must be determined simultaneously with the monopolist’s
optimal investment behavior or exercise strategy. Once the end-node
project values are determined, we can work out the present value of the
investment by backward induction using risk-neutral valuation along
the binomial tree. When moving back along the binomial tree, we use
the risk-neutral probability from equation (5.4),
(1 + r ) − d
p= ,
u−d
to calculate the expected option values and discount the resulting

certainty-equivalent values at the risk-free rate r.
6. The monopolist’s profit function in equation (7.2) is a quadratic function of the demand
shock X T .
224 Chapter 7
If the time to maturity T is subdivided into n equal subintervals of

length h = T n as in appendix 5A, the expanded NPV of the investment
for the monopolist firm is obtained recursively as
⎛ n⎞ j
∑ ⎜⎝ j ⎟⎠ p (1 − p) NPV (u d X 0 )
n n− j M j n− j
j =0
E−NPV = , (7.5)
( 1 + r )n
where
⎛ n⎞ n!
⎜⎝ j ⎟⎠ ≡ j !(n − j )!
and
⎛ n⎞ j n− j
⎜⎝ j ⎟⎠ p (1 − p)
is the binomial distribution giving the probability that the market demand
parameter X t will take j upward jumps in n time steps, each with (risk-
neutral) probability p.
7.2 Quantity Competition under Uncertainty
In the previous section we developed an investment option model char-

acterizing the optimal behavior of a monopolist firm having an exclusive
right to enter the market. We next look at the situation when several
firms may enter the market, involving uncertainty about the future
industry structure as a result of both market demand uncertainty and
(endogenous) multiplayer strategic interactions.
7.2.1 Cournot Duopoly
To value the option to invest under both demand and strategic uncertain-
ties in the case of a duopoly, we consider at each end node at maturity
a simultaneous game where each player does not know the strategic
action chosen by the rival firm. We assume complete information con-
cerning the cost structure of the players and the level of demand reached
at maturity (time T ). One way to illustrate the time elements of the
problem is to look at decision time versus real time. Game theory models
strategic interactions in terms of decision time, whereas in real-world
decisions real time matters in the evolution of exogenous demand
firm i
firm j
qi qj
Decision
time 1 2
Strategic uncertainty (2 decisions)
Real
time 1 2 3 T–2 T–1 T
Demand uncertainty (T periods)
Figure 7.4
Cournot model involving demand (real-time) and strategic (decision-time) uncertainties
uncertainty. Real time is essential in financial theory. It drives the evolu-

tion of the underlying asset in the binomial tree. Figure 7.4 illustrates the
binomial tree approach to time and uncertainty evolution.
We subsequently analyze Cournot quantity competition under uncer-
tainty, considering in turn the case of (1) cost symmetry and (2) asym-
metry. Suppose two firms compete over a homogeneous product but
differ in their cost structure. The variable (marginal) cost of firm i is ci
and of firm j is c j, with ci , c j ≥ 0.7 Firm i’s (linear) cost function is given
by Ci (qi ) = ci qi, and its profit by π i ( qi , q j , X t ) = ⎡⎣ p (Q, X t ) − ci ⎤⎦ qi. Firm j’s
cost and profit functions are given similarly. The equilibrium profit value
in a Cournot duopoly under certainty (with X t constant and equal to 1)
was shown in equation (3.21) to be8
π iC =
(a − 2ci + c j ) 2 .
9b
Under market uncertainty (with X T being random), this becomes
π iC ( X T ) =
(aX T − 2ci + c j ) 2 . (7.6)
9b
To be entitled to these profits, each firm must incur investment cost I i

(I j, respectively). Let k be the appropriate risk-adjusted discount rate.
7. The fixed costs are not explicitly considered or alternatively are included into the
market-entry cost.
8. The superscript C stands for “Cournot.”
226 Chapter 7
Table 7.1
Comparison of project value payoffs in monopoly and Cournot (quantity) competition
Monopoly NPVi M ( X T ) = Vi M ( X T ) − I i
(only firm i)
Cournot duopoly NPViC ( X T ) = ViC ( X T ) − I i
Note: Vi M ( X T ) = ( aX T − ci ) 4bδ , ViC ( X T ) = (aX T − 2ci + c j ) 9bδ .

2 2
The Cournot–Nash equilibrium value of this investment generating

the above annual profits in perpetuity (from the end of year T ) is
given by9
π iC ( X T )
NPViC ( X T ) = − I i. (7.7)
δ
If both firms decide to invest at maturity, the (asymmetric) Cournot
duopoly game payoffs obtain. If the cost asymmetry among the players
is sufficiently large, we assume that only one firm, the advantaged one,
enters at an intermediary demand level, the industry structure then
becoming a monopoly.10 If demand is low, no one enters (both firms make
zero profits). Table 7.1 compares the value functions in monopoly and in
Cournot duopoly.
We here consider pure strategies, namely firms chose whether or not
to enter the market. This decision is driven by the firms’ respective
optimal exercise or trigger policies. When a specified threshold demand
level is reached, firm i (firm j) will invest. These optimal investment trig-
gers depend on the (exogenously given) values of k , g , a, b, ci, c j, and on
the level of demand reached at maturity, X T . Analogous to the monopoly
case, the optimal investment strategies in Cournot duopoly are based on
whether the demand parameter X T at maturity T exceeds or is below
certain threshold levels. However, the equilibrium strategies in the
9. The first term is again the value of a perpetuity starting at the end of year T or equiva-
lently in year T + 1.
10. This statement has common-sense appeal. As stated here, it is, however, based on weak
game-theoretic foundations. In chapter 12 we analyze the coordination problem arising in
the intermediary region in a context involving perpetual American investment options. We
show there that depending on the magnitude of the cost asymmetry, two situations may
emerge. For “small” cost difference, the disadvantaged firm may try to enter first as well,
leading to preemption effects. For large cost asymmetry, the disadvantaged firm may accept
its role as follower, whereby the advantaged firm enters peacefully as leader with no risk
of preemption. At this early stage of discussion, we prefer to rely on the assumption that
the advantaged firm enters first (becoming monopolist in the intermediary region) for
pedagogical reasons since the technicalities involved to demonstrate the latter result are
fairly involved and hence are deferred to chapter 12.
duopoly case differ depending on whether the industry consists of sym-

metric or asymmetric-cost firms. The discrete-time analysis of the invest-
ment dynamics under quantity competition that follows reveals more
intuitively the role of these investment thresholds. The optimal invest-
ment policy of each firm depends on the actual level reached by the
underlying random variable compared to the investment thresholds.
These thresholds are crucially important in the analysis of investment
strategies under endogenous competition as they help induce firms’
optimal investment strategies.
Cournot under Cost Symmetry

Suppose that firms i and j share a European investment option in a
duopoly. Firms compete over quantity (capacity) when they both operate.
Costs are identical between the two firms, each facing variable unit
cost c. Investment outlays are the same, I (≥ 0). For symmetric firms we
might assume symmetric investment (exercise) policies; the industry
structure will be either “both invest” or “neither invests.” Consequently
investment thresholds are identical and, provided they are reached at
maturity ( X T ≥ X C ), both firms will invest.
In the case of the investment opportunity being analogous to a Euro-
pean call option the firms decide to invest only at the end nodes.11
At maturity, each firm decides whether to enter (à la Cournot) or not.
Firm i will invest at the end node at maturity if realized demand X T is
high enough such that the forward investment NPV is positive, meaning
if NPV C ( X T ) ≥ 0.12 The investment condition is therefore13
X T ≥ X C
(provided that X T ≥ c a). The Cournot investment trigger for both sym-
metric firms in a duopoly is
3 bδ I + c
XC ≡ , (7.8)
a
where δ ≡ k − g. The Cournot investment trigger strategies discussed
above are shown in figure 7.5. Both firms have the same investment
11. The case of sequential investment with one firm investing as leader in the expanding
phase of a market and the rival as follower when the market is mature is excluded by
assumption.
12. At maturity there is no further option to defer the investment, so the NPV rule holds.
13. When X T ≥ X C , condition X T ≥ c a is satisfied. Therefore the condition X T ≥ c a
becomes redundant. If X T < X C, then the project end node value is zero since the option
is not exercised. If X T ≥ X C , the option is exercised since the project has positive NPV.
228 Chapter 7
Binomial tree evolution Threshold Investment decision Payoff (firm i, j)
High
~
~ NPV C (XT)
XT ≥ X C Invest ~
NPV C
(X )
T
~
X0 XT XC
Do not invest 0
X T < X C
Low
(abandon) 0
t=0 T
Figure 7.5
Investment decisions and payoffs at maturity for symmetric Cournot duopolists
X C = (3 bδ I + c) a is the investment trigger of symmetric Cournot duopolists.
trigger. We can derive the present value of the investment by backward

induction working back through the binomial tree.
Example 7.2 Investment Trigger for Symmetric Cournot Duopolists

Two symmetric firms compete in quantity, facing symmetric variable
costs of c = 15. Firms are identical, facing the same risk-adjusted discount
rate k = 10 percent and investment outlay I = 250 to enter the market.
After maturity T steady state is reached. The demand parameter X t
evolves stochastically, with a = 5 and b = 1. Given these parameters, the
(common) investment trigger for the Cournot duopolists obtained from
equation (7.8) is X C = (3 1 × 0.10 × 250 + 15) 5 = 6. Thus each duopolist
will invest at maturity provided the demand parameter X T exceeds
X C = 6. Once the investment decisions at maturity are determined, if
demand is high and both firms enter, we utilize the Cournot equilibrium
profit of equation (7.6) to obtain the net project value from equation
(7.7). Figure 7.6 depicts the Cournot duopoly end-node payoffs (NPV)
as a function of the stochastic demand level at maturity, X T . The payoff
function in the symmetric cost case looks like the payoff function of a
call option with exercise price X C = 6.
One difference compared with the monopoly case lies in the relevant
profit function once investment is made. Since monopoly profits are
higher than individual profits of Cournot duopolists the payoff (NPV)
values at maturity in the monopoly case (see in figure 7.3) are higher.
NPV C at maturity
(in thousands)
25
20
15
10
0
0 5 XC 10 15 20 25
~
End-node value XT
Figure 7.6
Payoff ( NPV C ) at maturity for option to invest in (symmetric) Cournot duopoly
Cost Asymmetry
In case of cost asymmetry, the investment triggers for Cournot quantity
competition are determined similarly but require taking a closer look at
the strategic interactions, since firms are less likely to follow symmetric
strategies. In the case of cost asymmetry, we assume a cost leader with
comparative cost advantage (subscript L) and a high-cost firm (subscript
H) as follower.
At the end nodes (at maturity), each firm (i = L, H ) will decide to
invest (enter) or not. Under cost asymmetry an investment game results
with industry structure (monopoly or duopoly) depending on the specific
trigger policies of the two firms. Once the firms enter, they choose the
appropriate output given knowledge of the prevalent number of active
firms. To help determine the investment strategies, consider the strategic
(normal) form of the simultaneous game shown in table 7.2. If both firms
invest (e.g., under high demand), the resulting industry structure is an
asymmetric Cournot duopoly. If only one firm invests, it results in a
monopoly, and if none invests no one turns a profit (0). Once they have
invested, firms select their output optimally. We next look closely at the
resulting payoffs in the strategic form to deduce under which conditions
each firm invests.
230 Chapter 7
Table 7.2
Strategic form of end-node investment game in asymmetric Cournot duopoly
Firm j (high cost)
Do not invest
Invest (abandon)
Firm i Invest ⎛ NPViC ( X T )⎞ ⎛ NPVi M ( X T )⎞

(low cost) ⎜ ⎟ ⎜ ⎟
⎝ NPVj ( X T )⎠ ⎝ 0 ⎠
C
Do not invest ⎛ 0 ⎞ ⎛ 0⎞
(abandon)
j ( T )⎠
⎜ NPV M X ⎟
⎝ ⎝⎜ 0⎠⎟
Note: NPVi M ( X T ) and NPViC ( X T ) are given in equations (7.3) and (7.7).
If NPViC ( X T ) ≥ 0, meaning if X T ≥ X iC , where

3 bδ I i + ( 2ci − c j )
X iC ≡ , (7.9)
a
firm i has a dominant strategy to invest at maturity regardless of the
decision of its rival. The firm is always better off (its investment has posi-
tive NPV) because its value as a monopolist exceeds the value as Cournot
duopolist (at least for the low-cost firm). If NPVi M ( X T ) < 0, meaning if
X T < X iM with X iM ≡ (2 bδ I i + ci ) a, firm i has a dominant strategy not
to invest at maturity. If realized demand X T is such that NPViC ( X T ) < 0
and NPVi M ( X T ) ≥ 0, meaning if X iM ≤ X T < X iC , firm i has no dominant
strategy. The same arguments apply for firm j. Deriving the outcome of
strategic interactions is more involved in the absence of dominant strate-
gies. Two cases can be distinguished to facilitate further analysis:
1. Firm i has no dominant strategy (if X iM ≤ X T < X iC ), but firm j has a

dominant strategy ( X T ≥ X Cj or X T < X jM ). If X T ≥ X Cj , firm j has a
dominant strategy to invest whereas firm i should not invest since
NPViC ( X T ) < 0. If X T < X jM , firm j has a dominant strategy not to invest,
but firm i should invest since NPVi M ( X T ) ≥ 0.
2. Neither firm i (if X iM ≤ X T < X iC ) nor firm j (if X jM ≤ X T < X Cj ) has a
dominant strategy. In this case there are two pure-strategy Nash
equilibria. If firm j invests, the optimal (re)action of firm i is not to
invest. If firm j does not invest, the optimal response of firm i is to
invest. Symmetrically, if firm i invests, the best reply for firm j is not
to invest. If firm i chooses not to invest, firm j should invest. The
two pure-strategy Nash equilibria are (Invest, Abandon) and
(Abandon, Invest).14 To solve this problem, we employ a focal-point

argument.15
The optimal investment strategies again depend on the level of demand

X T reached at maturity T. The end-node equilibrium payoffs (NPVT) can
again be determined as a function of the demand parameter X T. Three
regions or demand zones can be distinguished for firm i: X T < X iM ,
X iM ≤ X T < X iC , and X T ≥ X iC . Similarly there are three demand regions
for firm j: X T < X jM , X jM ≤ X T < X Cj , and X T ≥ X Cj .
The discussion so far applies for the general case. Let’s now consider
explicitly that firm i is the low-cost firm (L) and firm j the high-cost firm
(H), denoting the cost subscript accordingly (cL < cH ). When this cost
asymmetry is taken into account, some cases sort themselves out, being
mutually exclusive given that X LM < X HM and X LC < X HC. If X T < X LM , the
case where X T ≥ X HM is not possible. Similarly, if X T < X LC , X T ≥ X HC does
not hold. These explicit investment trigger restrictions enable deducing
the optimal investment policies for the duopolist option holders. Once
the investment policies are determined, we can deduce the equilibrium
value payoffs at maturity depending on the level of demand reached at
time T . The above are summarized in table 7.3.
Depending on the future evolution of the underlying demand, three
industry structures may result at maturity (T ):
• No one invests if X T < X LM (< X HM ).
• Monopoly Only one firm (the cost leader) invests, while the rival has
no incentive to invest and compete with the low-cost firm. The low-cost
firm (L) becomes a monopolist if X LM ≤ X T < X HC.
• Cournot competition Both firms invest simultaneously, choosing
their individually rational output à la Cournot. This case occurs when
X T ≥ X HC ( > X LC > X LM ).
Consequently the low-cost firm would choose not to invest, become a

monopolist, or become a cost-advantaged Cournot duopolist, depending
14. A third Nash equilibrium in mixed strategies also exists, as discussed later.
15. Schelling (1960) introduced the notion of “focal point” to support the use of Nash
equilibrium as a solution concept. Some use this approach to select among several pure-
strategy Nash equilibria. The focal-point argument suggests that among multiple equilibria
some are more likely to occur due to common sense or psychological reasons. The “focal
point” here is that the low-cost firm invests and the high-cost firm does not. This outcome
may be the most likely since it Pareto dominates other strategy profiles. In other words, a
social planner would give incentives to the low-cost firm to invest and to the high-cost firm
to stay out if it wants to achieve the socially optimal equilibrium. The focal-point argument
has questionable mathematical foundations so that one might prefer to rely on alternative
equilibrium selection procedures. Such an alternative is alluded to later and discussed in
detail in chapter 12.
Table 7.3
232
Investment triggers and equilibrium payoffs (NPV) at maturity for Cournot quantity competition
High-cost firm (H)
Low demand Intermediate demand High demand
X T < X HM X HM ≤ X T < X HC X T ≥ X HC
Low-cost High demand X T ≥ X LC Monopoly ⎛ NPVLM ( X T )⎞ Monopoly ⎛ NPVLM ( X T )⎞ Cournot ⎛ NPVLC ( X T )⎞

firm (L) ⎜ ⎟ ⎜ ⎟ ⎜ C
⎟
⎝ 0 ⎠ ⎝ 0 ⎠ ⎝ NPVH ( X T )⎠
Intermediate demand X LM ≤ X T < X LC Monopoly ⎛ NPVLM ( X T )⎞ Focal ⎛ NPVLM ( X T )⎞ Monopoly ⎛ 0 ⎞
⎜ ⎟ point ⎜ ⎟ ⎜ NPV M X ⎟
⎝ 0 ⎠ ⎝ 0 ⎠ ⎝ H ( T )⎠
Low demand X T < X LM No ⎛ 0⎞ Monopoly ⎛ 0 ⎞ Monopoly ⎛ 0 ⎞

investment ⎜⎝ 0⎟⎠ ⎜ NPV M X ⎟ ⎜ NPV M X ⎟
⎝ H ( T )⎠ ⎝ H ( T )⎠
2 2
Note: X iM ≡ 2 bδ I i + ci a, X iC ≡ 3 bδ I i + 2ci − c j a, NPVi M ( X T ) ≡ ⎡(aX T − ci ) 4bδ ⎤ − I i , NPViC ( X T ) ≡ ⎡( aX T − 2ci + c j ) 9bδ ⎤ − I i , for i = L, H.
( ) ( ) ⎣ ⎦ ⎣ ⎦
Chapter 7
Investment decision/
Binomial tree Threshold Payoff function
industry structure
~
~
Both invest NPVLC (XT)
High XT ≥ XHC (asymmetric ~
Cournot) NPVHC (XT)
~
NPVLM (XT)
Low-cost firm
Inter- ~ invests (monopoly)
X0 mediate XLM ≤ XT < XHC
High-cost firm 0
does not (0)
~ 0
Low XT < XLM None invests (0)
0
t=0 T
Figure 7.7
Investment decisions, industry structure and payoffs (NPV) at maturity in asymmetric
Cournot duopoly
X iM = (2 bδ I i + ci ) a, X iC = (3 bδ I i + 2ci − c j ) a , for i = L, H .
on demand realization X T . The high-cost firm does not invest or becomes

a Cournot duopolist (it cannot become a monopolist). The resulting
industry structures are summarized in figure 7.7.
Example 7.3 Investment Triggers in Asymmetric Cournot Duopoly

To help understand industry dynamics under cost asymmetry, let us
revisit the example used previously (in the case of cost symmetry),
assuming now that there is a low-cost firm with cost cL = 10 and
a high-cost firm with cH = 15. Both face an identical capital investment
cost I = 250. The investment triggers under asymmetry are now
(
given from (7.4) and (7.9) by X LM = 2 1 × 0.10 × 250 + 10 5 = 4 and )
( )
X HC = 3 1 × 0.10 × 250 + 2 × 15 − 10 5 = 7.
Figure 7.8 shows the firm payoffs at maturity (NPV) when costs are
asymmetric. One can discern three demand regions: for realized demand
X T lower than the lower investment trigger X LM, no one invests; in
the intermediary demand zone, X LM ≤ X T < X HC, only the low-cost
firm (L) invests; at high demand (i.e., when X T ≥ X HC = 7), the industry
becomes an (asymmetric) Cournot duopoly.
There is a noticeable discontinuity in the low-cost firm’s (L) payoff
function as the low-cost firm suffers a sudden value drop upon entry of
the rival at X HC. At intermediate levels of demand, given its cost advan-
tage, the low-cost firm is the only one to enter the market and chooses
its quantity accordingly to enjoy temporary monopoly profits. However,
234 Chapter 7
NPV at maturity
(in thousands)
15
10
Low-cost firm (L)
High-cost firm (H)

0
0 XLM 5 XHC 10 15
~
End-node value XT
Figure 7.8
Payoffs at maturity for option to invest in asymmetric Cournot duopoly
as demand ( X T ) rises, the low-cost firm recognizes that the high-cost firm
is also able to enter and make a profit, and thus adjusts its optimal quan-
tity à la Cournot. The discontinuity occurs at this point. The low-cost firm
produces more than the high-cost firm due to its cost advantage, still
earning higher profits.
The situation above rests on the resolution of the coordination problem
(who enters first) in the intermediate demand region by use of the focal-
point argument, namely that the low-cost firm (L) naturally invests first
or is the only entrant. An alternative would be to assume that the Cournot
duopolists decide to leave their market-entry decision to chance and use
mixed actions at each end node. In this case firm i chooses its (equilib-
rium) investment probability qi* such as to make its competitor (firm j)
indifferent between investing, receiving
qi* NPVjC + (1 − qi* ) NPVjM,
and abandoning, receiving zero. The equilibrium investment probability

for firm i is thus16
16. This logic is close to notions used later in chapter 12, in particular the equilibrium
investment “intensity” or probability used to solve the coordination problem by use of
continuous-time mixed strategies. In the present context, however, the follower’s value is
equal to zero since we consider the problem at finite maturity (T ).
NPVjM
qi* = . (7.10)
NPVjM − NPVjC
For asymmetric firms, one specific pure-strategy Nash equilibrium yields

a Pareto-optimal payoff allocation. We assume that this strategy profile
is the most likely based on a focal-point argument. The mixed-strategy
approach provides an alternative to resolve the coordination problem.
In the intermediate region, it is socially optimal for only one firm to
invest. In this region each firm will invest with a positive probability
(nondegenerate mixed strategy) as per equation (7.10). Note, however,
that a “coordination failure” where both firms invest in the market,
although only one can enter profitably, may still emerge in equilibrium.
This point is addressed in chapter 12. In the following discussion, we do
not allow for mixed strategies (this approach is less analytically
tractable).
7.2.2 Asymmetric Cournot Oligopoly
In the previous section on Cournot duopoly, we have seen that in the

case of two asymmetric firms, three market structures may result: (1) no
investment, (2) monopoly, or (3) duopoly. The threshold from the no-
investment demand region to the monopoly zone depends on the NPV
of the low-cost firm (L), once it has invested. The threshold from the
“monopoly zone” to “duopoly” is a function of the NPV expression of
the high-cost firm seen as a “natural-born” follower.
We can recast the results of the previous section in a more general
setting. The focal point argument used above was based on the idea that
the low-cost firm invests first in case of a coordination problem. Our
present approach consists in generalizing this argument considering that
the high-cost firm (H) is a “born” follower due to its cost disadvantage
and will only invest if its NPV as Cournot duopolist is positive. We also
recognize that the low-cost firm (L) will enter the market even if the
investment is unprofitable for the high-cost firm.
We here generalize this approach to an asymmetric oligopolistic indus-
try where n firms share an (European) investment option, with firms
having different, firm-specific costs. Let the transcript i = 1, . . ., n indicate
the rank in relative cost advantage: firm 1 is the absolute (lowest) cost
leader, firm 2 has a relative cost advantage compared to firms 3, 4, . . .,
n, and so on and on. T indicates the number of periods to maturity.
Let π i( n, X T ) and NPVi ( n, X T ) denote the profit and the net present
value resulting from the investment by firm i, when there are n active
236 Chapter 7
firms in the market. In chapter 3, equation (3.26), we derived the

profit for firm i in an oligopoly setup with n firms in case of certainty
( X t = 1) as
1 (a − nci + ( n − 1) c− i )
2
π iC ( n, 1) = , i = 1, . . ., n,
( n + 1)2 b
where c ≡ ∑ j =1 c j n is the average variable production cost in the

n
industry and c− i ≡ ∑ j ≠i c j (n − 1) the average production cost for all

other firms except firm i. Alternatively, we have
2
1 ⎢ a + ∑ j =1 c j − ( n + 1) ci ⎥
⎡ n
⎤
π ( n, 1) = π ( n) =
C
i
C
i , i = 1, . . ., n.
b⎢ n+1 ⎥
⎣ ⎦
The equilibrium profit value for firm i in case of uncertain end-node
profits is similarly
2
⎡
1 ⎢ aXT + ∑ j =1 c j − ( n + 1) ci ⎥
n
⎤
π i( n, XT ) =
, i = 1, . . ., n. (7.11)
b⎢ n+1 ⎥
⎣ ⎦
Let δ ≡ k − g, where k is the risk-adjusted discount rate and g the rate at
which the underlying uncertain factor grows. The end-node NPV for firm
i in case of investment with uncertain profits is
2
⎡
1 ⎢ aXT + ∑ j =1 c j − ( n + 1) ci ⎥
n
⎤
NPVi ( n, XT ) =
− Ii , i = 1, . . ., n.
bδ ⎢ n+1 ⎥
⎣ ⎦
Firm n has an absolute cost disadvantage and will invest (as the latest
entrant) if and only if NPVn ( n, X T ) ≥ 0, namely if X T ≥ X nC , where17
( n + 1) bδ I n + ( n + 1) cn − ∑ j =1 c j
n
X ≡
C
n .
a
Similarly firm n − 1 will invest if and only if NPVn−1 ( n − 1, X T ) ≥ 0,

(
namely if X T ≥ X nC−1, where18 X nC−1 ≡ n bδ I n−1 + ncn−1 − ∑ j =1 c j a. This
n−1
)
can be generalized to any firm i, i = 2, . . ., n. Firm i will invest if and only
if NPVi (i, X T ) ≥ 0, namely if XT ≥ X iC , where
1⎡ i
⎤
X iC ≡ ⎢( i + 1) bδ I i + (i + 1) ci − ∑ c j ⎥ , i = 2, . . ., n. (7.12)
a⎣ j =1 ⎦
17. If n = 2 , this reduces to expression (7.9) for the asymmetric Cournot duopolist. This is
subject to aX T + ∑ nj =1 c j − (n + 1) cn ≥ 0. If this condition is not met, the profit for firm n is
negative and so the nth investor will not invest.
18. This is subject to aX T + ∑ nj =−11 c j − ncn−1 ≥ 0 .
In the special case of the first investor (i.e., of firm 1) preempting all
others, the investment trigger is that of a monopolist given in equation
(7.4) previously:
2 bδ I i + ci
X iM ≡ .
a
Equation (7.12) thus applies to the case where i = 1 is included in

the set {1, . . ., n}. The first (lowest cost) investor adopts a myopic
stance when determining its investment strategy disregarding all
rivals’ investment policies since they affect only the overall value of
the investment but not its own optimal exercise strategy. Since
X 1M < X 2C < . . . < X iC < . . . < X nC, the equilibria and payoff functions for
the asymmetric firms in a Cournot oligopoly can be ranked as shown in
figure 7.9.
To further benchmark this result with previous known results, consider
the special case of a duopoly with a cost leader (i = L) and a cost follower
( j = H ). The investment trigger of the low-cost firm (L) is
2 b δ I L + cL
X LM = ,
a
and for the high-cost firm (H),
Binomial tree evolution Threshold Investment decision Payoff function
~
NPV1 (n, XT)
~ ...
~
High
XT ≥ XnC All firms invest NPVi (n, XT)
...
~
NPVn (n, XT)
… … …
~
NPV1 (i, XT)
Inter- ...
X0 mediate ~
XiC ≤ XT < Xi+1
C Only first i firms ~
NPVi (i, XT)
invest 0
...
0
… … …
Low 0
~ ...
XT < X1C None invests
0
t=0 T
Figure 7.9
Investment decisions and payoffs (NPV) in an asymmetric Cournot oligopoly with n firms
X iC = ⎡(i + 1) bδ I i + (i + 1) ci − ∑ j =1 c j ⎤ a , i = 1, . . ., n.
i
⎣ ⎦
238 Chapter 7
Table 7.4
Project payoffs (end-node NPVs) under differentiated Bertrand price competition
Monopoly (firm i ) NPVi M ( X T ) ≡ Vi M ( X T ) − I

Bertrand duopoly ( i = 1, 2) NPVi B ( X T ) ≡ Vi B ( X T ) − I
Note: Vi M ( X T ) ≡ (ai X T − c ) 4bδ , Vi B ( X T ) ≡ (1 − s ) ( ai X T − c ) b(1 + s) ( 2 − s ) δ .

2 2 2
3 b δ I H + ( 2 c H − cL )
X HC = .
a
This confirms equations (7.4) and (7.9) derived in the preceding section
on asymmetric Cournot duopoly under uncertainty.
7.3 Differentiated Bertrand Price Competition
The analysis in the previous section assumed that firm actions were
strategic substitutes and that firms engaged in quantity competition. In
this section we turn to the case of actions that are strategic complements
characterizing price competition. For more realism we consider the
general case where products are differentiated and firms may have dif-
ferent demand functions. The uncertain market (inverse) demand func-
tion for firm i, following equation (3.1′), is assumed to be of the form:
pi (Q, X t ) = ai X t − b ( qi + sq j ), (7.13)
where b > 0 characterizes a downward-sloping demand, s (0 ≤ s < 1) cap-

tures the degree of substitutability, and ai is a constant price parameter
assumed specific to firm i (ai ≠ aj). Each firm must incur the same capital
cost I upon entry. Costs are here assumed symmetric: firm i’s cost func-
tion is Ci (qi ) = cqi, with same variable cost c ( ≥ 0 ). Using the equilibrium
profits for monopoly and for simultaneous differentiated Bertrand price
competition derived in chapter 3, equations (3.4) and (3.10), we obtain
the end-node NPVs. These are summarized in table 7.4 for each of the
above two industry structures.
The results, when presented in strategic form, help better illustrate
under which conditions these outcomes may occur. This strategic form
representation is depicted in table 7.5.
If NPVi B ( X T ) ≥ 0, namely if X T ≥ X iB, where19
2 − s ⎞ bδ I (1 − s 2 ) + c
X iB ≡ ⎛ , (7.14)
⎝ 1− s⎠ ai
19. This formula is an approximation. In the present context we assume asymmetric
demand intercepts (ai ≠ aj) to be able to rely on a focal-point argument in favor of the
demand-advantaged firm. For expositional simplicity we rely on equation (3.10), which uses
identical demand intercepts.
Table 7.5
Strategic form of end-node investment game under differentiated Bertrand price
competition
Firm j
Do not invest
Invest (abandon)
Firm i Invest ⎛ NPVi B ( X T )⎞ ⎛ NPVi M ( X T )⎞

⎜ ⎟ ⎜ ⎟
⎝ NPVj ( X T )⎠ ⎝ 0 ⎠
B
Do not invest ⎛ 0 ⎞ ⎛ 0⎞
⎜⎝ 0⎟⎠
j ( T )⎠
(abandon) ⎜ NPV M X ⎟
⎝
Note: NPVi M ( X T ) ≡ ⎡( ai X T − c ) 4bδ ⎤ − I,
2
⎣ ⎦
NPVi B ( X T ) ≡ ⎡(1 − s )( ai X T − c ) b(1 + s) ( 2 − s ) δ ⎤ − I.
2 2
⎣ ⎦
firm i has a dominant strategy to invest since its value as a monopolist

is higher than its value as a (differentiated) Bertrand duopolist. A
similar argument holds for firm j. However, if NPVi M ( X T ) < 0, namely
if X T < X iM , where, by extension of equation (7.4),20
2 bδ I + c
X iM ≡ , (7.15)
ai
firm i will have a dominant strategy not to invest. If X iM ≤ X T < X iB, there
is no dominant strategy for firm i. In this case, to identify the pure-
strategy Nash equilibria two cases need to be distinguished:
1. Firm i has no dominant strategy to invest while firm j has a dominant

strategy. If X T ≥ X jB, firm j has a dominant strategy to invest, but firm i
should not invest. If X T < X jM, firm j has a dominant strategy not to
invest, but firm i should invest.
2. Neither firm i nor firm j has a dominant strategy to invest. In this case
there are two Nash equilibria in pure strategies. If firm j invests, the
optimal reaction for firm i is not to invest. If firm j does not invest,
the optimal response for firm i is to invest. Similarly, if firm i invests,
the best reply for firm j is not to invest. If firm i chooses not to invest,
firm j should invest. The two Nash equilibria are (Invest, Abandon)
and (Abandon, Invest). A focal point may be found, where the firm
with the higher differentiated price parameter ai invests and the other
does not.
20. Subject to X T ≥ c ai .
240 Chapter 7
Let firm i be the firm with the high-price parameter aH. Firm i is
denoted H henceforth. Firm j is the firm with the low-price parameter
aL. Some combinations are again mutually exclusive, for example,
X HM < X LM and X HB < X LB. Based on these investment triggers, the
optimal investment policies and equilibrium payoffs at maturity T
can be deduced depending on the level of demand reached at time T
(see table 7.6). Again, we identify three regions of demand. For
low demand (i.e., X T < X HM ), no one invests; for high demand (i.e.,
X T ≥ X LB), both firms invest as (differentiated) Bertrand duopolists; and
for an intermediary demand zone ( X HM ≤ X T < X LB), the resulting indus-
try structure is a monopoly.
The outcomes of the shared investment option game under differenti-
ated Bertrand price competition at maturity are depicted in figure 7.10.
As noted, the Cournot model is often used to describe industry structures
where players first select the production capacity level for the long run
and then compete in the short-term over prices (à la Bertrand). The
Cournot model or its extensions may be more appropriate in case of
option games involving long-term capacity investment decisions. For this
reason most of the option games we consider subsequently are described
in a Cournot quantity competition framework as strategic investment
decisions typically have a long-term impact.
Conclusion
In this chapter we have built upon the materials developed earlier in

chapter 3 to derive the value and optimal exercise formulas for bench-
mark option games under uncertainty. We first examined the monopo-
list’s deferral option to help identify the main factors influencing the
investment policy of a firm. We later extended the analysis to quantity
and price competition. We showed the importance of deriving the trigger
strategies as part of the firm’s investment policy under uncertainty. Each
firm should select a trigger level for the stochastic demand factor and
decide to invest when the actual value of the process exceeds this invest-
ment trigger. Due to the existence of strategic interactions in the market,
firms cannot simply set a trigger as a monopolist; they have to anticipate
whether and when the rival will exercise its investment option in future
states. The optimal investment option value reflects firms’ optimal future
behavior in interaction with rivals and the resulting equilibrium industry
structures.
Table 7.6
Investment triggers and equilibrium payoffs (NPV) under differentiated Bertrand price competition
Low-demand firm (L)
Low demand Intermediary demand High demand

Option to Invest
X T < X LM X LM ≤ X T < X LB X T ≥ X LB
High- High demand X T ≥ X HB Monopoly ⎛ NPVHM ( X T )⎞ Monopoly ⎛ NPVHM ( X T )⎞ Bertrand ⎛ NPVHB ( X T )⎞

demand ⎜ ⎟ ⎜ ⎟ ⎜ B
⎟
⎝ 0 ⎠ ⎝ 0 ⎠
Firm (H) ⎝ NPVL ( X T )⎠
Intermediary demand X HM ≤ X T < X HB Monopoly ⎛ NPVHM ( X T )⎞ Focal point ⎛ NPVHM ( X T )⎞ NA
⎜ ⎟ ⎜ ⎟
⎝ 0 ⎠ ⎝ 0 ⎠
Low demand X m < X HM * No ⎛ 0⎞ NA NA
investment ⎜⎝ 0⎟⎠
2 − s⎞ ⎡ 2 2 2
Note: X iM ≡ 2 bδ I + c ai, X iB ≡ ⎛⎜
( ) ( bδ I (1 − s 2 ) + c ai ⎤⎦, NPVi M ( X T ) ≡ ⎡(ai X T − c ) 4bδ ⎤ − I, NPVi B ( X T ) ≡ ⎡(1 − s )( ai X T − c ) bδ (1 + s) ( 2 − s ) ⎤ − I,
)
⎝ 1 − s ⎟⎠ ⎣ ⎣ ⎦ ⎣ ⎦
i = L, H. NA = nonapplicable.
241
242 Chapter 7
Payoff function
Binomial tree evolution Threshold Investment decision
(firm H, L)
~
~ NPVHB (XT)
High XT ≥ XLB Both firms invest
~
NPVLB (XT)
~
NPVHM (XT)
High-demand firm
Inter- ~ invests (monopoly);
X0 mediate XHM ≤ XT < XLB
Low-demand firm 0
does not (0)
~ 0
Low XT < XHM None invests (0)
0
t=0 T
Figure 7.10
Thresholds, investment decisions, and payoffs (NPV) in differentiated Bertrand price
competition
NPVi M ( X T ) ≡ Vi M ( X T ) − I ; Vi M ( X T ) ≡ ( ai X T − c ) 4bδ ; X iM ≡ (2 bδ I + c) ai ;
2
NPVi B ( X T ) ≡ Vi B ( X T ) − I , Vi B ( X T ) ≡ (1 − s ) ( ai X T − c ) bδ (1 + s) ( 2 − s ) ;
2 2
X iB ≡ ⎡⎣((2 − s) (1 − s)) bδ I (1 − s 2 ) + c ⎤⎦ a , i = L, H .
Selected References
Smit and Ankum (1993) extend binomial trees with embedded strategic-
form games. Smit and Trigeorgis (2004) develop a systematic approach
to option games involving several option games models in discrete time
meant to describe various industry settings. Dixit and Pindyck (1994)
discuss some of these issues in continuous time.
Smit, Han T. J., and L. A. Ankum. 1993. A real options and game-
theoretic approach to corporate investment strategy under competition.
Financial Management 22 (3): 241–50.
8 Innovation Investment in Two-Stage Games
R&D investments are typically made under uncertainty. Firms cannot

safely predict the state of demand when the resulting product offering
will be launched in the marketplace, nor what the competitive situation
will be. Box 8.1 discusses how real options analysis can provide intuitive
insights regarding R&D investment. Here we complement such analysis
with game-theoretic thinking.
Strategic investments are often made under conditions of uncertainty
about key market factors (e.g., demand, costs, or competitors’ strategies).
When moves are hard or costly to reverse, the value of preserving flex-
ibility must be explicitly assessed and traded off against the strategic
benefits gained from early investment commitment. The trade-off
between keeping one’s options open (the option to wait) and committing
earlier to benefit from a positive strategic impact or rival behavior must
be quantified. To address this issue, Smit and Trigeorgis (2001, 2004)
extend Fudenberg and Tirole’s (1984) business strategy framework when
one key underlying factor, namely demand, is uncertain. The uncertainty
in demand is modeled as a multiplicative binomial process (e.g., see Cox,
Ross, and Rubinstein 1979). In this chapter we propose a methodology
to capture the trade-off between commitment and flexibility and present
valuation expressions for quantifying the value of flexibility and commit-
ment. The chapter is organized as follows. In section 8.1 we discuss the
problem of investment in R&D when firms face spillover effects. Section
8.2 considers an application involving determination of optimal patent-
ing strategies, while section 8.3 discusses the incentive to create goodwill
in a context where firms compete in price.
8.1 Innovation and Spillover Effects
In chapter 7 we analyzed quantity competition involving asymmetric

costs that were given exogenously. Now we consider two-stage games
244 Chapter 8
Box 8.1
Real options and gut feeling in R&D
In R&D, the Next Best Thing to a Gut Feeling

Amal Kumar Naj, Wall Street Journal
The tendency of Japanese companies to take advantage of innovations

devised in the US is almost automatically attributed to Japan’s lower
capital costs and its supportive government-industry alliances. But it’s
often overlooked that from the very start US corporations put their
emerging technologies at an enormous disadvantage because of the tech-
niques they use to evaluate payoffs. The rigid equations and models cur-
rently used unfortunately have replaced the instinct and intuition that
once guided US entrepreneurs.
The fundamental test used in most US companies is: Does the return
exceed the cost of capital over the life of the project? To find the answer
companies subject the project to a variety of discounted-cash flow mea-
sures. Dozens of assumptions go into this methodological overkill. Many
of the assumptions aren’t reliable. Some are tenuous at best. And if it’s a
long-term project that would take, say, 10 years to commercialize (five
years being the outer limits of American corporations’ horizon), the
distant estimates are considered highly speculative and are heavily dis-
counted. Even the “terminal value,” the value of the plant and other assets
upon commercialization, is assumed to be zero. When all is said and done,
the payoff estimates produced by the quantitative analyses are usually too
low. They stand little chance of beating that ultimate yardstick—the cost
of capital. Nine out of 10 projects, on average, fail the test.
Perhaps the most fundamental problem with the current techniques is
that they fail to take into account the consequences of not pursuing a
technology. An auto maker may give up on ceramic engines, because
technically they seem unfeasible. But a rival who makes prosaic ceramic
parts with the aim of one day using the knowledge to build a ceramic
engine—as the Japanese are doing—can quickly change the competitive
balance.
How to get American companies to act on their intuition again? There
is a new technique that will go a long way toward that. It deserves wide
attention, for it comes closest to simulating the old-fashioned gut feeling.
Designed after well-developed stock-options theories, the technique
works something like this: Suppose there are two emerging technologies,
X and Y, that have some bearing on the company’s main business. The X
may involve a well-understood technology and a market. The Y may
involve a wide range of possible outcomes and new markets but with,
say, 40 percent chance of technical failure. The benefits of X are easily
quantifiable, and hence salable to top management for funding. The Y is
unsalable because it’s unquantifiable, even though it seems more
promising.
Innovation Investment in Two-Stage Games 245
Box 8.1
(continued)
Instead of ignoring Y, the company commits small amounts to develop

the technology, in effect taking a “call option” on the underlying technol-
ogy. The option allows R&D people to explore its technical possibilities,
market opportunities, development costs and competitors’ strategies. If
these don’t become clear within the time period of the option, the option
is allowed to “expire.”
The loss is limited to the small initial funding (the value of the R&D
option), just as in the stock option. “The important thing to realize is that
the initial expenditures are not directed so much as an investment as they
are toward creating an option,” says William Hamilton of the University
of Pennsylvania’s Wharton School, who has co-authored a paper on
options valuations of R&D with Graham Mitchell, director of planning at
GTE Laboratories in Waltham, Massachusetts.
R&D options, fundamentally, help identify the unapparent outcomes
that may be the most important reasons for undertaking the investment.
Consider:
• In 1984, W.R. Grace decided to invest in a new technology for catalytic
converters for the automobile aftermarket. The discounted cash flow anal-
ysis—which used a generous “terminal” value—showed that it was an
“attractive” project. What looked like a sure-fire technology now can’t
compete on price. “We didn’t accurately predict the price-performance
requirement we needed in the aftermarket,” says Peter Boer, chief techni-
cal officer.
Grace would have dropped the project, except that other opportunities
for that technology intervened. The recent clean-air legislation has created
applications in cogeneration plants, in plants to reduce ozone emissions,
and in utilities to control emissions. Suppose the automotive catalyst tech-
nology had been given a thumbs-down by the quantitative techniques, but
the other downstream markets loomed on the horizon. Could Grace have
overturned the negative signal and invested in the automotive catalyst
anyway? “I don’t think I would have been able to communicate that to
the finance people,” says Mr. Boer.
• In the early 1980s, General Electric initially ignored the emerging mag-
netic resonance imaging (MRI) technology for medical diagnosis. The
MRI market was unclear. And most important, it would have cannibalized
the market for GE’s existing CT diagnostic machine, which uses X rays.
GE overruled the directive of the discounted cash flow technique, as it
realized that if it didn’t cannibalize the CT market, someone else was going
to. Walter Robb, director of GE’s R&D, says he doesn’t have much use for
quantitative techniques now. “The challenge is to find 30 projects a year
that will pay off not by NPV (net present value) but by the seat of our
pants,” he says.
246 Chapter 8
Box 8.1
(continued)
• It’s the downstream rewards that are allowing the pharmaceutical

company Merck & Co. to plan extensive automation. When it considered
the idea first for a drug packaging and distribution plant, the labor savings
didn’t justify the investment. Moreover, with no prior experience with
robots, Merck also wasn’t certain about the technical success.
“It was a tricky thing to convince the management. But options valua-
tion allowed engineers to articulate a whole range of outcomes and their
benefits,” says Judy Lewent, chief financial officer at Merck. The manage-
ment agreed to take an “option” on automating the plant, and results from
the pilot project since early this year have clarified the potential future
benefits to the point that the company is now willing to expand automation
to its diverse manufacturing operations.
• US West, a telecommunications concern in Denver, faced with fast-
changing technologies in its industry, also has taken the options approach.
It’s pursuing technologies—that it otherwise wouldn’t be able to justify—
aimed at making its cellular phones and paging devices more user-friendly.
“Our company doesn’t have the maturity and experience to act on gut
feelings,” says David Sena, strategic technology planner of US West, a
company spawned in 1984 by the AT&T breakup.
The options technique needs refining (how to calculate the value of an
R&D option is a subject of debate, for instance). But it is the first clear
mechanism for R&D people to communicate with their finance men.
Reprinted with permission of The Wall Street Journal, Copyright © 1990

Dow Jones & Company, Inc. Publication date: May 21, 1990.
where a firm may make a first-stage strategic investment (K) that can
influence future variable costs. Suppose that the low-cost firm in a
duopoly invests in an R&D process innovation to further reduce
its variable cost cL.1 By reducing its second-stage variable cost,
the low-cost firm faces a lower investment trigger and the project is
1. Having the low-cost firm ( L ) make the strategic investment is simpler. If the high-cost
firm ( H ) is the one making such an R&D investment, two effects would result: (1) firm
H ’s cost position is improved, affecting all the players’ investment triggers, and (2) for
substantial change in the cost differential, the industry structure might change in the
intermediate demand region from firm H staying out (without strategic commitment) to
investing as a monopolist (with strategic commitment). This second effect creates a discon-
tinuity in the value function. By focusing on the problem where the low-cost firm may
improve its cost position, we are more in line with Fudenberg and Tirole’s (1984) analysis
where the value function is differentiable in the first-stage investment. Considering the
reverse problem would make the analysis more involved while being unable to isolate the
pure strategic effect resulting from the commitment.
more likely to be worthwhile (“in the money”), namely the opportunity

to invest will be of higher value. At the same time this cost improve-
ment reduces the rival’s incentives to enter in that it cannot extract as
much value upon entering. That is, when the incumbent firm (L) lowers
its future variable cost, the investment trigger for its rival X HC rises such
that the high-cost firm is less likely to invest as a Cournot duopolist.
Furthermore the firm investing in the lower cost production technology
receives a higher temporary monopoly profit as well as higher duopoly
rents compared to the case where it operates under the old technology.
Four concurrent effects influence the investment decision as a result of
this action:
1. The investment trigger of the low-cost firm ( X LM ) decreases, so it is

more likely to invest (its option value increases).
2. The investment trigger of the rival ( X HC) increases, and consequently
the low-cost firm is more likely to enjoy longer temporary monopoly
profits.
3. At the intermediate demand zone, X LM ≤ X T < X HC, the profit made by
the low-cost firm is higher (with process innovation leading to a decrease
in its variable cost).
4. When demand is very high ( X T ≥ X HC ) and the high-cost firm also
enters resulting in a Cournot duopoly structure, the low-cost firm may
achieve higher profit (than without the upfront R&D investment).
The firm therefore has an incentive to reduce variable costs not only
because it enhances its chance of being NPV positive but also because
of strategic interactions that may make the investing firm tougher, result-
ing in a (greater) cost disadvantage for its rival. We next discuss this
problem at length.
In analyzing strategic investment commitment, one has first to set a
benchmark. At t = 0 firm i may decide to commit to an early strategic
investment (e.g., R&D in process innovation) or not. If firm i does not
commit now, it still has managerial flexibility to wait. This is the “base
case.” By comparing the base case of no investment and the case involv-
ing strategic investment, we can determine the incremental value of
commitment. Once the base case is set, we can assess whether early
strategic investment commitment has a positive or a negative incremen-
tal value and compare the relative value of the investment strategy with
versus without commitment. We first analyze the case when firms compete
in quantity à la Cournot.
248 Chapter 8
The model developed previously makes it possible to value option

games when one of the underlying factors is uncertain, such as when the
demand shock parameter X t in the demand function
p (Q, X t ) = aX t − bQ (8.1)
follows a multiplicative binomial process. To analyze strategic commit-

ment, for example in R&D investment, it is useful to distinguish between
“proprietary” and “shared” R&D investment. Firm L is contemplating
investing ex ante in R&D (process innovation) that can reduce its unit
production costs in the ex post competition phase. The base case involves
the situation where firm L does not invest or reap the benefits of R&D
investment. We assume that there is already a cost advantage for the
low-cost firm even without the new commitment (cL < cH). Suppose that
the R&D effort by firm L decreases ex post production cost, cL, by an
amount ω (0 < ω < cL) to
cL ′ ≡ cL ′(ω ) = cL − ω.
The high-cost firm H does not itself invest in R&D, but due to R&D
spillovers in case R&D is made and shared, it may partly or fully benefit
from firm L’s investment in R&D as well. The unit production cost for
the high-cost (noninvesting) firm reduces to
cH ′ ≡ cH ′ (ω ) = cH − γω .
The degree of spillover effect (shared R&D benefits) is reflected in

the unit production cost savings of the high-cost firm via parameter
γ ∈[ 0, 1]. If γ = 0, there are no R&D spillovers (the proprietary R&D
case); if γ = 1, the high-cost firm simply free-rides from innovative firm
L’s R&D investment (fully shared R&D).2 In some cases (e.g., in patent
licensing) γ can be a decision variable.
From chapter 7, equations (7.4) and (7.9), the investment triggers
under the pre-R&D asymmetric cost structure are given by
2 bδ I + cL
X LM ≡
a
and
2. Spillovers measure to what extent the investment in R&D is “shared.” High spillovers
mean that the competitor also benefits or free-rides on the investing firm. Low spillovers
means that the investing firm can effectively protect its innovation and is the sole party
benefiting from the R&D investment.
3 b δ I + ( 2 c H − cL )
X HC ≡ .
a
Let X LM ′ and X HC ′ be the investment triggers under the new, post-R&D
cost structure. These are given by
2 b δ I + cL − ω
X LM ′ = (8.2)
a
and
3 bδ I + ( 2cH − cL ) + (1 − 2γ ) ω
X HC ′ = . (8.3)
a
Comparing these investment triggers, note first that X LM ′ < X LM (for all
ω such that 0 < ω < cL). With process innovation, the cost and investment
trigger of the investing firm decline and the likelihood that its option is
in the money increases. In the American-type option framework we
analyze later on (see later continuous-time analysis), this means that the
low-cost firm will invest earlier in the production stage. A lower invest-
ment trigger resulting from innovation implies that the investment will
be more attractive.
Another insight is that the first-stage R&D investment of firm L may
alter the investment trigger of its rival, depending on the size of the
cost savings from innovation (ω ) and the degree of spillover (γ ). Since
X HC ′ − X HC = (1 − 2γ ) ω a, X HC ′ ≥ X HC if γ ≤ 1 2 (a and ω are positive
numbers). This has interesting implications on whether firm L should
invest in R&D or not. For a low degree of spillover (γ ≤ 1 2), the invest-
ment threshold of the rival firm rises if the low-cost firm invests in R&D.
For an American-type investment option this means that the rival invests
later. This case with low spillover corresponds to the proprietary R&D
investment case in Smit and Trigeorgis (2004). In patent licensing (see
later section 8.2) it corresponds to the case of not licensing out, so the
innovating firm keeps the innovation benefits to itself. By making the
strategic R&D investment, firm L invests earlier in production (lower
investment threshold for the low-cost firm); if the investment is propri-
etary or spillovers are low, this investment makes the rival firm less
aggressive in the product market stage (i.e., it invests later on). This kind
of positive strategic effect leads to the “top dog strategy” in Fudenberg
and Tirole’s (1984) taxonomy. Investing in R&D makes innovative firm
L tough, and the rival firm responds less aggressively in the competition
250 Chapter 8
stage (strategic substitutes), producing a positive strategic effect for the

investing firm. Firm L should thus “overinvest.” In case of high spillover
(γ > 1 2), however, the strategic investment in R&D by firm L reduces
its own investment trigger as well as the investment trigger of its rival,
so both firms benefit. Since firm L’s strategic move is also beneficial to
the rival, it represents a soft commitment for firm L, who should refrain
from investing.
A third insight is obtained if we examine the difference between the
investment thresholds of firm L as a monopolist in equation (7.4) and
firm H as a duopolist in equation (8.3):
bδ I + 2 ( cH − cL ) + (1 − 2γ ) ω
X HC ′ − X LM = ,
a
noting that
∂ ( X HC ′ − X LM ) 2ω
=− (< 0 ).
∂γ a
The higher the spillover effect (γ ), the lower the discrepancy between
the investment thresholds of the two firms. If the spillover effect is high
and firm L’s investment decision (to do R&D or license its technology
to its competitor) also benefits the rival firm (the investment is “shared”),
although the investment trigger of the low-cost firm is reduced the likeli-
hood to become a monopolist is lower. In this case, firm L should refrain
from making the strategic investment commitment. Firm L should wait
or “underinvest” and keep a lean-and-hungry look. In this case “over-
investing” has a negative strategic effect.3 If the spillover effect (γ ) is low,
however, the discrepancy between the two investment thresholds under
the new cost structure widens and the attractiveness of firm L investing
to reap proprietary benefits as a monopolist increases. The low-cost firm
should overinvest (in R&D or licensing out its patent), acting as a top
dog.4
So far we examined whether R&D investment has a positive or a
negative strategic effect. To decide whether the firm should invest in
R&D (license out its patent) or not, the net value of the investment
under the two cost structures must be determined as discussed in the
previous chapter.
3. Only a “suicidal Siberian” would overinvest under strategic substitutes even though
investment would make it soft.
4. The low-cost firm would be a “submissive underdog” if it decided to underinvest to
accommodate entry when its commitment makes it tough and actions are strategic
substitutes.
Example 8.1 Investment Triggers in a Duopoly Faced with Low

R&D Spillover
Let us revisit previous example 7.3, where cL = 10, cH = 15, b = 1,
a = 5, k = 10 percent, g = 0 percent, I = 250 . Under the pre-
R&D investment cost structure, the investment triggers given by
(
equations (7.4) and (7.9) were X LM = 2 1 × 0.10 × 250 + 10 5 = 4 and )
( )
X HC = 3 1 × 0.10 × 250 + 2 × 15 − 10 5 = 7. Now suppose that the low-
cost firm L makes an upfront strategic investment in R&D of K = 200
to decrease its variable costs in the competition stage, achieving cost
savings of ω = 4. Suppose that the spillover effect is low, with
γ = 0.25 ( < 1 2 ). Firm L should then invest in R&D given that this com-
mitment makes it tough and that firms compete in quantity (strategic
substitutes). Under the new cost structure cL ′ = 10 − 4 = 6 and
cH ′ = 15 − 0.25 × 4 = 14. The new investment triggers given by equations
( )
(8.2) and (8.3) are X LM ′ = 2 1 × 0.10 × 250 + 6 5 = 3.2 (lower than
X LM = 4); and (
X HC ′ = 3 1 × 0.10 × 250 + 2 × 15 − 10 + 0.5 × 4 5 = 7.4 )
(larger than X H = 7).
C
As confirmed in figure 8.1, panel a, the investment trigger of the low-

cost firm decreases ( X LM ′ < X LM ) such that the firm is more likely to invest.
Furthermore the investment trigger of its rival increases so firm L is more
likely to act as a monopolist in the marketplace. The project value is
consequently higher for the low-cost firm and lower for its competitor.
Depending on the size of the upfront strategic investment cost, firm
L may be better off refraining from investing in R&D even if doing so
has a positive strategic effect. It will do so when the cost of the invest-
ment necessary to obtain this strategic effect is higher than the incre-
mental option value created by the strategic effect.5
Example 8.2 Investment Triggers in a Duopoly Faced with High

R&D Spillover
Consider the same situation but suppose now that the spillover effect is
higher at γ = 0.75 ( > 1 2 ). The post-R&D costs now are cL ′ = 6 and
cH ′ = 15 − 0.75 × 4 = 12. The new investment triggers are X LM ′ = 3.2 (same
as with low spillover) and X HC ′= 6.6 (lower). Figure 8.1, panel b, confirms
that as a result of the shared benefits of this R&D investment, both firms
now face lower triggers and are more likely to invest in the product
5. Assuming a maturity of T = 5 years over 10 equally spaced time steps, volatility of
σ = 30 percent, and risk-free rate r = 3 percent, the value of the option for the low-cost firm
under the post-R&D cost structure is estimated to be 168 . The value of the option under
the pre-R&D cost structure is 82 . If the additional cost advantage via R&D costs more
than 168 − 82 = 86, it is not worthwhile creating a costly competitive advantage since the
probability that this advantage will be useful does not offset today’s necessary cash outlay.
252 Chapter 8
NPV at maturity
(in thousands)
3
Low-cost firm (L)

1
High-cost firm (H)
0
2.5 5.0 7.5 10.0
XLM' XLM XHC XHC '
~
End-node value XT
Old cost structure (pre-R&D)
New cost structure (post-R&D)
(a)
NPV at maturity
(in thousands)
3
Low-cost firm (L)

1
High-cost firm (H)
0
0 2.5 5.0 7.5 10.0
XLM' XLM XHC ' XHC
~
End-node value XT
Old cost structure (pre-R&D)
New cost structure (post-R&D)
(b)
Figure 8.1
R&D investment
(a) With low spillover (γ = 0.25); (b) with high spillover (γ = 0.75)
market stage. Firm L, however, is less likely to enjoy monopoly profits

than in the previous example since the rival’s entry trigger is now lower
( X HC ′ drops from 7.4 to 6.6) and will more likely enter. When spillover is
high, the incentive to invest in R&D is greatly reduced and the value is
lower, compared to the previous case with low spillover.6
The analysis above confirms that firm L should refrain from investing
in process innovation if spillover is high and its rival will likely get a
free-ride. This result, however, may get reversed if the innovation ben-
efits are shared with the rival benefiting not for free but with adequate
compensation, such as when firm L decides to license out its new innova-
tion to firm H for a fixed cash payment or for a royalty fee. In this case
the degree of spillover (γ ) in effect becomes a decision variable for firm
L, namely whether to license out (γ = 1) or not (γ = 0). We examine this
interesting application next.
8.2 Innovation and Patent Licensing
Previously we analyzed the impact of spillover effects on the investment

decision made by two firms in a Cournot duopoly owning a shared invest-
ment option. Here we examine a strategic situation where whether there
will be a “spillover” effect (sharing the benefits of the innovation) or not
is an endogenous choice variable by the innovating firm through its
outlicensing decision. In this context there is no a priori external pure
spillover effect (γ = 0) unless the firm holding the patented process inno-
vation or cost-reducing technology decides to license out its technology
to the rival (in which case γ = 1) in exchange for some upfront payment
or royalty fee. Option games analysis can extend previous game-
theoretic literature on patent licensing and provide new insights about
optimal decisions under uncertainty. In this section we review related
literature on patent licensing and the trade-off between fixed fee and
royalty fee in a Cournot duopoly setting, extending the analysis to incor-
porate uncertain demand along the product development phase.
8.2.1 Patent Licensing: Deterministic Case
Patents and Licensing

Patents are meant to balance incentives for firms to innovate while
ensuring dissemination of benefits for consumers. Patents presumably
6. We assume the same parameter values as in example 8.1. Under this post-R&D cost
structure with high spillover (shared) benefits the value of the option for the low-cost
firm is 134 . Here the threshold at which the R&D investment destroys value is lower
(134 − 82 = 52) compared to the low-spillover case.
254 Chapter 8
encourage innovation by providing firms with temporary monopoly

rights enforceable by law.7 Licensing is a means by which a patent-
holding firm can derive benefits from its intellectual property (IP) rights.8
Arrow (1962) analyzed cost-reducing innovations and the impact of
drastic versus nondrastic innovation on competitive market equilibria.
According to Arrow, a drastic innovation is one for which the post-
innovation price of a monopolist is below the pre-invention competitive
price. If the cost of producing under the old technology is constant and
equal to c, the post-invention monopoly price must be less than c (the
price set in perfect competition) for an innovation to be “drastic.” Licens-
ing payments generally take one of the following three forms: (1) a fixed
fee the licensee pays to the licensor, (2) a royalty rate as a function of
the revenues or volumes the licensee produces, or (3) a mix of the above,
namely an upfront fixed fee plus regular royalty payments. Only the first
two forms are discussed here.
In patent licensing, the game-theoretic interaction between the patent-
holding firm and would-be licensee(s) is typically as follows. At first, the
patent-holding firm proposes a deal, choosing the type of licensing con-
tract (fixed fee vs. royalty rate) and the terms of the contractual relation-
ship (e.g., amount of the fee). Would-be licensees may either accept or
refuse the proposal made by the patent holder. If they accept it, they can
use the new (cost-reducing) technology conditional on the payment of
the fees to the patent-holding firm. In the last stage simultaneous com-
petition occurs between producing firms (potentially including the patent
holding firm). They may compete either in quantity or in price. The game
is played once and all relevant information is common knowledge to all
the players. The licensor works out its licensing proposal as part of a
subgame perfect Nash equilibrium, with the optimal decisions deter-
mined by backward induction.
Below we discuss the case of a homogeneous-good duopoly where one
of the rivals acquires a cost-reducing process innovation that it may
license to a single would-be licensee.9 Firms i and j have a shared (Euro-
pean) option to launch the new product in the market. Firm i holds a
patent with a technological edge and can decide to license its technology
to its rival for a certain fixed fee or royalty rate. In the last stage the
7. This proprietary right is granted if the innovator provides public authorities with suffi-
cient information concerning the innovation content so that society and researchers can
benefit and further build on it.
8. For a general overview of the game-theoretic literature on patent licensing, see Kamien
(1992).
9. This model follows Wang (1998) who models Cournot duopoly with symmetric quantity
competition. Here the asymmetric case is considered.
duopolists compete in quantity, setting their output independently and

simultaneously (Cournot quantity competition). The patent-holding firm
is concerned with maximizing its total profit when designing the offer
(setting its fixed fee or royalty rate). For the patent holder the total profit
consists of the profit derived from its own production plus any licensing
revenues.10 The would-be licensee is also profit maximizing and may
reject the offer if it does not make it better off.
Suppose that the two firms face a linear (inverse) demand function as
in equation (3.1), namely p (Q) = a − bQ, with Q = qi + q j. Prior to intro-
ducing the new process innovation (pre-innovation or base case), firms’
unit production cost are ci and c j (old technology) with ci ≤ c j. If the
market is not sufficiently large for both firms to produce, the only active
firm (say firm i) would earn monopoly profits, based on equation (3.4),
equal to:
(a − ci )2
π iM ( ci , c j ) = . (8.4)
4b
If the market is large for both firms to be producing, firm i’s profit equals
the (asymmetric) Cournot equilibrium profit of equation (3.21)
π iC ( ci , c j ) =
(a − 2ci + c j )2 . (8.5)
9b
The equilibrium profits for firm j are analogous. Suppose that firm i
develops a process innovation and obtains a superior technology that
enables it to lower its marginal production cost by (savings) amount
ω (> 0), resulting in a post-invention unit production cost ci’ ≡ ci − ω . Firm
i’s innovation can be drastic (offering it the possibility to pre-empt and
set monopoly prices) or nondrastic (letting room for competition).
Drastic process innovations reduce costs by a sufficient amount such that
the patent-holder can reap monopoly rents for some time. By contrast,
nondrastic innovations are associated with a slight cost advantage over
competitors, not sufficient to drive out rivals. Firm i will license its tech-
nology if doing so makes it better off. Four cases (six subcases) can be
distinguished: (A) innovation is drastic and firm i prefers not to license
out its process innovation; (B) innovation is nondrastic and firm j is given
no access to the technology (no licensing); (C) innovation is drastic
10. The model by Wang (1998) differs from that of Kamien and Tauman (1986) who also
analyze licensing in a Cournot oligopoly in that the patent holder in Wang’s (1998) model
is one of the incumbents competing in the industry for production. Kamien and Tauman’s
(1986) key result relating to the superiority of the fixed-fee licensing over royalty licensing
stems from this differentiating feature.
256 Chapter 8
Table 8.1
Alternative cases for licensing out a patented technology and type of innovation
Innovation
Drastic Nondrastic
Innovator firm i No licensing out Case A Case B

Licensing out Fixed fee Case C1 Case D1
Royalty rate Case C2 Case D2
and firm i chooses to license it; (D) innovation is nondrastic and firm i
licenses it. In addition, when firm i licenses its technology, it may either
select a fixed fee or a royalty payment. These cases are summarized in
table 8.1.
Consider first cases A and B in which licensing out does not occur
(because it is not in the patent holder’s interest to do so). In both cases
firm i produces with its new (lower cost) technology alone, while its
competitor is forced to operate its business using the old technology (if
it produces at all).11 Firm i’s marginal production cost with the new tech-
nology is ci′ ≡ ci − ω, whereas firm j’s cost remains c j.
Drastic Innovation
If innovation is drastic, firm j is driven out of the market; the (monopoly)
price set by the patent holder is lower than (or equal to) the marginal
production cost of its competitor (using the old production technology),
that is, from equation (3.3):
a + ci′
pM = ≤ cj. (8.6)
2
The monopoly price is lower than the marginal cost of the rival (based
on the old technology) when the savings from innovation are greater
than (or equal to) ω ≡ a + ci − 2c j (i.e., if ω ≥ ω ). If firm i decides not to
license out its technology when the innovation is drastic (i.e., ω ≥ ω ),
case A emerges. By contrast, if innovation is nondrastic (i.e., if ω < ω )
and firm i insists not to license, case B arises.
Case A (ω ≥ ω ) If innovation is drastic, firm j can be driven out of the
market while firm i acts as a monopolist earning monopoly profits
π iM ( ci′, c j ). Equilibrium profits for firms i and j, based on equation
(3.6), are
11. Under no licensing, it is assumed that no spillover effects occur (γ = 0 ).
( a − ci + ω )2
π iM ( ci′, c j ) = , j ( ci′, c j ) = 0.
πM (8.7)
4b
Case B (ω < ω ) If the process innovation is nondrastic and the market

is large enough for both firms to produce, both firms maximize their
profits by optimally selecting their output (simultaneously), resulting in
asymmetric Cournot-Nash equilibrium profits:
π iC ( ci′, c j ) =
(a − 2ci + 2ω + c j )2 , π Cj (ci′, c j ) =
(a − 2c j + ci − ω )2 . (8.8)
9b 9b
Alternatively, conditional on the monetary profit the patent holder will

receive from licensing out, it may decide to license out its technology to
its rival. Firm i selects the type of licensing contract (fixed-fee or royalty
payment) and chooses the (optimal) price to be charged for licensing out
the new technology. As the leader, it determines its optimal price by
backward induction. Consider the cases where the patent holder decides
to license out its technology. The innovation can be drastic (case C) or
nondrastic (case D). The patent holder may license out its technology
either for a fixed fee (cases C1 and D1) or for a royalty payment (cases
C2 and D2).
Fixed-Fee Licensing
Consider first the fixed-fee licensing cases (C1 and D1). Suppose that
the patent-holding firm licenses its process innovation for a fixed fee F.
If innovation is nondrastic and licensing out occurs for a fixed fee (case
D1), both firms will produce with the new technology at a marginal
production cost ci′ ≡ ci − ω (respectively, c ′j ≡ c j − ω ). Equilibrium Cournot
profits are
π iC ( ci′, c ′j ) =
(a − 2ci + ω + c j )2 , π Cj ( ci′, c ′j ) =
(a − 2c j + ω + ci )2 . (8.9)
9b 9b
The profit expression π iC (ci′, c ′j ) is taken into account (backward induc-

tion) when the patent-holding firm sets its optimal fixed fee (case D1).
In addition to the profit firm i receives as a Cournot duopolist (if both
firms produce), it will also receive the fixed-fee payment F from outli-
censing. The maximum fee firm j would be willing to pay for the license
is the difference between its profit as a privileged licensee (case D1)
versus a nonlicensee under nondrastic innovation (case B). Firm i there-
fore sets the optimal fixed fee (F*) such that π Cj ( ci′, c ′j ) − F ≥ π Cj ( ci′, c j ).
The maximum fixed fee the patent-holding firm i can charge licensee
258 Chapter 8
firm j is such that the licensee is indifferent between producing with the
new technology (having lower production cost c ′j) versus the old technol-
ogy (operating with cost c j). This yields the maximum licensing fixed fee
the patent holder could charge:
F * = 4ω
(a − 2c j + ci ). (8.10)
9b
Firm i’s total profit is thus made up of last-stage production profits

plus the fixed-fee licensing payment, namely π iC (ci′, c ′j ) + F *. Firm i will
choose to license out its patent if π iC ( ci′, c ′j ) + F * > π iC ( ci′, c j ), with c ′j < ci.
This occurs if the cost reduction obtained by the innovation ω is small
(ω < ω , with ω ≡ 2 ( a + 4ci − 5c j ) 3). Equivalently, firm i will achieve a
higher profit through licensing out its new nondrastic technology when
the amount of cost reduction (ω ) is lower than ω . If the cost reduction
is large (ω ≥ ω ), it will prefer not to license out under the fixed-fee licens-
ing contract.12
If innovation is drastic (case C1 with ω ≥ ω ), the maximum fixed fee is
thus given by
F * = π Cj ( ci′, c ′j ) − π Cj ( ci′, ∞ ) = π Cj ( ci′, c ′j ). (8.11)
Comparing its profit under no licensing (π iM ( c′i )) and its total profit
under fixed-fee licensing (π iC (ci′, c ′j ) + F *) allows firm i’s management to
decide whether it is justified licensing out its technology. Since when the
innovation is drastic (case C1) π iM (ci′) > π iC ( ci′, c j′ ) + F *, the patent holder
would prefer to keep its technology for itself (not licensing it out) and
become a monopolist, driving the rival out of the market.
Royalty Rate Licensing

Consider next the royalty licensing case (cases C2 and D2). Here the
patent holder considers licensing out its technology to a licensee at a set
royalty rate based on the quantity the licensee (firm j) produces using
the new licensed technology.13 The marginal cost of the patent-holding
company (firm i) stays unchanged at the lower level ci′ ≡ ci − ω . Firm j
benefits from the new technology but has to pay a proportional amount
R per unit of output. Its marginal cost is now effectively higher, given
by c ′j + R (with c ′j ≡ c j − ω ) if it licenses the technology, and c j otherwise.
12. The threshold for an innovation to be drastic (ω ) is strictly greater than the threshold
for firm i selecting a fixed-fee licensing contract (ω > ω ).
13. In practice, royalty rates are often set as a percentage of revenues but for simplicity
we adopt the assumption made in the literature of the royalty being a set amount per unit
of quantity produced.
The licensee would not accept to pay a royalty rate higher than the
marginal benefit from producing with the new technology, namely
0 ≤ R ≤ ω. From the perspective of the patent-holding firm i, in addition
to its own production profit it also receives an extra revenue from licens-
ing (of R q j).
Drastic Innovation (Case C2)

When both firms are active in the market, they will each select (simulta-
neously) their quantity to maximize their profits. Firm j’s profit is
given by
π j ( qi , q j ) = [ p (Q) − c ′j − R ] q j .
Firm j considers firm i’s quantity as given when maximizing its own profit
(by selecting q j ), leading to a best-reply (reaction) function analogous to
(3.13) of
1 ⎛ a − c ′j − R ⎞
q j * ( qi ) = ⎜ − qi ⎟ . (8.11)
2⎝ b ⎠
Firm i’s total profit is made up of two components: the profit obtained
in simultaneous (quantity) competition with firm j and the revenue it
receives from royalty fees
π i ( qi , q j , R ) = [ p (Q) − ci′] qi + R q j .
Firm i will select its output qi to maximize its total profit π i ( qi , q j , R ). By
differentiating the profit function with respect to qi, the right-hand term
R q j drops out, so the best-reply function for firm i is
1 a − ci′
qi* ( q j ) = ⎛ − qj ⎞ . (8.12)
2 ⎝ b ⎠
The equilibrium quantities, found at the intersection of the two best-

reply curves, are
a − 2ci + c j + ω + R a − 2c j + ci + ω − 2R
qi* ( R ) = , q j * (R ) = . (8.13)
3b 3b
Equilibrium profits are therefore given by
π i* ( R ) = π iC ( ci′, c ′j + R) + R q j * ( R ), π j * ( R) = π Cj ( ci′, c ′j + R). (8.14)
The optimal royalty rate (R*) that maximizes the licensor’s total profit
(in subgame perfect Nash equilibrium) is obtained from the first-order
condition as
260 Chapter 8
5 ( a + ω ) − ( ci + 4c j )
R* = . (8.15)
10
Nondrastic Innovation (Case D2)

In this case the maximum royalty rate the licensee would be willing to
pay (in deciding whether to accept or reject the offer) is the one at which
firm j is indifferent between being a licensee (having cost c ′j) and con-
tinuing operating with the old technology (at production cost c j). In the
case of nondrastic innovation, the maximum royalty rate is R* = ω , where
c ′j + R* = c j. Equilibrium profits for firms i and j are
π i* (ω ) = π iC ( ci′, c ′j + ω ) + ω q j * (ω ) = π iC ( ci′, c j ) + ω q j * (ω ),
π j* (ω ) = π Cj (ci′, c ′j + ω ) = π iC (ci′, c j ).
Firm j’s cost is the same whether firm i licenses out the technology or
not. As ∂π j * (ci , c j ) ∂ci > 0 and ω > 0, firm j’s post-innovation profit is
lower than its pre-innovation profit.
Once the patent holder has determined the optimal royalty rate to
set, it can decide whether to license out or not. When the innovation
is nondrastic, since the total profit the patent holder receives from licens-
ing under a royalty rate is higher than under no licensing, namely
π iC ( ci′, c j ) + ω q j * (ω ) > π iC ( ci′, c j ), licensing out under a royalty rate fee
makes the patent holder better off. Given the additional benefit
ω q j * (ω ), the patent holder will prefer licensing out its patent when a
royalty licensing method is used and process innovation is nondrastic.
Comparison
In case of drastic innovation (case C2), firm j will not produce.14 The
would-be licensee is indifferent between being a licensee or not produc-
ing at all, in both cases earning zero profit.15 The patent-holding firm thus
ends up earning monopoly profits when the innovation is drastic. More-
over, as the profit earned by the patent holder (firm i) under the optimal
royalty contract, π i* ( R*), equals the monopoly profit π iM under drastic
innovation and no licensing, the patent holder is indifferent between
being monopolist and licensing for a high royalty rate, R*. Thus, under
drastic innovation, licensing out via a royalty rate yields the same
outcome as choosing not to license. Under the royalty-payment licensing
2
14. Since ci ≤ c j , max {q j* (ω*); 0} = max
5 {( }
ci − c j ) ; 0 = 0 .
15. In case ci < c j , firm j will refuse the licensing contract and earn zero profit (as in
case A).
method the patent holder will license its innovation to its rival if the
innovation is nondrastic (case D2) but will keep it for itself and become
a monopolist if the process innovation is drastic (case C2).
How do the fixed fee versus the royalty rate alternatives compare?
Several cases result depending on (1) the nature of the innovation
(drastic vs. nondrastic) and (2) the type of licensing payment (fixed-fee
vs. royalty rate). When innovation is drastic (ω > ω ), the patent holder
will choose to keep the new technology for itself and become a monopo-
list. No licensing contract makes the patent holder better off. For non-
drastic innovation involving small cost savings due to process innovation
(i.e., for ω < ω < ω ), the patent-holding firm earns more by licensing out
using a fixed-fee contract than not licensing, receiving π iC ( ci′, c j′ ) + F *. If a
royalty rate is selected instead, the patentee will earn π iC ( ci′, c j ) + ω q j * (ω ).
The incremental profits under the two licensing methods (royalty vs.
fixed fee) are
ω
[π iC (ci′, c j ) + ω qj * (ω )] − [π iC (ci′, c j′ ) + F *] = 9b [a − c j − 5 (ci − c j )] (> 0).
That is, for nondrastic innovation involving small cost savings
(ω < ω < ω ), the patent holder is better off licensing out its technology
via a royalty rate payment (q j R*) than via a fixed fee (F*).
For somewhat larger cost savings (ω < ω < ω ), the patent holder is
better off not to license than to license under the fixed-fee contract. By
contrast, in this region the patentee is better off licensing under the
royalty rate method than not licensing. In other words, in case of non-
drastic innovation (ω < ω ) the patent-holding firm will prefer to license
out its technology using the royalty rate contract. In this case equilibrium
profits will be π i* (ω ) = π iC ( ci′, c j ) + ω q j * (ω ), and π j * (ω ) = π Cj ( ci′, c ′j + ω ).
In case of drastic innovation, the patent holder will not license out,
ending up as a monopolist.16
8.2.2 Patent Licensing under Uncertainty
The game-theoretic analysis above can be extended to incorporate

product demand uncertainty. Depending on market development, differ-
ent industry structures may occur once uncertainty is considered.
16. These results differ from Kamien and Tauman (1986) who show that licensing by means
of a fixed fee makes a (nonoperating) patent holder better off. The difference lies in the
fact that, in the model above, royalty rate licensing gives an increased cost advantage to
the patent holder through the royalty payment acting as an additional marginal cost for
the licensee. This extra marginal cost advantage does not exist under fixed-fee licensing
and does not affect equilibrium quantities.
262 Chapter 8
However, first-stage innovation investment and second-stage licensing

policy may alter industry structure altogether. Suppose that in each end
state at maturity firms behave optimally, that is, set Cournot-Nash quanti-
ties and select the optimal licensing policy. If the innovation is nondrastic
(i.e., if ω < ω ), the patent-holding firm will license its technology to its
rival and earn a royalty payment (at an optimal rate R* = ω ). If innova-
tion is drastic, the patent holder will drive its competitor out of the
market and earn monopoly profits.
Suppose that the low-cost firm (firm L) is the patent holder (having
a pre-invention cost cL). Its process innovation allows it to reduce its
production cost further by ω , facing a reduced post-invention cost of
cL′ ≡ cL − ω . The patent holder may license its technology to the high-cost
firm (firm H). The necessary investment outlay is identical for both firms
(I ). From equations (7.4) and (7.9) the investment triggers in the stan-
dard Cournot option game for a monopolist and an asymmetric Cournot
duopolist are given by
2 bδ I + cL 3 bδ I + ( 2cH − cL )
X LM = , X HC = .
a a
Compared to the previous option games, here a new threshold needs to

be considered. This is the critical threshold which distinguishes drastic
from nondrastic innovation, namely ω ≡ a + cL − 2cH. This threshold
increases for higher levels of the demand intercept (a). The demand
intercept a used in deterministic cases earlier is now substituted by aX t
in expression (3.1), where X t follows a stochastic process in discrete time.
The demand threshold separating drastic from nondrastic innovation
is determined as follows. Innovation is drastic if ω > ω ( ≡ aX t + cL − 2cH ),
or alternatively if demand is limited such that X t < X , with
ω − cL + 2cH
X≡ . (8.16)
a
Innovation is nondrastic if demand is sufficiently high for both

firms to operate profitably, namely if X t > X . If X LM > X or
( )
ω < ω M ≡ cL − cH + bδ I , the patent holder will not be able to drive its
competitor out of the market. If ω ≥ ω M, there exists a region of demand
( X LM < X t < X) where the patent holder will be a monopolist. For very
low demand ( X t < X LM ), the low-cost firm does not enter the market.
If innovation is nondrastic and the high-cost firm H also enters the
market, firm L will license out its cost-reducing technology to its com-
petitor. The unit production cost for firm H using the new technology
is cH′ + R* = cH. The investment trigger (in case of licensing) for the high-
cost firm is
3 b δ I + ( 2 c H − cL )
X HC = . (8.17)
a
( )
If X < X HC , that is, if ω < ω C ≡ 3 bδ I , the existence of drastic innovation
does not impact the investment decision of the high-cost firm at maturity;
firm H will invest if X t ≥ X HC > X . For ω > ω C and X > X HC , drastic inno-
vation will affect the investment behavior of the high-cost firm. The firm
will invest if X t ≥ X > X HC. Both in the base case and in the licensing case
above the investment trigger of the high-cost firm is unchanged as the
firm earns the same profit.
Four possible cases are distinguished, resulting in different industry
structures. These are summarized in figure 8.2.
Pre-innovation Post-innovation
∞ ∞ ∞ ∞
Duopoly Duopoly
XHC
XHC Monopoly
M
Monopoly
Case A X L Case B X
M
X L
X No investment
No investment
0 0 0 0
∞ ∞ ∞
Duopoly
M
X L
X
Mutually exclusive
Case C conditions for w Case D
X XHC Monopoly
XLM
C
X H
No investment
0 0
Figure 8.2
Possible outcomes for patent licensing game
264 Chapter 8
• Case A If (ω < ω C ) ⇔ ( X < X HC ) and (ω < ω M ) ⇔ ( X < X LM )) (small

cost savings).
• Case B If (ω < ω C ) ⇔ ( X < X HC ) and (ω > ω M ) ⇔ ( X < X LM ) (interme-
diate cost savings).
• Case C If (ω > ω C ) ⇔ ( X > X HC ) and (ω < ω M ) ⇔ ( X < X LM ) (interme-
diate cost savings).
• Case D If (ω > ω C ) ⇔ ( X > X HC ) and (ω > ω M ) ⇔ ( X < X LM ) (large
cost savings).
In cases A and B the first-stage innovation investment only impacts the

optimal investment strategies through small cost savings and the royalty
payments. Firm L’s profit and value as a monopolist in the market is
enhanced through these cost savings, resulting in a lower investment
trigger. In addition firm L also receives the royalty payment paid by
licensee firm H. For firm H the marginal cost savings it gains from using
the new technology (ω ) are offset by the royalty rate fee payment—
chosen optimally by firm L at R* = ω . That is, the patent-holding firm can
set its optimal royalty rate (R*) such as to extract the full cost savings
resulting from its new technology (ω ). Hence its profits under no licens-
ing and under licensing based on the optimal royalty rate are the same.
However, from the licensee’s perspective compared to the pre-innova-
tion case, its profit is lower because its competitor (firm L) has reduced
its marginal cost as a result of the process innovation. Thus firm H’s
investment strategy is impacted adversely since its post-innovation profit
and net present value decline and its investment trigger increases. The
patent-holding firm L is more likely to exercise its investment option as
a monopolist. Case C will never occur since cL < cH . The inequalities
cL − cH + bδ I < bδ I < 3 bδ I hold and preclude case C. Case D is the
one where the impact of innovation is most pronounced. Beyond the
effect on profits and value from the cost savings, the first-stage innova-
tion investment here changes the industry structure dramatically. Com-
pared to the pre-innovation case (where the high-cost firm invests if
X t > X HC ), post-innovation firm H is driven out of the market in the
region X HC < X t < X . Its actual investment trigger is not X HC but rises
to X given by equation (8.16).
8.3 Goodwill/Advertising Strategies
In this section we discuss advertising/goodwill in price competition situ-

ations where the entry decisions by firms depend on both the firm’s
goodwill (endogenous factor) and on market development (exogenous).

Suppose that two firms have an option to launch a new innovative
product generation. One of the two firms (high-demand firm H) has the
possibility to make a first-stage advertising investment to raise customer
awareness by enhancing its brand image. The firm realizes that it can
influence the rival’s second-stage behavior by committing to a strategic
marketing campaign. Suppose that firms compete in prices and sell
horizontally differentiated products (differentiated Bertrand). A differ-
entiation parameter enters both firms’ profit function. It is given by s
(0 ≤ s < 1), representing the substitution effect between the two dif-
ferentiated product offerings. The (inverse) linear demand function for
firm i, i = L, H (with aH > aL), analogous to equation (3.1′) and (7.13), is
given by
pi (Q, X t ) = ai X t − b ( qi + sq j ).
Firm H considers spending a certain amount on advertising and goodwill

building (K i) that can alter customers’ beliefs and the substitution
between the two competing products. The rival, firm L, also has a shared
option to expand and launch at maturity a substitute product competing
with firm H’s innovative product. This scenario will likely occur in high-
demand regions. Unlike its rival, however, firm L has no possibility to
launch a strategic advertising campaign.
Firm H can promote its brand image by stressing (1) its product’s
distinctive features or (2) the fact that firm H’s and firm L’s products are
competing in the same field. Apple® serves to illustrate the first kind
of investment. Over the last decade the California-based company
has developed a strong brand identity that it can leverage in many
segments: having its roots in information technology, the firm has suc-
cessfully diversified into legal music downloading (iTunes®), music
players (iPod®), and mobile telecommunication (iPhone®). Customers
of Apple’s products appreciate the unique image of Apple and prefer
them against would-be competing products. Even if the iPod® is not of
better quality than its MP3 player counterparts, these products are dif-
ferentiated by the brand image of the product and the manufacturer.
Through its strategic advertising and marketing campaigns, Apple has
managed to lower the substitution effect with competing products setting
a substitution effect (s) close to zero. This kind of marketing strategy
also has a beneficial effect for rivals. By differentiating one’s product
from others, these firms are behaving as in a monopoly-like segment
and can set higher prices than in a fierce competitive environment.
266 Chapter 8
If products were perfect substitutes (s → 1), firms would face the risk of
zero economic profit as into the Bertrand paradox.
The advertising warfare PepsiCo and Coca Cola Company waged in
the United States illustrates another kind of advertising investment.
Each firm advertised that its product has a better taste than its competi-
tor’s, creating in customers’ mind the feeling that the products of these
firms are on an equal footing. Launching such kind of marketing cam-
paigns increases the substitution effect between the competing products.
Instead of dividing the market in two differentiated segments, each firm
tried to capture a larger slice of the market by luring customers from the
other side. Competing fiercely over close substitute products, firms end
up earning lower prices. The Bertrand paradox, like the sword of Damo-
cles, stands ready to serve punishment on both firms if they deviate in
setting prices. Investment in such advertising campaigns represents a
tough investment trying to hurt the competitor.
As noted, strategic interactions in the second stage (in case entry is
accommodated) may alter dramatically firm H’s optimal investment
decision in the first stage. Here firms compete over prices (differentiated
Bertrand) with their strategic actions being reciprocating (strategic
complements). Firm L’s entry decision in the second stage may be endo-
genously influenced by firm H’s first-stage strategic commitment.
In addition to such endogenous factors (strategic effects), exogenous
factors (e.g., demand uncertainty) may also alter investment incentives.
Firm L’s investment policy may be affected as well by actual market
developments.
Depending on the first-stage investment by firm H, its rival (firm L)’s
investment triggers will be impacted accordingly. Several implications
result:
• In case of advertising campaign of the first type (soft investment),
investment by firm H eventually benefits the rival, making firm H soft
and less aggressive in second-stage price competition (at the limit setting
prices as if in a monopoly-like segment). The very fact that these firms
are operating on distinct segments of the market gives them less incen-
tive to set a low price in the second period. Firm H can be “soft” and
less aggressive toward its rival in the second stage. The incumbent may
actually increase prices to accommodate entry and soften second-stage
competition. In this situation it might be advisable for the incumbent to
(over-)invest in goodwill building/advertising to accommodate entry in
the second period. Following such soft strategic commitment, firm H will
accommodate entry and raise its price. Its rival firm L (if it enters) will
adjust its price according to its reaction curve (representing its best
response to firm H’s actions). As a best reply to firm H’s price increase,
firm L would increase its price in a reciprocating manner (strategic
complements). This results in a Bertrand–Nash equilibrium where the
second-stage market-clearing price is high. Firm H thus has an incentive
to overinvest in soft advertising commitment, even though this is also
beneficial to its rival (fat cat effect).
• In case of an advertising campaign of the second type (tough commit-
ment), firm H will set a lower price (products are more substitutable);
this entails a price decrease by its competitor, which will be eventually
detrimental to both firms. Firm H therefore has an incentive not to invest
or underinvest, playing the puppy dog ploy. The first-stage advertising
campaign will eventually result in a lower equilibrium price in the second
period as the firms’ reaction curves are upward sloping. This causes a
negative strategic effect involving fiercer competition in the second stage.
The results above apply when both firms invest in the second stage in a
deterministic world. In an uncertain world, the insights concerning the
effects of strategic commitment must be revisited in terms of optimal
investment triggers as they also depend on market development. It is
not always advisable to invest in the market when it is less attractive
than previously expected. It may be that a tough first-stage advertising
investment results in equilibrium in a higher investment trigger for
firm L (hurting it) but decreases firm H’s investment option value. By
contrast, a large investment in first-stage strategic commitment that
makes firm H soft, even though it decreases the competitor’s investment
trigger, may generate a higher option value. To illustrate the effect of
market uncertainty, consider the following situation.
Example 8.3 Investment Triggers and Value in Goodwill/Advertising

The demand function parameter b is 2 3. Firm H has a slight competitive
advantage over its competitor, reflected in firm-specific demand param-
eters aH = 12 and aL = 10. Unit marginal cost for both firms is c = 1. The
risk-adjusted discount rate is k = 0.13 for both firms and there is no
expected growth ( g = 0). The investment cost or option’s exercise price
amounts to I = 100 for both firms. Figure 8.3 summarizes the option
values obtained in the three cases of base case, soft, and tough commit-
ment. Through soft commitment investment, firm H can increase its
investment option value. To determine the net commitment effect, one
268 Chapter 8
Millions
of euros
35
+ 6.8 30.9
30
25 (3.2) 24.1
21.0
20
15
10
0
Tough Total commitment Base case Total commitment Soft
commitment effect effect commitment
Incentive to invest in soft commitment
Figure 8.3
Investment values depending on the type of up-front strategic commitment
has to take into account the necessary outlay for the first-stage strategic
commitment. Consider first the base case.
Case A: Base case (no investment, s = 0.5) Firm H does not invest in
the first-stage and the substitution effect parameter is s = 0.5. The
maturity of the investment option T is 5 years. High-demand firm’s
investment trigger, from equation (7.4), is X HM ≡ 2 Iδ b + c aH = ( )
( )
2 100 × 0.13 × 2 3 + 1 12 ≈ 0.57 and firm L’s, from equation (7.14),
( )
is X LB ≡ ⎡⎣((2 − s) (1 − s)) Iδ b (1 − s 2 ) + c ⎤⎦ aL = 3 13 × 1 2 + 1 10 ≈ 0.86 .
To value the investment opportunity, a binomial tree made up of 20 steps,
each of size h = 0.25, is used. Given an annual risk-free rate (r) of 5
percent, the discount factor used to value 1 received at time t + h as of
time t is e − rh ≈ 0.987. Given a market volatility of σ = 30 percent, the
up multiplicative parameter is u = eσ h ≈ 1.16, d = 1 u = 0.86, and the
(risk neutral) up probability is 0.504.17 The demand process starts at
17. Here, we adjust equation (5.4) to consider that the risk-free rate over a period of length
h is rh rather than the annual risk-free rate r, yielding p = (1 + rh − d ) (u − d ) ≈ 0.504 .
X 0 = 0.40. Given these assumptions and trigger values, we can construct

the binomial tree, determine the industry structure at the end nodes, and
assess the resulting values for each firm. The value of the investment
opportunity for high-demand firm H in the base case is 24.1 m.18
Consider next the case where firm H makes a first-stage commitment

to alter second-stage market conditions for the better. There are two
subcases: (1) The firm promotes unique branding, decreasing the substi-
tution effect between the products (soft commitment), or (2) it harasses
its competitor trying to lure customers away from its rival’s customer
base, eventually leading to an increase in the substitution effect (tough
commitment).
Case B: Soft commitment (low, s = 0.3) Firm H invests in first-stage

advertising emphazing brand uniqueness. Demand parameters aL and aH
are unchanged, but the substitution effect is decreased from 0.5 to 0.3.
The investment trigger of firm H as a monopolist is not affected (it
remains X HM = 0.57). The low-demand firm’s trigger is slightly altered
through the strategic effect of the first-stage investment, being reduced
from X LB ≈ 0.86 to X LB ′ ≈ 0.78. Firm L’s investment trigger is driven by
the profit the firm would make under differentiated Bertrand competi-
tion. Firm H’s upfront strategic investment affects second-stage profits
in competitive equilibrium, altering market conditions and firm L’s
investment trigger altogether. In the soft commitment case, firm H’s
investment option value rises (from 24.1 m in the base case) to 30.9 m.
Through its first-stage strategic commitment, firm H enhances its option
value by nearly 6.8 m, even though its investment has benefited firm L
as well (through larger Bertrand duopoly profit values, lower investment
trigger and consequently higher option value). Firm H thus has an incen-
tive to invest in this kind of advertising campaign. This confirms the fat
cat business strategy to “overinvest” in soft commitment where actions
are strategic complements or reciprocating. If, however, the required
investment cost for the first-stage investment is more than
6.8 m, firm H should not make this investment as the cost exceeds the
expected benefits.
Case C: Tough commitment (high, s = 6.8) Now consider the second
type of advertising investment. Firm H directly attacks its rival, convinc-
ing customers that the products are close substitutes. Such an advertising
campaign represents a tough commitment, aiming at hurting the
18. The low-demand firm’s value is determined likewise.
270 Chapter 8
competitor in the second stage. In doing so, firm H increases the substitu-
tion effect (from 0.5 in the base case) to 0.8. Firm H’s investment trigger
again remains unchanged ( X HM ≈ 0.57), whereas firm L’s rises (from
X LB ≈ 0.86 in the base case) to X LB ′′ ≈ 1.16. The rival’s trigger is driven by
strategic interactions in Cournot duopoly, affected by the first-stage stra-
tegic investment by firm H. In the tough commitment case the option
value for firm H is reduced to 21 m. Regardless of the necessary upfront
commitment investment cost, the tough advertising campaign destroys
more than 3 m compared to the base case.
Figure 8.4 illustrates the profit impact (not the option effect) from
changing the substitution parameter s. A lower substitution effect is
beneficial to both firms. In the extreme case (s = 0), firms earn monopoly
profits. Yet increased substitution effect leads to lower (equilibrium)
profits and hurts both firms. In the opposite extreme case (s → 1), firms
sell perfect substitute products and make a zero profit (Bertrand
paradox), a result analogous to perfect competition.
Millions
of euros
50
40
Firm H
30
Firm L
20
10
0
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
Monopoly Substitution parameter (s) Bertrand
rent paradox
(0 profits)
Figure 8.4
Equilibrium profits in differentiated Bertrand competition
We assume a linear (inverse) demand function of the form pi (Q, X t ) = ai X t − b (qi + sq j ),
with parameters: aH = 12, aL = 10, X 0 = 1, b = 2 3. Unit cost is c = 1.
Conclusion
Strategic interactions in two-stage games influence the incentive

to invest and alter the value of future investment plans in a competitive
context. Both the flexibility value and the strategic effects in the
marketplace should be brought together to address both market
and strategic uncertainty. The resulting expanded NPV should
incorporate three concomitant effects: (1) the flexibility effect,19 (2)
second-stage strategic interactions,20 and (3) the strategic commitment
effect.21
An early strategic investment may have a high or low (even negative)
net commitment value depending on the direct and strategic effects. The
sign of the strategic effect itself may be positive or negative, depending
on whether the benefits are proprietary or shared, and may be opposite
for reciprocating competition (under strategic complements, e.g., price
competition) than for contrarian competition (under strategic substi-
tutes, e.g., quantity competition).
Using option games, we have analyzed under conditions of market
uncertainty various competitive strategies, depending on whether com-
petitive actions are strategic complements or substitutes and whether the
investment makes the firm tough (e.g., proprietary benefits) or soft
(involving shared benefits). Several key results might be advisable to
take into consideration:
19. This encompasses managerial flexibility to revise investment schedules over time,
such as by delaying or staging investment. A strategic investment commitment signals
competitors which kind of competition would emerge in the second stage. Although
this involves sunk cost with a short-term negative effect on the P&L, it may nonethe-
less enhance option value by creating more favorable competitive conditions. From
an options perspective, flexibility value increases with the level of interest rates, time
to maturity, and market demand uncertainty (volatility).
20. In a multiplayer competitive environment strategic interactions can affect the shared
option value by giving rise to different industry structures. For a monopolist option-holding
firm, only two situations are possible: no investment or monopoly. In case of duopolist
option holders with shared options, three industry structures are possible: no one invests,
monopoly, or duopoly.
21. Early commitment may result in both a direct effect (additional cash flows) and a
strategic effect. The strategic effect alters the competitor’s investment trigger favorably
(under optimal business strategies) or detrimentally (if suboptimal strategies are pursued).
The nature of equilibrium second-stage actions (reciprocal or contrarian) may critically
influence the optimal choice of commitment strategy. In some cases an early commitment
may create a competitive disadvantage if it limits the investor’s leeway and reduces its
ability to be aggressive in later stages (under strategic substitutes) or if it induces the inves-
tor into being aggressive in the second stage and the competitor will follow suit (under
strategic complements).
272 Chapter 8
• When strategic actions are contrarian and the benefits of strategic com-
mitment are proprietary, the firm should build up competitive advantage
that makes it tough in later competition stages (e.g., invest in R&D
under quantity competition). This strategy results in a higher investment
trigger for the follower and increases the innovator’s likelihood of being
a monopolist.
• When the innovation benefits are shared between duopolists and
actions are contrarian, the firm should refrain from investing. When
spillover effects are high, investing in R&D creates worse competitive
conditions in the second stage for the investing firm. An alternative may
be to license out the technology.
• When the investing firm benefits exclusively (or primarily) from its
investment commitment and aggressive moves induce aggressive
response by the rival (strategic complements), the firm should avoid
investing to preserve its flexibility and avoid intensified competition.
• When the strategic investment is beneficial to both firms (spillover
effects) and strategic actions are reciprocating, there is an incentive to
invest and commit. Even if the rival also benefits from the investment,
the investing firm is eventually better off.
The optimal competitive strategy thus depends not only on the nature
of the investment commitment but also on the type of competitive reac-
tions (strategic complements vs. substitutes). Option games enable simul-
taneously the determination of the equilibrium market structure under
uncertainty (in a binomial-tree process) along with taking into account
strategic interactions in multistage settings. Management may thus for-
mulate appropriate dynamic competitive strategies that enable it to react
effectively to changes in the market environment and competitive
landscape.
Selected References
Smit and Trigeorgis (2001, 2004) analyze a number of option game appli-
cations in discrete time to illustrate the balanced effects of commitment
versus flexibility. The authors present a number of case applications on
R&D, infrastructure and goodwill-building investments. Wang (1998)
discusses the licensing problem and the type of fee in a deterministic
setting.
Smit, Han T. J., and Lenos Trigeorgis. 2001. Flexibility and commitment
in strategic investment. In Eduardo S. Schwartz and Lenos Trigeorgis,
eds., Real Options and Investment under Uncertainty: Classical Readings
and Recent Contributions. Cambridge: MIT Press, pp. 451–98.
Wang, X. Henry. 1998. Fee versus royalty licensing in a Cournot duopoly
model. Economic Letters 60 (1): 55–62.
III OPTION GAMES: CONTINUOUS-TIME
MODELS
We focused so far on discrete-time analysis of option games. The dis-

crete-time approach is well suited for practical investment applications
and is more accessible to corporate managers since it does not require
knowledge of advanced mathematics. In part III we discuss continuous-
time modeling of option games. Conditions for obtaining analytical solu-
tions can be quite restrictive but continuous-time models that admit
closed-form solutions can be useful to analyzing the main value drivers
and depicting the trade-offs faced by firms. The continuous-time approach
is often preferable for research purposes. We particularly focus here on
models dealing with optimal investment timing.
Even if an investment has a positive NPV if undertaken today, the firm
may be better off to defer the investment and undertake the project in
the future to limit potential undesirable effects of unexpected adverse
market developments. The basic investment principle (i.e., the NPV rule)
is now revised to: “undertake a project when its value exceeds the value
of the deferral option.” Option game models can address the issue of
investment timing in oligopolistic markets. They specifically deal with
whether and when firms should exercise their shared investment options
when strategic interactions among rivals are explicitly considered. A key
benchmark is the seminal paper by McDonald and Siegel (1986) who
study the optimal investment timing and option value of a monopolist
when the underlying project value follows a stochastic process (geomet-
ric Brownian motion). The investment outlays are treated here as a sunk
cost, highlighting the long-term impact of strategic investment. The
investment timing issue is thus of critical importance.
9 Monopoly: Investment and Expansion Options
We argued previously that the firm’s ability to delay investment invali-

dates the common “NPV rule” that asserts firms should “invest when the
value of a project exceeds the cost of investment.”1 This static investment
rule effectively turns a blind eye to the opportunity cost of investing now
when firms can wait for more accurate information. The real options
paradigm explicitly takes into consideration this opportunity cost,
revising the investment rule as follows: “invest when the project value
exceeds the opportunity cost of waiting.” This raises the following imple-
mentation issues: When exactly should a firm invest? When does the
value of a project exceed its opportunity cost? What is the current value
of an investment opportunity, accounting for the embedded flexibility to
defer investment?
Before embarking on a study of these issues in an oligopolistic setting,
it is useful to first dwell on the benchmark model of a monopolist, which
does not involve strategic interactions. In doing so, we also lay down the
foundations of continuous-time real options analysis, demonstrating the
basic methodology to solve investment-timing games. The same method-
ology is amenable (with some adjustment) to situations involving strate-
gic interactions, and thus helps highlight common characteristics of optimal
investment strategies. We here adopt an approach based on determining
investment trigger strategies that is not yet widespread in the real options
literature. This approach provides the same results as more standard
techniques but with greater ease. It is also more intuitive. Alternative
approaches build on complex techniques originating from stochastic cal-
culus and control theory. Our preferred approach levers on basic
1. A refinement of the NPV rule prescribes to select the project with the highest NPV
among mutually exclusive projects. Viewing a project with differing starting dates as mutu-
ally exclusive alternatives, one can attempt to capture timing flexibility and provide insights
about optimal investment timing. The problem of determining the appropriate discount
rate, however, remains unresolved in such a setting. Real options analysis addresses this
issue properly.
278 Chapter 9
principles of microeconomics instead.2 To smooth out the exposition, we

first discuss the corresponding deterministic problem. In sections 9.1 and
9.2, respectively, we analyze two kinds of options faced by a monopolist
firm:
1. The option when to invest (or wait) This option arises when a firm
not currently producing considers the opportunity to enter or develop a
new market (called the “new market” model), such as when to develop
an oil reserve.
2. The option to expand This option emerges when a firm already
active in the market has an option to increase or expand its production
capacity should the market become more attractive than initially expected
(called the “existing market” model), such as lump-sum capacity addition
by an electric utility.
Box 9.1 introduces two practical examples involving such options related
to investment and expansion, namely the development of oil reserves
and the trade-off between scale and flexibility in capacity addition.
9.1 Option to Invest (Defer) by a Monopolist
Consider a government-protected natural monopoly or a firm that has

acquired a patent ensuring it an exclusive access to a new market.
Suppose that there are insurmountable structural entry barriers or the
patent has a very long (effectively infinite) life. This protection enables
the firm to invest whenever it wants, with no fear of rival entry. The
investment problem in this case boils down to deriving the optimal
investment-timing rule for a single agent (the monopolist) considering
that investment can occur anytime, today or in the future. Since the
monopolist faces no potential rivals, it can form its optimal investment
strategy in isolation, disregarding strategic interactions. In effect, the
monopolist has a perpetual American call option to wait for new infor-
mation to come.3 Below we discuss two deferral option cases: the case
of investment with deterministic growth (certainty) and the case of
investment with stochastic growth (uncertainty). The latter serves as the
foundation of continuous-time real options analysis.
2. Our alternative approach has also been used by Dixit, Pindyck, and Sødal (1999) and
Sødal (2006, 2012). The mathematical prerequisites we develop in the appendix to the book
are a cornerstone for option games models applied in later chapters.
3. This problem was investigated by McDonald and Siegel (1986) in their seminal work on
“the value of waiting to invest” and served as a building block for Dixit and Pindyck’s
(1994) analysis of real options.
Monopoly: Investment and Expansion Options 279
Box 9.1
Investment and expansion options in business practice
The Options Approach to Capital Investment

A. K. Dixit and R. S. Pindyck, Harvard Business Review
As companies in a broad range of industries are learning, opportunities to

apply option theory to investments are numerous. Below are a few exam-
ples to illustrate the kinds of insight that the options theory of investment
can provide.
Investment in Oil Reserves

Nowhere is the idea of investments as options better illustrated than in
the context of decisions to acquire and exploit deposits of natural resources.
A company that buys deposits is buying an asset that it can develop imme-
diately or later, depending on market conditions. The asset, then, is an
option—an opportunity to choose the future development timetable of
the deposit. A company can speed up production when the price is high,
and it can slow it down or suspend it altogether when the price is low.
Ignoring the option and valuing the entire reserve at today’s price (or at
future prices following a preset rate of output) can lead to a significant
underestimation of the value of the asset.
The US government regularly auctions off leases for offshore tracts of
land, and oil companies perform valuations as part of their bidding process.
The sums involved are huge—an individual oil company can easily bid
hundreds of millions of dollars. It should be not surprising, then, that unless
a company understands how to value an underdeveloped oil reserve as an
option, it may overpay or it may lose some very valuable tracts to rival
bidders.
Consider what would happen if an oil company manager tried to value
an undeveloped oil reserve using the standard NPV approach. Depending
on the current price of oil, the expected rate of change of the price, and
the cost of developing the reserve, he might construct a scenario for the
timing of development and hence the timing (and size) of the future cash
flows from production. He would then value the reserve by discounting
these numbers and adding them together. Because oil price uncertainty is
not completely diversifiable, the greater the perceived volatility of oil
prices, the higher the discount rate that he would use; the higher the dis-
count rate, the lower the estimated value of the undeveloped reserve.
But that would grossly underestimate the value of the reserve. It com-
pletely ignores the flexibility that the company has regarding when to
develop the reserve—that is, when to exercise the reserve’s option value.
And note that just as options are more valuable when there is more uncer-
tainty about future contingencies, the oil reserve is more valuable when
the price of oil is more volatile. The result would be just the opposite of
what a standard NPV calculation would tell us: In contrast to the standard
280 Chapter 9
Box 9.1
(continued)
calculation, which says that greater uncertainty over oil prices should lead
to less investment in undeveloped oil reserves, option theory tells us it
should lead to more.
By treating an undeveloped oil reserve as an option, we can value it
correctly, and we can also determine when is the best time to invest in the
development of the reserve. Developing the reserve is like exercising a
call option, and the exercise price is the cost of development. The greater
the uncertainty over oil prices, the longer an oil company should hold
undeveloped reserves and keep alive its option to develop them.
Scale versus Flexibility in Utility Planning

The option view of investment can also help companies value flexibility in
their capacity expansion plans. Should a company commit itself to a large
amount of production capacity, or should it retain flexibility by investing
slowly and keeping its options for growth open? Although many busi-
nesses confront the problem, it is particularly important for electric utili-
ties, whose expansion plans must balance the advantages of building
large-scale plants with the advantages of investing slowly and maintaining
flexibility.
Economies of scale can be an important source of cost savings for com-
panies. By building one large plant instead of two or three smaller ones,
companies might be able to reduce their average unit cost while increasing
profitability. Perhaps companies should respond to growth opportunities
by bunching their investments—that is, investing in new capacity only
infrequently but adding large and efficient plants each time. But what
should managers do when demand growth is uncertain, as it often is? If
the company makes an irreversible investment in a large addition to capac-
ity and then demand grows slowly or even shrinks, it will find itself bur-
dened with capital it doesn’t need. When the growth of demand is uncertain,
there is a trade-off between scale economies and the flexibility that is
gained by investing more frequently in small additions to capacity as they
are needed.
Electric utilities typically find that it is much cheaper per unit of capacity
to build large coal-fired power plants than it is to add capacity in small
amounts. But at the same time, utilities face considerable uncertainty
about how fast demand will grow and what the fuel to generate the elec-
tricity will cost. Adding capacity in small amounts gives the utility flexibil-
ity, but it is also more costly. As a result knowing how to value the flexibility
becomes very important. The options approach is well suited to the
purpose.
For example, suppose a utility is choosing between a large coal-fired
plant that will provide enough capacity for demand growth over the next
10 to 15 years or adding small oil-fired generators, each of which provides
Box 9.1
(continued)
for about a year’s worth of demand growth as needed. The utility faces
uncertainty over demand growth and over the relative prices of coal and
oil in the future. Even if a straightforward NPV calculation favors the large
coal-fired plant, that does not mean that it is the more economical alterna-
tive. The reason is that if it were to invest in the coal-fired plant, the utility
would commit itself to a large amount of capacity and to a particular fuel.
In so doing, it would give up its options to grow more slowly (should
demand grow more slowly than expected) or to grow with at least some
of the added capacity fueled by oil (should oil prices, at some future date,
fall relative to coal prices). By valuing the options using option-pricing
techniques, the utility can assess the importance of the flexibility that small
oil-fired generators would provide.
Utilities are finding that the value of flexibility can be large and that
standard NPV methods that ignore flexibility can be extremely misleading.
A number of utilities have begun to use option-pricing techniques for
long-term capacity planning. The New England Electric System (NEES),
for example, has been especially innovative in applying the approach to
investment planning. Among other things, the company has used option-
pricing techniques to show that an investment in the repowering of a
hydroelectric plant should be delayed, even though the conventional NPV
calculation for the project is positive. It has also used the approach to value
contract provisions for the purchase of electric capacity and to determine
when to retire a generating unit.
Source: Reprinted with permission of Harvard Business Review from “The

Options Approach to Capital Investment,” by A. K. Dixit and R. S. Pindyck,
May–June 1995. Copyright © 1995 by the Harvard Business Review
School Publishing Corporation; all rights reserved.
9.1.1 Deterministic Case
We consider first the deterministic case to help give intuition and guid-
ance into how to solve investment-timing problems, paving the way for
development of the case involving uncertainty. The opportunity to defer
investment even in the deterministic case dramatically alters traditional
investment principles (e.g., the NPV rule). Overlooking the basics of
investment timing may lead to suboptimal choices. Suppose that the
monopolist has a perpetual option to invest in a new market by incurring
a necessary investment outlay I . Suppose that the underlying market
(monopoly profit) grows compoundly at a rate g percent per year and
that the current project value V0 is lower than the required investment
282 Chapter 9
cost I , resulting in a negative NPV. In this case the monopolist has an

incentive to defer the investment and wait until the project becomes
sufficiently profitable before investing. In the deterministic case with no
volatility, project value is sure to increase at a rate of g percent each year
(i.e., the actual growth exactly matches the expected one). Suppose that
the discount rate is r ( > g ). The discount factor—that translates future
time-t values in today’s (time t0 = 0) terms—is
B0( t ) = e− rt . (9.1)
The underlying profit starts at π 0 and by time t ( > t0 ) it grows with cer-
tainty to π t = π 0 e gt. The time-0 gross value of the project, obtained as a
discounted perpetual stream of profits, is
∞ π0
V0 = ∫ (π 0 e gt ) e − rt dt = , (9.2)
0 δ
where δ ≡ r − g ( > 0 ) is analogous to a dividend yield or opportunity
cost of waiting. If the project is initiated at a future (nonrandom) time
T and profits are received from that moment on, the value of the project
at time T is
πT
VT = = V0 e gT . (9.3)
δ
Note that both the profit and the project value grow at the rate g . From
equation (9.3), we can express T as a function of the initial value V0 and
the time-T value VT. From (9.1), an alternative expression for the dis-
count factor is4
b
⎛V ⎞
B0 (T ) = B (V0 ; VT ) = ⎜ 0 ⎟ , (9.4)
⎝ VT ⎠
where b ≡ r / g . The discount factor, as expressed in (9.4), can be thought

of as a discount factor over states (V0 and VT).
In the deterministic case the firm’s strategy consists in selecting a pre-
specified investment time T at which to invest. Alternatively, the firm
may select directly a critical threshold value VT and invest when this
value is first reached (at time T ). These two strategy formulations are
equivalent: the investor looks for the optimal timing decision or for the
optimal target level at which to invest. For a given timing strategy
(i.e., to invest at time T ), the time-0 value of the investment option equals
4. By inverting (9.3), we obtain gT = ln (VT V0 ) so that B0 (T ) = exp [ − ln (VT V0 ) b]. The
result follows.
the pre-specified forward value (net of the investment cost) VT − I , dis-

counted back to time 0 using the discount factor in equation (9.1) or
(9.4). Denote by M0 (T ) or M0 (VT ) the time-0 value of the monopolist’s
investment option. It is then given by
M0 (T ) ≡ M0 (VT ) = B0 (T ) × (VT − I ). (9.5)
Pre-specifying a target strategy enables separating the value function

into two separate multiplicative components: the forward NPVT ≡ VT − I
and the discount factor B0 (T ). This version of the optimal-timing problem
is known as Wicksell model in the theory of natural (e.g., forest) resources,
where VT represents the forward (time-T ) value of the forest, g the
growth rate of the trees, I the cost of cutting them and r the opportunity
cost that captures the patience of the landowner. From expression (9.4),
the discount factor B (V0 ; VT ) is a decreasing function of the target thresh-
old VT. As VT − I is clearly increasing in the threshold, the investor faces
a trade-off between obtaining a higher forward net present value,
NPVT ≡ VT − I , and a lower present value due to discounting. The value
function in equation (9.5) is concave in T (or equivalently in VT).
The optimal timing strategy is found based on standard optimization
techniques. The first-order condition (MV (VT ) = 0) leads to the
following sufficient and necessary condition for the optimal (tree-size)
threshold V*:
V*
= Π*, (9.6)
I
where
b r
Π* ≡ = ( ≥ 1) (9.7)
b−1 δ
is the profitability level that indicates whether the project should be
undertaken (e.g., whether the trees should be cut). Note that b ≡ r / g can
be seen as the (constant) elasticity of the discount factor with respect to
the trigger value VT.5 Alternatively, the investment rule in equation (9.6)
can be rewritten to provide guidance into the return on investment that
should be attained at the time of optimal investment. This form of the
investment rule reads
5. From equation (9.4),
∂B B(V0 , VT )
(V0 , VT ) = −b .
∂VT VT
The elasticity expression obtains readily.

284 Chapter 9
π*
= r, (9.8)
I
where π * satisfies V* = π * δ . The optimal investment rule suggests to
invest whenever the profitability index (i.e., the ratio of the project value
over the investment cost) V I exceeds the specified profitability target
Π* given in equation (9.6), or equivalently to invest whenever the return
on investment π* / I exceeds the investor’s opportunity cost of capital r
as per equation (9.8). The first investment rule is analogous to Tobin’s q
theory of investment. The second relates to the Jorgensonian rule of
investment. From b ≡ r g , it obtains that the target profitability measure
Π* strictly exceeds 1 (provided that r > g > 0 or δ > 0). It is 1 only when
the project value remains unchanged over time (as the limit of Π* for
g → 0), prescribing then to invest when the project value equals or
exceeds the investment cost. If there is growth, however, the investment
rule based on equation (9.7) brings out a contrast with the commonly
taught NPV rule advising to invest when project value VT [ = π T δ ]
exceeds the investment cost I . The static NPV rule, suggesting to invest
now if NPV ≥ 0, is strictly correct in the case wherein the asset is not
subject to growth. Even in the absence of uncertainty, when an investor
is faced with an opportunity to delay investment in an asset that grows
( g > 0), she should require project value to strictly exceed the investment
cost (Π* > 1) to account for the opportunity cost to kill her growth
option. As the standard NPV paradigm does not explicitly take into
consideration optimal timing or investment flexibility value, it potentially
leads to suboptimal investment timing and early investment. When an
investor has no timing flexibility (i.e., is required to invest immediately),
the NPV rule will then hold.
9.1.2 Stochastic Case
The basic approach used previously can be extended and adapted to take
account of market uncertainty. The stochastic process X t here describes
a shock affecting firms’ profits. Our approach for the stochastic invest-
ment case is based on our proposed new methodology for valuing the
option to invest, which consists of the following steps:
1. Specify the value of the investment as a function of the target strategy

chosen.
2. Determine the optimal investment strategy (trigger) given the invest-
ment payoff function (derived in the previous step).
3. Reassess the investment payoff given the derived optimal investment

strategy.
Before we do this, we need to define more precisely what is an invest-

ment strategy.
Investment Strategy
An investment strategy is a contingent plan of action that stipulates what
investment action to take for each contingency (i.e., in each possible
future state of the process). In case of a perpetual American investment
option, the investment strategy consists in choosing for each possible
value of the stochastic process X t the action to “invest” or to “wait” (the
action set is discrete). In most cases the strategy can be simplified and
implemented using the following principle: choose ex ante a specified
future target (trigger) value XT to be reached by the stochastic process
X t and invest in the project when this value is first reached.6 The strategy
space is continuous: the option holder may adopt a continuum of differ-
ent strategies (any value for XT ). However, only one investment strategy
is optimal and should be followed by a rational option holder.7
An important metric is the first time, T, the threshold XT is reached
{
T ≡ inf t ≥ 0⏐ X t ≥ XT . }
The first-hitting time T is determined by the chosen investment trigger
and depends on the process value dynamics with (T being a random vari-
able).8 In terms of investment strategy formulation (in the uncertain
6. Equivalently one could think of partitioning the state space. The strategy consists in
waiting for X t located in the region ( −∞, XT ) and investing when X t is found for
the first time in [ XT , ∞ ) . Since investment is irreversible, there is path-dependency for the
industry structure. The current value of the process does not perfectly reflect whether the
firm is operating. X t could be located in ( −∞, XT ), but the firm may be active if XT was
previously exceeded. These alternative definitions of the investment strategy could be
readily extended in case of multiple option holders. For multiple option holders the optimal
investment strategy is part of an industry equilibrium. When a decision maker has to choose
among a number of alternatives, the optimal investment strategy does not always take the
form of a trigger strategy since the optimal investment region may be dichotomous. Días
(2004) and Décamps, Mariotti, and Villeneuve (2006) discuss such situations.
7. The existence and uniqueness of the investment trigger is established in Dixit and
Pindyck (1994, pp. 128–38).
8. In paradigms where the investment decisions are made based on expected profit flows,
investment timing (e.g., capacity expansion) is deterministic. Given the growth of the
market, one can easily determine when the (expected) market size will be sufficiently large
for the firm to invest profitably. By contrast, real options theory considers stochastic invest-
ment timing, whereby the volatility of the underlying investment is explicitly taken into
account. The real options approach makes sense because managers are rarely committed
to an investment time schedule and can frequently revise it, for example, by deferring their
decision if the market is less attractive than initially expected. Since actual profits evolve
stochastically, the investment time cannot be selected ex ante.
286 Chapter 9
case), it is convenient to use XT as the reference point for strategy defini-

tion rather than T .9 In a stochastic framework, the time to invest cannot
be determined ex ante. The use of the random variable T to define the
investment strategy is therefore nontrivial.10
The monopolist will invest when the underlying stochastic (Itô) process
X t first reaches XT , receiving the forward project value VT (as a function
of XT ) and incurring the investment cost outlay I at time T . The option
payoff at time T is the forward NPV (i.e., NPVT ≡ VT − I ). Let M0 ( XT )
be the present (time-0) value of the option to invest by the monopolist
(new market model) who chooses to invest at random time T . For
XT ≥ X 0, the expected present value of the investment opportunity (con-
sidering the deferral option) equals the forward NPV (NPVT) discounted
back at the present time (t = 0), namely

M0 ( XT ) = Eˆ ⎡⎣ NPVT × e− rT ⎤⎦ ,
where Ê [⋅] denotes the expected value under the risk-neutral probability
measure.11 If the investment strategy chosen by the monopolist is to
invest now (at time t0 and state X 0), the value of the investment oppor-
tunity is simply the (static) NPV of the project, NPV0 = V0 − I. Investing
now, however, would kill the opportunity to delay the investment. Imme-
diate investment therefore entails an opportunity cost. Thus investing
now may not be the optimal decision. Since the forward value VT is
determined ex ante and does not depend on the actual path of the
process (being a deterministic function of the chosen trigger level XT )
and the investment outlay I is also deterministic, the forward net present
value, NPVT, is independent of the path of the stochastic process X t and
is solely conditional on the target level XT . Thus, in the monopolist inves-
tor’s value expression above, the expectation relates only to the discount
factor term whose value is driven by the random timing parameter T .
Therefore, for XT ≥ X 0,
9. In the certain case discussed above and in Reinganum’s (1981a, b) and Fudenberg and
Tirole’s (1985) game-theoretic investment timing models, the investment time T defines
the investment strategy. These models are, however, deterministic. The models by Reinga-
num (1981a) and Fudenberg and Tirole (1985) are explained in detail later in chapters 11
and 12 and are amended to allow for stochastic profit flows.
10. More advanced mathematical treatments of this problem generally optimize over the
space of first-hitting (stopping) times (Snell envelope problem). We prefer a more intuitive
definition of the strategy in terms of triggers as in the present case involving a simple parti-
tion of the state space.
11. In part III we generally follow the risk-neutral valuation perspective presented in
chapter 5. This valuation approach applies for complete markets with no arbitrage oppor-
tunities. In the appendix at the end of the book, we also present an alternative exposition
that would apply generally, even if the assumptions of risk-neutral valuation do not hold.
This latter formulation consists in using an exogenous risk-adjusted discount rate k rather
than the risk-free rate r.
M ( XT ) = NPVT × Eˆ ⎡⎣e − rT ⎤⎦ = NPVT × B0 (T ),

where the expected discount factor is
B0 (T ) ≡ Eˆ ⎡⎣e− rT ⎤⎦.

Alternatively, analogous to the certainty case, B0 (T ) can be understood

as an expected discount factor over states X 0 and XT . It can be formu-
lated as B0 (T ) = B0 ( XT ) = B( X 0 ; XT ). If the target value XT selected by
the firm is lower than (or equal to) the current level X 0 (or X 0 is in the
investment region [ XT , ∞ )), the firm would invest immediately and
receive the static net present value of the project, NPV0 = V0 − I. The
time-0 value of the monopolist’s option to invest (defer) when the target
value XT is first reached is thus given by
⎪⎧ NPVT × B0 (T ) if X 0 < XT ,

M 0 ( XT ) = ⎨ (9.9)
⎩⎪ NPV0 if X 0 ≥ XT .
Consider now the case where X t follows a geometric Brownian motion
(GBM) of the form
dX t = ( gX t ) dt + σ X t dzt, (9.10)
where g and σ are the constant drift and volatility parameters and zt
is a standard Brownian motion.12 Under risk-neutral valuation, g gets
replaced by ĝ = r − δ . As shown in equation (A.43) in the appendix at the
end of the book, the expected discount factor in case of geometric
Brownian motion is
β
⎛X ⎞
1
B0 (T ) = ⎜ 0 ⎟ , (9.11)
⎝ XT ⎠
where (in the risk-neutral case) from equation (A2.4)

αˆ ⎛ αˆ ⎞
2
r
β1 = − + ⎜⎝ 2 ⎟⎠ + 2 2 ( > 1) (9.12)
σ2 σ σ
with αˆ = gˆ − (σ 2 2).13 The time-0 value for the monopolist investor that
invests when XT is first reached is thus obtained from equations (9.9)
and (9.11) as
12. More information on the geometric Brownian motion is provided in the appendix,
section A.1.
13. In the appendix at the end of the book, we use two distinct fundamental quadratic
functions, one with an exogenous given discount rate and the other under risk-neutral
valuation, using β1 and β̂1 respectively. In part III we generally employ the risk-neutral
valuation approach. For notational simplicity we denote here (in the main text) the positive
root of the fundamental quadratic in the risk-neutral case by β1 , instead of β̂1 as in the
appendix.
288 Chapter 9
β1
⎧ ⎛ X0 ⎞
⎪ T ⎜ X0 < XT ,
⎝ XT ⎟⎠
NPV (wait) if
M 0 ( XT ) = ⎨ (9.13)
⎪ NPV X0 ≥ XT .
⎩ 0 (invest) if
For an investment target or trigger higher than the starting value ( X 0 < XT),
the value of the strategy equals the forward NPV at future date T dis-
counted back to the present time (time 0) using the expected discount
factor of equation (9.11). The result given in equation (9.13) confirms the
option value for a monopolist obtained by McDonald and Siegel (1986).14
Optimal Investment Strategy

The investment value presented in equation (9.13) of the previous section
has no prescriptive implications from a strategic-management viewpoint.
It does not necessarily provide guidelines whether or when the monopo-
list firm should invest (optimal behavior). It simply helps management
assess the value of an arbitrarily chosen investment strategy, but it does
not prescribe which strategy is the optimal to pursue. In this (monopoly)
case the value-maximizing investment strategy can be deduced from
standard optimization techniques. In this section we determine the
optimal investment strategy and derive the optimal investment trigger
that allows obtaining the “expanded NPV” value for the monopolist
investor, namely the overall value obtained given the optimal investment
timing decision. We start with the general case of an Itô process.
The investor may potentially choose XT among a continuous set (with
infinite possibilities). What matters for the investor is to determine ex
ante the optimal contingent investment rule. Let us denote by X*
the optimal investment target (trigger) and by T* the random time when
X* is first reached. The optimal trigger X* is such that it maximizes
the given investment option value expression; that is, it is such that
M0 ( X*) ≥ M0 ( XT ) for all XT, where M0 ( XT ) is in general given by equa-
tion (9.9) or by (9.13) for GBM. The expression for the expanded net
present value (total investment value taking account of the value of
managerial flexibility) is given by
M0 ( X*) = max M0 ( XT ). (9.14)

XT
14. In McDonald and Siegel’s (1986) model, the stochastic process X t corresponds to the
project value, so that NPVT = XT − I . We have not yet determined the optimal strategy to
be followed by the monopolist, namely when exactly the monopolist should invest. This
will be discussed next. The “expanded NPV” is the value of the investment option when
the monopolist invests at the optimal time. Compared to formula (9.13), McDonald and
Siegel (1986) embed the optimal timing behavior in their value function. They also consider
a case where both the underlying project value and the investment cost follow correlated
geometric Brownian motions.
In the case of geometric Brownian motion, an analytical solution to the

expression above exists if the dividend yield δ is (strictly) positive. It is
of the form
β1
⎧ ⎛ X0 ⎞
⎪ NPVT* ⎜ ⎟ (wait) if X 0 < X *,
M0 ( X *) = ⎨ ⎝ X *⎠ (9.13′)
⎪ NPV X 0 ≥ X *.
⎩ 0 (invest) if
If this condition does not hold (δ ≤ 0), the optimal solution for the per-
petual American investment option is to delay investment indefinitely
(i.e., never exercise the option). Over time there is no opportunity cost
or value loss due to missed “dividend payments” while the present value
of the investment cost I declines by delaying. The parameter δ may rep-
resent some form of a payout rate or opportunity cost (below-equilib-
rium return).15
As in the certainty case the monopolist’s optimization problem here
also presents the option-holding investor with a trade-off. First, to avoid
adverse developments, the monopolist may delay deciding to invest
when a higher forward net present value (NPVT ≡ VT − I ) is achieved,
namely by selecting a higher value for the target (trigger) XT .16 Then
again, a higher target leads to investment postponement further out in
the future so that the present value of the investment reward is eroded
due to a lower discount factor. This trade-off confirms that the value
function is concave such that there exists an optimal value for the invest-
ment trigger. This situation is illustrated in figure 9.1.
The trade-off above is analogous to the situation we discussed in
chapter 3 concerning the price-setting dilemma faced by a monopolist
when demand or the market-clearing price is downward sloping, namely
when the price decreases with industry output (∂p ∂q < 0). We saw then
that if the monopolist sets a higher price p, it can earn a higher profit
margin ( p − c) on each unit sold but the reachable market (volume of
sales or number of units sold) will be lower (∂q ∂p < 0). A higher price
set for the product, although intended to achieve a higher profit margin,
may actually backfire because it may deter potential customers from
purchasing it. Although there are exceptions (e.g., when demand increases
with price as in the case of luxury products), in most situations
15. Merton (1973) shows that the dividend yield δ must be (strictly) positive for a finitely
lived American option to be exercised before maturity. Here we deal with perpetual
American options, but the result is equivalent for a pre-specified constant exercise price.
16. Dixit, Pindyck, and Sødal (1999) explain this trade-off in terms of an option premium.
The premium mirrors the difference between the value of the project at the time of invest-
ment and the exercise price of the option ( I ). The option premium is analogous to the
forward net present value defined earlier.
290 Chapter 9
Discount factor
~
B0(T ) Forward NPV
1.2 6
1.0
Forward NPV
0.8 NPVT ≡ VT − I 4
Discount factor
0.6 ~
B0(T )
0.4 2
0.2
0.0 0
1 2 3 4 5 6 7
(0.2) Investment trigger XT
(0.4) –2
Figure 9.1
Trade-off between higher profitability and lower discount factor for optimal investment
strategy
X t follows a geometric Brownian motion driving the project value dynamics. The discount
rate is r = 7 percent. The drift or growth parameter is ĝ = 6 percent. Volatility is σ = 20
percent. The starting value for the process is X 0 = 1. The investment outlay is I = 2.
monopolists face this classic trade-off in setting prices. To capture a larger

market, a monopolist may lure more customers into buying by setting
lower prices; the resulting revenues may be higher as the quantity sold in
the marketplace is higher, even though the profit margin per unit is lower.
This trade-off is governed by the rate at which demand declines as price
is raised, namely by the price elasticity of demand. A similar approach is
used here to deduce the optimal investment trigger chosen by the monop-
olist option holder. The optimal threshold X* is the target level XT that
maximizes the monopolist’s value M ( XT ). The first-order condition gives
BX ( X*) × V* + B0( X*) × VX ( X*) = BX ( X*) × I,
where BX = ∂B ∂XT , VX = ∂V ∂XT , and V* ≡ V ( X *) is the optimal project

value. The left-hand term is the discounted extra or marginal total reduc-
tion in gross project value V from raising the investment trigger XT by
a small (infinitesimal) amount dXT . The right-hand term is the dis-
counted marginal investment cost savings from delaying investment. At
the optimum level, X*, they become equal. The expression above thereby
leads to the following markup condition in equilibrium:
V* − I ε ( X*)
Λ≡ =− V , (9.15)
V* ε B ( X*)
where ε B(⋅) and ε V (⋅) denote, respectively, the elasticity of the discount
factor and the elasticity of the forward net present value, given by
XT
ε B ( XT ) ≡ − BX ( XT ) × ,
B0 ( XT )
(9.16)
XT
ε V ( XT ) ≡ −VX ( XT ) × .
VT ( XT )
The optimal investment trigger X* and the corresponding optimal dis-
count factor B0 (T*) are found at the point where the markup is given
as in equation (9.15). At the time of optimal investment, the project
return Λ ≡ (V* − I ) / V* must be equal or exceed the specified level given
in the right-hand side of equation (9.15). This term is affected by the
rate at which the discount factor decreases for a higher target value
(via ε B ( XT )) and the rate at which the forward value VT is increased by
the choice of a higher target XT (via εV ( XT )).
In case the underlying process is the gross project value (i.e., the sto-
chastic factor is Vt) and the investment trigger is a given target project
value VT, the elasticity of the forward NPV is constant and equal to
εV (VT ) = −1. In this case the optimal markup rule of equation (9.15)
reduces to
V* − I 1
Λ≡ = . (9.17)
V* ε B (V*)
This confirms a main result given in Dixit, Pindyck, and Sødal (1999). In
their model the optimal investment trigger is solely governed by the rate
at which the discount factor declines as the target project value VT is
increased. In our more general setting the elasticity of the forward (ter-
minal) value with respect to the selected investment trigger also inter-
cedes. It suggests that the optimal investment rule is governed as well by
the rate at which the forward value increases when the target investment
trigger XT is raised. In the setting of Dixit, Pindyck, and Sødal (1999), it
is easy to see the analogy with the optimal price-setting problem of a
monopolist. As noted, that pricing problem is solved based on the Lerner
index
p* − c 1
L≡ = ,
p* εp
292 Chapter 9
where p* is the equilibrium market-clearing price, c the constant

marginal cost of production, and ε p the price elasticity of demand
(ε p ≡ − ∂p ∂q × q p).
In our general setting, due to the Markov property of the underlying
stochastic (diffusion) process, the elasticity of the discount factor is
independent of the starting value X 0.17 The elasticity of the discount
factor is strictly positive (as BX (⋅) < 0). However, it may not always be
constant. The elasticity of the forward value is negative and is also
independent of the starting value.18 From the sign of these elasticities,
the markup Λ in equation (9.15) is strictly positive. Consequently
the value received from pursuing the optimal strategy V* strictly
exceeds the cost required to undertake the project, requiring that
the project’s NPV at the time of optimal investment be strictly posi-
tive. This confirms once again that the static NPV rule, advising to
invest when the project’s gross present value equals the investment
cost, is not strictly correct. A certain positive premium must be
attained before the investment is undertaken (in optimum). This
premium results from considering both the flexibility in delaying the
investment and the underlying uncertainty. Rewriting equation (9.15)
and setting19
ε B ( XT )
Π ( XT ) ≡ , (9.18)
ε B ( XT ) + ε V ( XT )
the premium (cushion) can be determined based on
V*
= Π*, (9.19)
I
where Π* ≡ Π ( X*) is obtained from equation (9.18) with XT = X*. From
equations (9.19) and (9.9), the ‘expanded NPV’ given the optimal invest-
ment strategy is
M0 ( X*) = [ Π* −1] IB0 (T*). (9.20)
The metric Π* is the equilibrium gross profitability index and Π* − 1 is

the excess profitability index. The gross profitability index is sometimes
interpreted as Tobin’s q or as the market-to-book ratio attained at the
17. See also Dixit, Pindyck, and Sødal (1999).
18. Since XT and VT are either both negative or positive and VX (⋅) > 0, the elasticity of
the forward value is strictly negative, that is, ε V ∈[ −1, 0 ).
19. Since I > 0 , Λ ≠ 1 and ε V ( X*) ≠ ε B( X*). The finiteness of Π ( XT ) at the optimal thresh-
old X* is thus ensured.
time of optimal investment.20 Dixit and Pindyck (1994) propose to inter-

pret Π* = V* I as Tobin’s q, the ratio between the real value of an asset
to the cost needed to produce it. Since the elasticities may not be con-
stant, the profitability index Π ( XT ) may vary with the target investment
trigger XT . Although the profitability index may change, what matters is
its value Π* at the optimal investment trigger X*. The geometric Brown-
ian motion has the convenient feature of admitting constant elasticities
and profitability index. The elasticity of the monopolist’s deferral option
equals the elasticity of the discount factor at equilibrium for time-
homogeneous Itô processes.21
Example 9.1 Geometric Brownian Motion

Suppose that project value Vt follows a geometric Brownian motion
similar to (9.10) with constant drift g (under risk neutrality ĝ = r − δ ) and
volatility σ . Since the project value is itself the underlying stochastic
factor, εV = −1. The expected discount factor is given analogous to equa-
tion (9.11) as
β1
⎛V ⎞
B0 (VT ) = ⎜ 0 ⎟ ,
⎝ VT ⎠
where β1 is given in equation (9.12). The first-order derivative of the

discount factor with respect to the investment trigger XT is
B0(VT )
BV (VT ) = −β1 .
VT
Hence the elasticity of the discount factor is constant and equal to
ε B = β1 ( > 1). (9.21)
The parameter β1 refers, interchangeably, to the elasticity of the discount

factor, B0 (T ), or the elasticity of the investment option. The option
markup formula in equation (9.15) becomes Λ = 1 β1. The profitability
index Π* of equation (9.18) is constant:
20. Dixit and Pindyck (1994) investigate this profitability index in the case of geometric
Brownian motion. Here the underlying project is generally assumed to follow an Itô process.
In traditional accounting, the balance sheet is used to record assets as the sum of the costs
incurred to procure them. The market value, on the contrary, reflects the real value of the
asset, namely the current value of the benefits the asset provides. The market-to-book ratio
determines the excess return of the project over the necessary investment outlay.
21. From optimal-stopping theory the investment trigger is determined by two “boundary
conditions”: the value-matching condition, M( X*) = V* − I ; and the smooth-pasting condi-
tion, M X ( X*) = VX ( X*). Both must hold at the point of optimal investment. The elasticity
of the option is ε M ( XT ) ≡ − M X ( XT ) × XT M( XT ). From the markup formula in (9.15),
equation (9.16), and the two conditions above, one obtains ε B( X*) = ε M ( X*). Section A.4
in the appendix summarizes briefly the relevant optimal-stopping theory.
294 Chapter 9
β1
Π* ≡ . (9.22)
β1 − 1
The expression above is similar to equation (9.7) in the certainty case
discussed earlier. The difference lies in the fact that under deterministic
growth, b is a function of r and g solely, whereas here β1 is the solution
of a quadratic equation involving r, ĝ , and the additional volatility
term σ capturing uncertainty about market developments. This version
of the profitability index given in (9.22) has been used extensively
by, for example, McDonald and Siegel (1986) and Dixit and Pindyck
(1994).22 Their demonstration is based on the standard contingent-claims
analysis approach (see appendix to this chapter).23 The optimal invest-
ment rule extended in case of uncertainty for the geometric Brownian
motion is
V* β1
V* = Π* I ⇔ = Π* ≡ . (9.23)
I β1 − 1
The investment rule derived in the deterministic case is a special
case of this investment rule under uncertainty.24 If σ = 0, β1 = b = r g .25
Utilizing the standard rule (under certainty) for investment problems
involving uncertainty, however, would lead to a suboptimal result where
the chosen investment trigger is lower than the optimal, leading to
22. McKean (1965) first derived this closed-form formula for perpetual American call
options. Karlin and Taylor (1975, pp. 364–65) and McDonald and Siegel (1986) developed
close models. McKean and later Karlin and Taylor use an expression for the fundamental
quadratic involving an exogenously given discount rate, while McDonald and Siegel adopt
the risk-neutral pricing approach. See the appendix of the book, box A.2, for more details
on the two quadratic equations.
23. The standard contingent-claims analysis or dynamic programming approaches (pre-
sented in Dixit and Pindyck 1994) consist in solving partial differential equations under
appropriately specified boundary conditions. Given these conditions, it may be possible (if
a solution exists) to derive a closed-form solution (e.g., in case of GBM). This methodology
requires the use of involved mathematics (stochastic calculus and optimal control), which
may be quite unintuitive for the nonseasoned reader. Our preferred approach is simpler
and more intuitive, relying on an analogy with basic markup trade-off problems common
in other fields of economics. Stochastic calculus is not absent from our proposed approach
either. The calculation of terminal values and expected discount factors relies on such
calculus. The techniques involved in these derivations are discussed in the appendix at the
end of the book, rather than directly in each real option valuation. Our simplified deriva-
tion of optimal investment rules is done by using the expected discount factor in case of
GBM.
24. In the deterministic growth case, the optimal trigger is given by (9.6) as V * = Π * I, with
the profitability index in (9.7) given by Π* = r δ . This result is analogous to the one derived
under uncertainty in (9.23), except that here Π* = β1 ( β1 − 1) .
25. As σ = 0, the fundamental quadratic simplifies to r − gβ (see box A.2 in the appendix
at the end of the book), which admits only one root, b = r g.
premature investment.26 From equations (9.13) and (9.23) the monopo-

list’s investment option value under uncertainty is27
β1
⎧ ⎛ V0 ⎞
⎪(Π* − 1) I ⎜ ⎟ (wait) if V0 < V*,
M0 (V*) = ⎨ ⎝ V* ⎠ (9.24)
⎪V − I if V0 ≥ V* .
⎩ 0 (invest)
Modified Jorgensonian Rule of Investment

In the case the uncertain profit π t follows a geometric Brownian motion,
the project value follows the diffusion process Vt ≡ π t δ , where Vt and
π t are characterized by the same stochastic differential equation
(but have different starting values). Let π* be the profit earned at
optimal investment. Equation (9.23) can be reformulated as a modified
version of the Jorgensionan rule prescribing to invest when π t is such
that
π t π * 1
> = Π* δ = r + β1σ 2 ( > r ). (9.25)
I I 2
The modified Jorgensonian rule of investment suggests to invest when

the project’s return on investment exceeds a certain hurdle compensa-
tion for both the interest rate (r) and the incentive (option) to
delay investment in an uncertain world (β1σ 2 2). This modified rule
under uncertainty is more stringent in terms of profitability (hurdle)
26. Suppose, by contraposition, that θ ≡ r (r − g ) − Π* ≤ 0 , with Π* as in (9.23). Since β1 > 1
and δ > 0, this implies that Θ ≡ δ (β1 − 1) θ ≤ 0. Since gˆ = αˆ + (σ 2 2) , Θ = r − β1αˆ − (β1σ 2 2) .
With β1 being a root of r − αβ ˆ − (σ 2 β 2 2) (fundamental quadratic), it obtains that
Θ = β1 ( β1 − 1) σ 2 2 > 0 , which contradicts the assumption. The markup is thus larger in the
uncertainty case. Moreover, as ∂Θ ∂σ > 0 , the higher the volatility, the higher is the dis-
crepancy between the optimal investment trigger and the trigger obtained when ignoring
the volatility.
27. The exit option (full closure) can be priced analogously. Suppose that a salvage
value S is received upon exiting. The net present value received at that time is S − VT ,
where VT is forgone project value. The expected discount factor in case of exit (low barrier)
involves the negative root of the (risk-neutral) fundamental quadratic,
2
αˆ ⎛ αˆ ⎞ r 1
β2 = − − ⎜ 2⎟ +2 2 , with αˆ = gˆ − σ 2 .
σ 2 ⎝σ ⎠ σ 2
The optimal lower barrier is V*, such that V* S = Π*, with Π * = β 2 ( β 2 − 1). The exit option
value is then worth
β2
⎧ ⎛ V0 ⎞
⎪(S − V*) ⎜ ⎟ (wait) if V0 > V*,
M0(V*) = ⎨ ⎝ V* ⎠
⎪
⎩S − V0 (divest) if V0 ≤ V* .
296 Chapter 9
Value for
monopolist
5
NPV = V0 − I
3
V* − I
2
Expanded NPV
M(V*)
1
0
0 1 2 3 4 5 6 7
I=2 V* = 4.46 Initial value V0
Waiting region Investment region
Figure 9.2
Waiting versus investment regions for a monopolist under uncertainty
Project value V follows a geometric Brownian motion with g = 5 percent and σ = 20
percent. The discount rate is k = 12 percent. Investment cost I = 2.
requirements than the standard version under certainty.28 Under cer-

tainty (σ = 0), the second (volatility) term in equation (9.25) vanishes
and equation (9.25) reduces to the expression given in equation (9.8) for
the certainty case. In a world of uncertainty, projects that do not meet
the requirement using the standard Jorgensonian rule of investment
(under certainty) a fortiori do not fulfill the requirements under uncer-
tainty either since uncertainty imposes an extra hurdle (the second term).
This property may be used by managers to readily identify (some) proj-
ects to be deferred, waiting longer if the standard Jorgensonian rule is
not fulfilled.
Figure 9.2 illustrates the value (waiting vs. investment) regions for the
monopolist’s investment option. For V0 > V* = 4.46, it is optimal to invest
28. Building upon such optimal investment rules, McDonald (2000) examines whether the
use of arbitrarily chosen hurdle rates and profitability indexes by management can roughly
proxy for optimal investment decision making. He finds that (under mild conditions) such
hurdle rate and profitability index recommendations can provide close-to-optimal invest-
ment rules.
immediately. At this point the value of the opportunity to invest (E-NPV)

just equals the value of the committed investment (NPV = V* − I ), which
is strictly positive in this region. For V0 ≤ V*, there is an incentive to
defer investment as investing immediately would kill the option to wait.
At V*, the option holder is indifferent between keeping the option open
or investing immediately (at this point the slopes of the two value func-
tions are equalized).29 The NPV line (=V0−I) is tangent to the option
value (E-NPV) function at X*.
Since for any value of the elasticity of the waiting option (for σ ≠ 0),
the profitability index (Π*) in equation (9.22) is strictly greater than one,
from equation (9.23) the value of the project V* should exceed the
necessary investment cost I by a certain positive premium. A number of
variables affect the size of this premium through their impact on the
profitability index:
• As ∂Π* ∂σ > 0, the greater the underlying uncertainty (σ ) the higher
the markup Π* between the optimal investment trigger and the invest-
ment cost. Monopolists require a larger excess return before irreversibly
investing when the market is riskier. If the project is extremely risky
(σ very high), the monopolist will defer the investment indefinitely and
never invest (with Π* becoming extremely large).
• As ∂Π* ∂δ < 0, the higher the dividend yield or opportunity cost of
waiting, δ , the lower the investment trigger. The monopolist ends up
investing earlier when δ is high.
•As ∂Π* ∂r > 0, when the risk-free rate is higher, the monopolist will
defer the investment longer.
Example 9.2 Arithmetic Brownian Motion

Suppose that project value vt is the underlying factor that follows an
arithmetic Brownian motion of the form
dvt = α dt + σ dzt. (9.26)
The elasticity of terminal value is ε V = −1. As obtained in equation (A.41)

in the appendix, the expected discount factor is
exp ( β1v0 )
B0(T ) = , (9.27)
exp ( β1vT )
29. This property stems from the value-matching and smooth-pasting conditions, asserting
that both the value function and its first-order derivative are continuous at the optimal
trigger threshold X*.
298 Chapter 9
where β1 is given in (9.12).30 In this case, the elasticity of the discount

factor is not constant. The first-order derivative of the discount factor
with respect to the investment trigger is Bv (vT ) = −β1 B (v0 ; vT ). Hence
from equation (9.16), ε B ( vT ) = −β1vT . The markup for the option to invest
in equation (9.15) is Λ ≡ (v* − I ) v* = 1 β1v*. The profitability index (at
equilibrium) in equation (9.18) becomes
β1v*
Π* = Π ( v *) = .
β1v* −1
Since the profitability index is not constant, the derivation of an analyti-
cal solution is cumbersome in this case.
The preceding examples serve to confirm the extent to which the geo-
metric Brownian motion is convenient for the derivation of closed-form
solutions. Since (as explained in the appendix in the last chapter) this
stochastic process is reasonably descriptive of many economic phenom-
ena, it is widely used in economic and financial analysis.
9.2 Option to Expand Capacity
In the previous section we discussed how to analyze the deferral option

or timing option to invest by a monopolist. Now we look at a slightly
modified investment problem relating to the option to expand. Here we
principally interpret this model in the context of adding capacity, though
it may also apply in other contexts, for instance, in the adoption of new
technology, expansion to a new country, or refurbishment of existing
assets to improve efficiency. Although this model can accommodate
many applications, for expositional simplicity we here follow one inter-
pretation, that of capacity expansion.
Suppose that the monopolist is already active in the market and holds
a certain amount of production capacity. If the market becomes more
profitable than expected, the monopolist may invest in added capacity
to take advantage of the demand upsurge. The monopolist thus has
an option to expand its production capacity. If the monopolist exercises
30. As noted, dynamic programming is considered the “general” approach as long as one
can identify the correct discount rate (which may not be an exogenous constant, as Dixit
and Pindyck 1994 assume). It applies to both incomplete markets (where there is a range
of solutions) and complete markets (where risk-free arbitrage ensures a single unique
solution, the risk-neutral version). The fundamental quadratic comes from a different
ordinary differential equation (ODE) for ABM than for GBM. In the dynamic program-
ming version of the ABM, the drift is α , whereas in the contingent-claims analysis version,
it is replaced by α̂ vt with α̂ = r − δ .
its real expansion option, its new (higher) profit flow will reflect both
the production capacity owned before the new investment as well as the
newly added capacity. As in the case of the deferral option, the problem
for the monopolist is to decide when exactly to invest in added capacity.
Once again, the monopolist’s strategy under uncertainty consists in
choosing a priori an investment trigger XT and investing at the (random)
time T ≡ inf {t ≥ 0 | X t ≥ XT } when XT is first hit.
Expansion options may be modeled in two ways. The first approach,
referred to as additional capacity models, involves a lumpy capacity
expansion investment (ΔQ) generating a profit flow increase by a given
discrete amount, for example, 20 percent. The second approach involves
incremental (very small) capacity expansion additions (dQ)—these
models are referred to as incremental capacity investment models. Here
the marginal effect on firm profit matters.31
9.2.1 Additional (Lumpy) Capacity Investment
Consider first the case where the firm can increase its capacity and profit
flow by a lumpy (large) amount. Once a project is undertaken, manage-
ment may have the flexibility to alter it in various ways at different times
during its life. Management may find it desirable, for example, to build
additional capacity if it turns out that its product is more enthusiastically
received in the marketplace that initially thought. In this sense the invest-
ment opportunity can be thought of as the initial scale project plus an
(American) call option on the future expansion opportunity. The exer-
cise price of the expansion option is I.
In the additional capacity case two stages are usually distinguished. In
the first stage, the monopolist is already active in the market and earns
a profit flow (π 0) as a function of the (old) production capacity it already
employs. In the second stage, when the monopolist expands its capacity,
it earns a higher profit flow than previously (π 1) due to the added capac-
ity. The additional capacity investment should occur at an optimal
(random) time T . The firm does not immediately expand capacity since
incurring the sunk investment cost may not be justified under the present
31. The second (incremental) approach seems less realistic, but it sometimes allows for
powerful analytical results from a research viewpoint. The incremental capacity investment
approach makes it possible to take the derivative of the profit function with respect to the
capacity stock and obtain analytic formulas. Models of incremental capacity investment
typically require the use of instantaneous control techniques (e.g., supercontact condition),
whereas models involving investment in additional capacity rely on optimal stopping and/
or impulse control methods (e.g., smooth-pasting condition). We look at the additional
capacity case first because it is more intuitive and realistic.
300 Chapter 9
Table 9.1
Firm’s profits in the two stages (regions) surrounding capacity expansion
Industry structure t Stochastic profit Certain profit
Before capacity investment 0 ≤ t ≤ T π 0 π0

After capacity expansion t ≥ T π 1 π1
economic conditions. The notation for the profit flows is summarized in

table 9.1.32
The expected value for the monopolist (as of time t0 = 0) from invest-
ing in additional capacity at random time T equals (for X 0 ≤ XT)

M0 ( XT ) = Eˆ ⎡ ∫ π 0 e− rt dt + ∫ π 1 e− rt dt − I e− rT ⎤.
T ∞
(9.28)
⎢⎣ 0 T ⎥⎦
Using property (A.45) in the appendix at the end of the book, one
obtains for the value of the strategy to invest in additional capacity
when XT is first hit (at time T ):
M0 ( XT ) = V0 [π 0 ] + B0 (T ) [VT [π 1 − π 0 ] − I ]. (9.29)
where Vt [π ] is the forward perpetuity value of receiving profit π from

time t on. As before, the monopolist maximizes its value by selecting the
optimal investment trigger X*. Using standard optimization techniques,
the first-order derivative of the value function is obtained as
M X ( XT ) = BX ( XT ) × [VT [π 1 − π 0 ] − I ] + B0 ( XT ) × VX [π 1 − π 0 ], (9.30)
The first right-hand term, V0 [π 0 ], in the value expression for M ( XT ) in

equation (9.29) above is independent of the trigger and drops out (the
perpetuity value of already-in-place capacity units does not depend on
subsequent investments). Letting ΔVT ≡ VT [π 1 − π 0 ] and ΔV * ≡ ΔVT *, the
first-order condition becomes
ΔV* − I ε ΔV ( X*)
Λ′ ≡ =− , (9.31)
ΔV* ε B ( X*)
where the elasticity of the discount factor (ε B) and of the additional
terminal value (ε ΔV) are
⎧ε X = − B X × XT ,
⎪⎪ B ( T ) X( T )
B0( XT )
⎨
⎪ε ΔV ( XT ) = − ΔVX ( XT ) × XT ,
⎪⎩ ΔV( XT )
32. Note that π 1 ( X t ) > π 0 ( X t ) for all X t , and π 1 > π 0 .
with BX (⋅) = ∂B ∂XT and ΔVX (⋅) = ∂ΔV / ∂XT. Equation (9.31) can be
reformulated as
ΔV*
= Π*, (9.32)
I
where Π* ≡ Π ( X*) and Π ( XT ) ≡ ε B ( XT ) [ε B ( XT ) + ε ΔV ( XT )] as per
equation (9.18). These expressions are analogous to the results obtained
for the investment option in equations (9.15), (9.16), and (9.19), with ΔV
replacing V . This equivalence makes sense since the perpetual option to
invest in additional capacity is analogous to a perpetual American call
option to invest involving the additional profit flows for a firm already
active in the market.
Let us be more specific concerning the uncertainty in the market.
Suppose that the stochastic profit flow consists of two parts:
• A deterministic profit component that mirrors the capacity held by the
firm (present or future). Let us define it generally as π (π 0 before capacity

addition and π 1 afterward). This component results from optimal behav-
ior at each stage by the monopolist. It is a reduced-form expression of
the monopolist’s profit, which depends on demand, costs, and price.33
• A multiplicative stochastic shock, X t , which follows an (time-homoge-
neous) Itô process of the form
dX t = g ( X t ) dt + σ ( X t ) dzt,
where g ( X t ) is the drift, σ ( X t ) is the diffusion and zt is a standard Brown-

ian motion. This shock multiplies the certain profit component π captur-
ing exogenous uncertainty about the market development.
This approach to viewing total uncertain profit as being made up of

two components (including a multiplicative shock) is useful for analyzing
problems of incremental capacity investment. In the following chapters
this decomposition of the stochastic profit flow into two components will
be used extensively.34
This modeling assumption is slightly different from what we used in
the discrete-time part. Previously uncertainty was introduced in the
33. This notion of deterministic reduced-form profits can be readily extended to
competitive settings. Several models to derive the certain profit in oligopolistic markets
have been investigated previously (see chapter 3).
34. In the previous section on the option to invest (defer), we assumed a setting close to
McDonald and Siegel’s (1986) model as summarized by Dixit and Pindyck (1994, p.142)
and Trigeorgis (1996, p. 204), where project value follows a geometric Brownian motion
with no decomposition of uncertain profits into two components.
302 Chapter 9
linear inverse demand function of equation (7.1), p ( X t , Q) = aX t − bQ,

via the demand intercept X t hypothesized to follow a specified stochastic
process. This represented an additive shock affecting firms’ profits. Here
the demand level is deterministic as captured by the reduced-form
certain profits, while profits are affected by a stochastic multiplicative
shock. The multiplicative shock may represent, for example, the exchange
rate between a foreign currency and the domestic currency. Suppose that
investment in added capacity enhances production made in the domestic
country but that products are sold in a foreign country. Foreign currency
must be repatriated to the parent firm at the prevailing currency exchange
rate X t . The profit from the project’s production in domestic currency at
time t is given by π 1 ( X t ) = π 1 × X t if additional capacity investment has
occurred (or π 0 ( X t ) = π 0 × X t otherwise).35 The terminal value (forward
NPV) function is linear, so
π0 (π − π 0 )
X 0 + B0 (T ) ⎡⎢ 1
⎤
M ( XT ) = XT − I ⎥. (9.33)
δ ⎣ δ ⎦
If X t follows the geometric Brownian motion, the elasticity
of the discount factor B0 (T ) is β1. With V0 ≡ π 0 δ , V1 ≡ π 1 δ , and
ΔV ≡ V1 − V0 = (π 1 − π 0 ) δ defined, the elasticity of the terminal value
obtained from equation (9.16) is ε ΔV ( XT ) = −1. From equations (9.32)
and (9.33), the time-0 value of the monopolist firm with the option to
expand production capacity (assuming it behaves optimally) is
β1
⎧ ⎛ X0 ⎞
⎪V0 X 0 + ( ΔV X* − I ) ⎜ if X 0 < X *,
M( X*) = ⎨ ⎝ X* ⎟⎠ (9.34)
⎪
⎩V1 X 0 − I if X 0 ≥ X*.
Here X* is such that

ΔVX*
= Π*, (9.35)
I
with
β1
Π* ≡ . (9.36)
β1 − 1
The above model of a monopolist with the option to invest in additional
capacity investment can also be used for a firm that is not currently
35. The underlying (exchange-rate) stochastic process, X t , is assumed the same for both
stochastic profit flows. There is no reason to believe that the (idiosyncratic) underlying
factor evolves differently before versus after the capacity expansion investment.
active, namely for a firm having the option to invest (defer) treated previ-
ously. If π 0 (⋅) = 0, the present model reduces to the previous one. That is,
the previous model of new investment can be thought of as a special case
of the model of additional capacity investment (where prior investment
is zero).
9.2.2 Incremental Capacity Investment
Consider now a slightly modified situation where a monopolist already

active in the market contemplates investing in incremental capacity,
namely to increase its production capacity by a very small amount. At
the beginning, the monopolist firm already owns production capacity and
earns a stochastic profit flow, π ( X t , Q), which is a function of the capacity
already installed, Q. The firm has an option to invest in incremental
capacity should the project be more profitable than expected. If the
firm exercises this real expansion option, it installs dQ of incremental
capacity at an incremental cost i per unit of new capacity. For an addi-
tional capacity dQ, the firm must incur an additional investment cost
of I ≡ i × dQ. At the (unknown) time T the monopolist invests in
new capacity and receives afterward a stochastic profit flow π Q × dQ
(where π Q ≡ ∂π ( X t , Q) ∂Q), in addition to the profit flow stemming
from the existing production capacity. Let vT (Q) ≡ VT [π Q × dQ].
Again, the monopolist’s investment strategy consists in choosing
upfront an investment trigger XT and investing at the (random) time
{ }
T ≡ inf t ≥ 0⏐ X t ≥ XT when XT is first reached.
The time-0 value of the monopolist firm consists of the perpetuity
profit flow resulting from the existing (old) production capacity plus the
value of the option to expand capacity:
M0 ( XT , Q) = Eˆ ⎡ ∫ π ( X t , Q) e− rt dt + (vT (Q) − I ) e− rT ⎤
∞
(9.37)
⎣ 0 ⎦
= V0 ⎡⎣π ( X t , Q)⎤⎦ + Eˆ ⎡⎣{vT (Q) − I } e− rT ⎤⎦ .

Since the incremental net present value from the project, vT (Q) − I , does
not depend on the actual path of the stochastic process,
M0 ( XT , Q) = V0 ⎡⎣π ( X t , Q)⎤⎦ + (vT (Q) − I ) B0 (T ) .
The optimal investment trigger X* is such that
M0 ( X *, Q) ≥ M0 ( XT , Q) ∀XT .
The first-order condition,
BX ( X*) × vT (Q) + B0 ( X*) × vX (Q) = BX ( X*) × I ,

304 Chapter 9
results in the option markup formula
v* (Q) − I ε ( X*)
=− v , (9.38)
v* (Q) ε B ( X*)
where
⎧ε X = − B X × XT ,
⎪⎪ B( T ) X( T )
B0( XT )
⎨
⎪ε v ( XT ) = −vX (Q) × XT .
⎪⎩ vT (Q)
Alternatively, the optimal investment rule is
v *(Q) = Π* I , (9.38′)
where, analogous to (9.18),
ε B ( X*)
Π* = .
ε B ( X*) + ε v ( X*)
Suppose again that stochastic project profit flow consists of two parts:
• A deterministic profit flow component corresponding to the capacity
held by the firm (present Q or future Q + dQ), namely π (Q). This value
results from market-clearing mechanisms. If the firm invests in incre-
mental capacity, the extra profit flow for the monopolist is given by
π Q × dQ, where π Q ≡ ∂π (Q) ∂Q.36
• A multiplicative shock, X t , that follows geometric Brownian motion.
The (stochastic) profit resulting from the project at time t is thus given
by
π ( X t , Q) = π (Q) X t ,
while the marginal profit flow resulting from an incremental investment
in capacity is
∂π
∂Q
( X t , Q) dQ = (π Q × dQ) X t.
Consider next the terminal value (forward NPV) and its elasticity. Given
the above, the terminal value is
36. The deterministic profit function as a function of capacity is standard in industrial
organization. For the sake of simplicity, we oftentimes equate capacities with quantities
(assuming constant returns-to-scale production technologies). Given these parameters, the
monopolist can optimally determine the production capacity needed.
XT
vT (Q) = (π Q(Q) × dQ)
δ
with δ ≡ k − g = r − ĝ. Letting v (Q) ≡ (π Q(Q) × dQ) δ ,
vT (Q) = XT v (Q). (9.39)
For an initially specified (planned) amount of capacity (Q), the term

v (Q) represents the perpetuity value of the deterministic incremental
profits (π Q × dQ) stemming from the new capacity investment (growing
at an annual risk-adjusted rate ĝ , with r being the interest rate). Alter-
natively, π Q × dQ is the contribution of the incremental capacity invest-
ment to the deterministic profit flow for the monopolist and v (Q) is the
expected present value of this incremental profit flow contribution.
The elasticity of vT is again constant and equal to ε v = −1. The optimal
investment rule again is v* (Q) = Π* I , where Π* = β1 ( β1 − 1). Since from
equation (9.39), v* (Q) = X* v(Q), the optimal investment trigger for the
monopolist is given by37
v (Q) X* (Q) π Q(Q) X*(Q) 1

= Π* or = r + β1σ 2. (9.40)
I I 2
Suppose, for example, that the monopolist faces a constant-elasticity

demand function of the form p (Q) = Q−1 ε p , where ε p is the constant price
elasticity of demand. Assume, for simplicity, that the monopolist has no
production cost. In this case the certain profit flow for the monopolist
is π Q(Q) = Q(ε p − 1) ε p and therefore ∂ π ∂Q = [(ε p − 1) ε p ]Q−1 ε p . For this
special case the monopolist’s investment trigger (as a function of the
capacity in place) is
⎛ ε p ⎞ 1 εp
X* (Q) = ⎛⎜ r + β1σ 2 ⎞⎟ ⎜
1
Q I. (9.41)
⎝ 2 ⎠ ⎝ ε p − 1⎟⎠
Figure 9.3 illustrates the above investment trigger for incremental capac-
ity investment by a monopolist as a function of the level of capacity
initially held (Q). It is shown that the higher the level of initial capacity,
the higher the investment trigger X* (Q), implying that large firms are
less sensitive to positive demand shocks than smaller firms in emerging
markets.
The additional (lumpy) capacity investment model in the previous
section can be thought of as a discretized version of the continuous
37. This result is also found in Pindyck (1988), Bertola (1988, 1989), and Dixit and Pindyck
(1994, p. 364).
306 Chapter 9
Optimal investment
trigger value
15
10 Investment trigger
X*
0
1 2 3 4 5 6
Initial capacity (Q)
Figure 9.3
Investment trigger for incremental capacity investment by a monopolist (as function of the
initial capacity held)
The underlying process follows a geometric Brownian motion with drift g = 12 percent,
volatility σ = 30 percent, and starting value X 0 = 1. Total return is k = 12 percent. The
necessary investment cost is i = 20 . The elasticity of the demand function is ε p = 2 .
incremental capacity investment model of this section. In the previous

model the optimal investment trigger was found in equation (9.35) at the
point where X* was such that (ΔVX *) I = Π* (with I being the invest-
ment outlay for additional capacity ΔQ). This reduces to the trigger
expression of equation (9.40) as ΔQ → 0.38 Thus the incremental capacity
investment model is the continuous equivalent of the additional (lumpy)
capacity investment model discussed earlier.39
Conclusion
In this chapter we discussed the situation faced by a firm having an

exclusive access to a market or enjoying insurmountable structural
38. Note that
ΠI δ ΠI
lim = ΠI = .
ΔQ→0 ( ΔV ΔQ) × ΔQ π Q(Q) dQ vQ(Q)
39. If in the additional capacity investment model the monopolist’s profits before and after
the additional capacity investment are determined by equilibrium conditions (e.g., derived
from profit-optimization techniques), a first-order derivative of the profit function (with
respect to starting capacity level Q) might be difficult to find (discontinuity of the profit in
Q). Then the equivalence between the discrete/lumpy and continuous/incremental prob-
lems may not hold.
barriers enabling it to ignore strategic interactions by rivals when devis-

ing its investment strategy. The standard investment timing rule has to
be revised under conditions of uncertainty to properly consider the vola-
tility in the underlying market, with the monopolist waiting longer than
in the deterministic growth case. We analyzed in turn the problem of
entering a new market and the problem of expanding the firm’s scale of
production. Both lump-sum and incremental capacity expansion models
were considered. We derived additional intuition exploiting the analogy
between the monopolist investor’s entry decision and the price markup
set by a monopolist.
Selected References
McDonald and Siegel (1986) investigate the investment timing decision

of a monopolist under uncertainty. Dixit and Pindyck (1994) extend this
analysis to other settings.40 Dixit, Pindyck, and Sødal (1999) examine
optimal investment timing and the (perpetual American call) investment
option problem using classical techniques from microeconomics. This
approach based on the elasticity of the expected discount factor is also
amenable to the study of other real options settings. Sødal (2006) analy-
ses hysteresis and the market entry and exit decisions along these lines.41
Dixit, Avinash K., and Robert S Pindyck. 1994. Investment under Uncer-
Dixit, Avinash K., Robert S. Pindyck, and Sigbjørn Sødal. 1999. A mark-up
interpretation of optimal investment rules. Economic Journal 109 (455):
179–89.
McDonald, Robert L., and Daniel Siegel. 1986. The value of waiting to
invest. Quarterly Journal of Economics 101 (4): 707–28.
40. Dixit and Pindyck (1994) provide a solution based on dynamic programming using an
exogenously given discount rate also applicable in case of incomplete markets. Since option
pricing is typically used for real options problems, we discuss here the contingent-claims
version (under the assumption of complete markets and no arbitrage). The two methodolo-
gies (contingent-claims analysis and dynamic programming) rely on somewhat different
assumptions. For further details on these two approaches regarding the investment timing
problem of a monopolist, see Dixit and Pindyck (1994, chs. 4 and 5). The dynamic program-
ming approach can be used, in principle, even if the underlying asset is not spanned in the
economy.
41. Dixit (1989) analyzes hysteresis in a real options setting. The preceding analysis of the
expected discount factor focuses on the upper threshold with the firm investing when the
threshold is first hit (investment option). If the firm may receive a scrap value upon exiting
the market, the “hysteresis band” involves a lower bound at which the firm exits. The pres-
ence of sunk costs (as the difference between entry and exit costs) creates “hysteresis” or
delay effects: firms are reluctant to enter and are likely to stay in the market longer in the
hope that the market might recover.
308 Chapter 9
Sødal, Sigbjørn. 2006. Entry and exit decisions based on a discount factor
approach. Journal of Economic Dynamics and Control 30 (11):
1963–86.
Appendix 9A: Contingent-Claims Analysis of the Option to Invest in

Monopoly
Real investment opportunities can be seen analogous to perpetual

American call options, giving the right but not the obligation to acquire
an asset at a predetermined exercise price. The investment-timing
problem is about when to invest, or equivalently when to acquire
an asset given that the exercise price (which here equals the investment
cost) is exogenously given and known. This problem is generally
solved by means of dynamic programming or contingent-claims analysis
(CCA).
To apply the CCA approach, we assume that changes in X t are spanned
by existing assets in the capital markets and that there exist no arbitrage
opportunities. These assumptions generally hold true in complete capital
markets , as is the case for most commodities. In this case a replicating
portfolio can be constructed.
Suppose that Vt follows the geometric Brownian motion as per equa-
tion (9.10) with g the expected percentage rate of change or growth
parameter and σ the volatility parameter. The difference between total
return k and the growth rate g represents some form of dividend yield,
denoted δ ≡ k − g . Unless δ > 0, the option will never be exercised
because the present value of the exercise price decreases for later invest-
ment. Let M be the value function of the monopolist firm’s option to
invest.42 To determine M , we can (1) construct a replicating, risk-free
portfolio and (2) determine its expected rate of return and equate that
expected rate of return to the risk-free rate, r. Consider a portfolio that
consists of a long position in M , and a short position (N units) in the
underlying asset Vt. The portfolio is therefore worth M − N Vt. The short
position pays, within each time interval dt , a dividend δ per unit invest-
ment in the underlying asset. Assuming that the short position N is held
fixed for an infinitesimal time period dt , the portfolio has a total expected
return over the short time interval dt of
E [ dM ] − N E ⎡⎣dVt ⎤⎦ − δ NVt dt.

42. We drop the dependence of M (and its derivatives) on the asset value Vt for notational
convenience.
By Itô’s lemma given in equation (A2.1) in the appendix at the end of

the book,
dM = ⎡⎢ gMV Vt + σ 2 MVV Vt 2 ⎤⎥ dt + σ MV Vt dzt,

1
⎣ 2 ⎦
so that
E [ dM ] = ⎡⎢ gMV Vt + σ 2 MVV Vt 2 ⎤⎥ dt.

1
⎣ 2 ⎦
From the two previous equations, the total expected return on the port-
folio is
1
( gMV − gN − δ N ) Vt + σ 2 MVV Vt2.
2
If arbitrage is precluded, the portfolio is risk-free earning the risk-free

return r so that N = MV . Therefore
1
σ 2 MVV Vt 2 − δ MV Vt = r ⎡⎣ M − MV Vt ⎤⎦ .
2
This results in the partial differential equation:
1
ˆ V Vt + σ 2 MVV Vt 2,
rM = gM
2
with ĝ = r − δ . A solution to this equation (if it exists) is of the form
M ≡ M(Vt ) = AVt β1 + BVtβ2 ,
where A and B are constants to be derived, β1 and β 2 are the positive and
negative roots of the “fundamental quadratic” given in appendix equa-
tion (A2.4). Applying the boundary condition that limVt → 0 M (Vt ) = 0, it
obtains that B = 0 (since β 2 < 0). From the value-matching and smooth-
pasting conditions (see section A.4 in the appendix to the book) we get
A = (V* − I ) V*(− β1 ) and V* = Π*I, where Π* = β1 ( β1 − 1).
Oligopoly: Simultaneous Investment
10
In the previous chapter we discussed optimal investment timing under

uncertainty for a monopolist. We considered two types of options:
invest (defer) and expand. The models developed in the monopoly
case help pave the way and set a benchmark for analyzing investment-
timing problems under uncertainty involving competition among two
or more firms. This last extension requires the use of game theory.
Here we will deal with simple cases of option games involving sym-
metric firms. Suppose, for simplicity and pedagogical usefulness, that
simultaneous investment occurs at the same trigger value because
firms agree to do so or tacitly collude.1 A social planner interested
in maximizing joint firm profit would select the same investment
trigger.
In the following sections dealing with oligopolistic industry structures,
we show how the presence of more rivals lowers the threshold that trig-
gers investment, so investment occurs sooner. The value of the invest-
ment timing (or deferral) option deteriorates with more competition.
The option to wait for new information before investing (new market
model) can be seen as a special case of the expansion or growth option
(existing market model), so we concentrate on the latter also obtaining
analytical results for the option to defer investment as a special case. We
consider, in turn, the following industry structures: oligopoly situations
where firms add capacity in lump sums (section 10.1), oligopoly situa-
tions where firms can increase their capacity incrementally (section 10.2),
and perfect competition, obtained in the limit as the number of incum-
bents becomes larger (section 10.3).
1. Whether such simultaneous investment can occur as part of a perfect Nash equilibrium
will be discussed in the next chapters. This analysis is relevant in cases of collusive agree-
ment between firms having shared investment options.
312 Chapter 10
10.1 Oligopoly: Additional Capacity Investment
We discuss next the existing market model (expansion option), and then
obtain the new market model (investment deferral option) as a special
case by setting an initial zero profit flow for each firm.
10.1.1 Existing Market Model: Expansion Option
Consider two identical firms already active in the market that contem-
plate investing in additional capacity. We ignore firm-specific risk factors
and concentrate on the industrywide demand shock, modeled as a sto-
chastic process X t following the general diffusion (or time-homogeneous
Itô process) of the form
dX t = g ( X t ) dt + σ ( X t ) dzt, (10.1)
where g( X t ) is the drift, σ ( X t ) the diffusion of the underlying process,

and zt a standard Brownian motion.2 This shock can capture exchange-
rate uncertainty or unexpected change in demand patterns. For simplic-
ity, consider a low initial value X 0 for the demand process. Suppose also
that firms share the option to expand capacity and decide to invest
simultaneously. Suppose the duopolist firms can only add capacity by a
given lump sum. At the outset, before adding investment in extra capac-
ity, each firm receives profits based on their existing capacity (assets in
place). We denote this initial profit flow by π 0. After investment in added
capacity units, each firm receives a higher profit flow, π 1, the same for
both firms (as investment among symmetric firms takes place simultane-
ously). As before, we decompose the stochastic total profit flow (π 0 or
π 1) into a deterministic reduced-form profit component (π 0 or π 1) and a
multiplicative stochastic shock, X t .
Firms’ joint investment strategy consists in investing simultaneously
the first time T the trigger XT (≥ X 0) is reached. Since the process X t
evolves stochastically, the first-hitting time is a random variable, given
{ }
by T ≡ inf t ≥ 0⏐ X t ≥ XT . Two demand regions are distinguished. If the
process remains below the jointly selected investment trigger XT , that is,
if X t < XT for all past t, firms stay put (wait). This set of values ( −∞, XT )
is the continuation or inaction region. At the first time the demand
process hits the boundary, XT , both firms invest. The corresponding set
of values [ XT , ∞ ) is the stopping or action region. As long as the process
2. Readers interested in the comparative effects of firm-specific or idiosyncratic shocks
may refer to Caballero and Pindyck (1996) or Dixit and Pindyck (1994, pp. 277–80).
Oligopoly: Simultaneous Investment 313
remains in the inaction region ( −∞, XT ), each firm receives π 0 = π 0 X t.

As soon as the process enters the action region [ XT , ∞ ) at random time
T , each firm invests and earns the higher profit amount π 1 = π 1 X t onward.3
The assessment of the investment option proceeds in several steps: (1)
assess the value induced by a given investment strategy XT , (2) deter-
mine the investment strategy that maximizes the firm’s value given the
strategy choice of rivals, and (3) use the optimal investment trigger to
obtain the expanded net present value (optimal investment value).
If both firms follow the joint strategy to invest when XT is first reached,
each has a time-0 value of

C0 ( XT ) ≡ C ( XT ; X 0 ) ≡ Eˆ 0 ⎡ ∫ π 0 X t e− rt dt + ∫ π 1 X t e− rt dt − I e− rT ⎤,
T ∞
⎣⎢ 0 T ⎦⎥
where I and r denote the capital investment cost and the risk-free interest
rate, respectively. Set V0 ≡ π 0 δ and V1 ≡ π 1 δ , with δ = k − g = r − ĝ ( > 0 )
representing the opportunity cost of delaying or a “dividend yield.” From
equation (A.45) in the appendix at the end of the book, we can decom-
pose the value expression into
C0 ( XT ) = V0 X 0 + B0(T ) ⎡⎣(V1 − V0 ) XT − I ⎤⎦. (10.2)
The first right-hand term represents the perpetuity value of the firm if it
stays put with its existing capacity forever, while the second term is the
additional net forward value ⎣⎡(V1 − V0 ) XT − I ⎦⎤ discounted back to
the present using the expected discount factor, B0 (T ), giving the time-0
value of )1 received at random future time T . In the special case that the
underlying stochastic factor X t follows the geometric Brownian motion,
dX t = ( gX t ) dt + (σ X t ) dzt, (10.3)
the expected discount factor is given by equation (A.43) in the appendix

as
β1
⎛X ⎞
B0 (T ) = ⎜ 0 ⎟ (10.4)
⎝ XT ⎠
with β1 (under risk neutrality) given in equation (A2.4) by

αˆ ⎛ αˆ ⎞
2
r
β1 = − + ⎜ ⎟ +2 2 ( > 1)
σ 2 ⎝ σ 2⎠
σ
3. The reduced-form certain profits π 0, π 1 capture the equilibrium profits at each time
t considered. We do not specify the type of competition governing the time- t marketplace.
In a context involving quantity competition it could be Cournot profits or the Pareto-
optimal outcome where both firms produce half the monopolist’s profit if it is enforceable
over time (see chapter 4, section 4.2.2).
314 Chapter 10
with αˆ = gˆ − (σ 2 2). By the methodology developed in chapter 9, the

optimal joint investment trigger X* must satisfy
ΔV X* ⎛ I ⎞
= Π*, or X* = Π* ⎜ ⎟⎠ , (10.5)
I ⎝ ΔV
where ΔV ≡ V1 − V0 is the deterministic value increment obtained upon

investing and Π* is the level of profitability required at the time of
optimal investment, given by
β1
Π* = . (10.6)
β1 − 1
If the two firms pursue the optimal joint investment strategy character-
ized by trigger value X*, based on equations (10.2) and (10.4), each will
receive at the outset:
β1
⎧ ⎛ X0 ⎞
⎪V0 X 0 + ⎜ ⎡(V1 − V0 ) X* − I ⎤⎦ (wait) if X 0 < X*,
C0 ( X*) = ⎨ ⎝ X* ⎟⎠ ⎣
⎪
⎩V1 X 0 − I (invest) if X 0 ≥ X*.
(10.7)
Equation (10.7) can be interpreted as follows. In the waiting region,

( −∞, X*), the firm’s total value involves two components. In the first stage,
each firm earns a reduced-form profit π 0 that reflects the initial capacity
levels, receiving V0 X 0 as perpetuity value. At random time T* , both firms
invest simultaneously, receiving net forward value (V1 − V0 ) X* − I . In
effect each firm “exchanges” its original perpetuity value stemming from
its initial installed capacity V0 for the new perpetuity value resulting from
expanded industry capacity V1. At time T* , the demand process has value
X*. This “exchange” involves a transaction cost I . To assess this net
forward value in time-0 terms, we use the expected discount factor in
equation (10.4). If the current demand value, X 0, is higher than the pre-
scribed optimal investment threshold level X*, both firms will invest
immediately receiving the higher net present value V1 X 0 − I.
10.1.2 New Market Model: Investment (Defer) Option
The value of the option to invest in a new market can be deduced as a

special case of equation (10.7) for the capacity expansion problem.
Setting the initial deterministic profit π 0 to zero with V0 = π 0 δ being
zero, the value of the option to invest in a new market is thus given by
β1
⎧ ⎛ X0 ⎞
⎪(V1 X* − I ) ⎜ (wait) if X 0 < X*,
C0 ( X*) = ⎨ ⎝ X* ⎟⎠ (10.8)
⎪
⎩V1 X 0 − I (invest) if X 0 ≥ X*,
where the optimal investment trigger X* is given as a special case of
(10.5):
⎛ I ⎞
X* = Π* ⎜ ⎟ ,
⎝ V1 ⎠
with the profitability index, Π*, as given by equation (10.6).

The expression in equation (10.8) looks similar to that for the value
of the option to invest by a monopolist obtained previously in equation
(9.13′).4 Suppose that firms collude both on investment timing (invest-
ment stage) and on output levels (market stage), for example, by invest-
ing in a joint venture in which each pays half the investment cost,
collectively paying the same investment cost as the monopolist. This
situation is equivalent to the monopoly case. In this joint venture,
π 1 = π M 2, where π M is the monopoly profit as given in equation (3.4).
The perpetuity value for each firm is V1 = V M 2 with V M ≡ π M δ . More-
over, each incurs cost I 2. The optimal investment trigger in this collu-
sive duopoly case is
⎛ I 2 ⎞
X* = Π* ⎜ ,
⎝ VM 2 ⎟⎠
the same optimal investment trigger as in the monopoly case. That is, the
joint venture or collusive duopolist investment trigger is identical to the
monopolist’s optimal target.5
Example 10.1 Cournot Quantity Competition in Oligopoly

Consider the oligopoly situation where, as in the Cournot model of
section 3.3 of chapter 3, n symmetric firms face a linear demand
p (Q) = a − bQ given by equation (3.1) and pay a constant marginal cost
4. Although the form of the solution is similar, the equilibrium reduced-form profits in
duopoly and monopoly may differ (all other things being equal). Since the profit of a
duopolist is generally lower than that of a monopolist, the investment trigger is higher in
a duopoly (as ∂X* ∂V1 < 0) so that the duopolist firm invests later. In this setting the
duopolist waits longer to ensure that the value it receives upon investment is sufficiently
large to justify spending the investment cost I . This result rests on two key assumptions:
(1) the investment cost incurred by one firm is the same whatever its market power
(monopoly vs. duopoly) or duopolists collectively face twice the investment cost of a
monopolist, and (2) firms collude or agree on the joint investment timing (investment
stage) but compete “as usual” in the market after the investment (market stage).
5. The relationships we develop in this section are useful later (chapter 12) when we
examine the option to expand when firms face a coordination problem.
316 Chapter 10
Table 10.1
Stage profits under Cournot quantity competition
Industry structure Number of firms Equilibrium profit
1 (a − c)
2
Monopoly 1
4 b
1 (a − c )
2
Duopoly 2
9 b
Oligopoly n 1 (a − c ) 2
(n + 1)2 b
c per unit output. Suppose that firms coordinate their actions in the
investment stage; that is, they agree on a joint investment trigger, X n*,
but do not necessarily collude in the market stage, competing à la Cournot
once they have entered the market.6 The reduced-form stage profit flows,
obtained in chapter 3, are summarized for convenience in table 10.1. The
investment cost paid by each firm, I , is the same whatever the industry
structure.
Let π ( n) and V1 ( n) ≡ π ( n) δ be the deterministic profit and perpetuity
value components obtained by each of the n (symmetric) oligopolist
firms. The multiplicative stochastic shock follows geometric Brownian
motion. In the inaction region, namely if X 0 < X n*, the value of the
investment option for any of the n firms when all firms follow the joint
optimal investment strategy is, by extension of equation (10.8), given by
β1 β1
⎛ X ⎞ ⎛ X ⎞
C0 ( X n*) = (V1 ( n) X n* − I ) ⎜ 0 ⎟ = (Π* − 1) I ⎜ 0 ⎟ , (10.9)
⎝ X n* ⎠ ⎝ X n* ⎠
where the investment trigger optimally chosen by the n colluding firms,

X n*, is given by
⎛ I ⎞
X n* = Π* ⎜
⎝ V1 ( n) ⎟⎠
with Π * given in equation (10.6). Since V1 ( n) decreases with the number

of firms (n), the optimal investment trigger X n* increases. This result
relates to the fact that investments are lumpy and that the investment
cost, I , is constant, regardless of the industry structure. Figure 10.1 con-
firms that the investment option value dissipates fast when more firms
are active in the marketplace (here, beyond n = 4 or 5 firms the option
6. We could assume instead that firms collude as well in the market stage, for example,
producing half the monopoly output after making a joint simultaneous investment if it is
more descriptive of the problem at hand.
Option value
(in millions of euros)
50
40
30
Aggregate industrywide
option value
20
10 Option value of an
individual firm
0
1 2 3 4 5 6 7 8 9 10
Number of firms (n)
Figure 10.1
Value of the option to invest in oligopoly as more firms are active in the market
Here the individual investment cost is considered constant whatever the number of firms
in the industry. It is possible to consider an investment cost decreasing with the number of
firms. This would lead to higher values for the investment trigger and the option.
p (Q) = 6 − Q; c = 2 ; I = 100 , k = 12 percent, g = 0.08 ; σ = 20 percent; X 0 = 1.
value becomes very small). The investment option value decreases as the
profit value of an oligopolist firm declines with the number of firms, n.
The option value does not vanish completely, however. Sustainability of
such collusive agreement is doubtful, especially in an oligopoly with a
large number of firms. Each firm may have an incentive to invest earlier
to wield more market power and temporarily earn higher profits.7
10.2 Oligopoly: Incremental Capacity Investment
An interesting variation of the above investment problem has been

developed by Grenadier (2002) to deal with situations where firms can
7. Simultaneous investment models in a dynamic setting are more challenging. In most
cases the problem is formulated with open-loop strategies, and the resulting Nash equilib-
rium strategy profiles may fail to form a subgame perfect Nash equilibrium if firms have
the possibility to observe and react to their rivals’ past actions, that is, if firms are permitted
to devise closed-loop strategies. In lumpy investment cases—as discussed, for instance, in
Huisman and Kort (1999)—tacit collusion can sustain as (Markov) perfect equilibrium for
a certain range of parameters, but in most cases tacit collusion is not likely. For both open-
loop and closed-loop strategies the monopolist will wait more since there is no preemption
threat. But with more firms following closed-loop strategies, preemption poses a real
threat. Rivalry can hasten rather than delay investment. We discuss this issue at length in
chapter 12.
318 Chapter 10
expand capacity by any small increment, rather than by a lump sum.8

This model is fairly general since it can accommodate various stochastic
(Itô) processes and demand functions. In this section we develop a com-
parable model based on our approach for investing at an optimal target
level.9 Suppose again that n firms already active in the market face
Cournot quantity (or capacity) competition and contemplate investing
in new capacity. Since firms can add capacity by any incremental amount,
they are more likely to react to small, favorable shocks by adding capac-
ity incrementally (by an amount dq), rather than waiting longer for a
large favorable shock to occur to justify a larger, lump-sum investment.
In this incremental capacity investment problem, we make the assump-
tion that symmetric firms invest simultaneously and by the same capacity
increment.
Consider the general case first. The profit flow firm j receives depends
on current total installed industry capacity and the current value of the
demand shock. Suppose that the shock follows the general diffusion
process in equation (10.1). Let Q be the current level of total industry
capacity, where qj denotes firm j’s individual capacity and Q− j the com-
bined capacity of all other firms except firm j. Thus, Q = q j + Q− j. Firm j
receives uncertain profit flow π j = π j ( X t ; Q) = π j ( X t ; q j , Q− j ). The profit
flow is the same for all identical incumbent firms.10 Let I (I ≡ i × dq j)
be the investment cost paid by firm j to expand capacity incrementally
and i the investment cost per unit of capacity.
Once again, a firm’s investment strategy consists in choosing ex ante
a future target level XT for the stochastic variable X t and investing when
{
this target value is first reached at random time T = inf t ≥ 0⏐ X t ≥ XT .11 }
VT [π j ] denotes firm j’s forward value as a perpetuity of profit flows
π j ( X t ; q j , Q− j ) from time T onward.12 When firm j invests incrementally
in new capacity (by small amount dq j), it receives an extra profit flow
amounting to π j ′ dq j , with
8. We here examine expansion options in the context of production capacity problems.
Pindyck (1988) and Dixit and Pindyck (1994) take a broader approach, interpreting them
in terms of capital stocks, including capacity, human capital (new labor, enhanced intel-
lectual capital), and technological expertise.
9. We do not intend to give a mathematical treatment of this problem here but rather to
stress the economic intuition.
10. Capacity is infinitely divisible so that the stage action set is continuous. The profit-flow
function is differentiable with respect to capacity.
11. For simplicity, assume that an industry organization is responsible for the industry’s
common interests and wields sufficient power to enforce its investment-timing decisions.
12. To avoid use of two subscripts, we drop the use of the subscript j henceforth, with
the understanding that these formulas concern an individual firm, not the industry as a
whole.
∂π j
π j ′ = π j ′ ( X t ; q j , Q− j ) ≡ ( X t ; qj , Q− j ).
∂q j
At random time T when firm j raises its capacity by dq j, it receives the
forward perpetuity value
vT (Q) = v ( XT ; Q) ≡ VT [π j ′ dq j ] (10.10)
or net forward value of vT (Q) − I . In equation (10.10), VT [⋅] is a forward

perpetuity value operator.
Let c0 ( XT ; Q) denote firm j’s time-0 value of investing at target level
XT given industry capacity Q. This value for firm j is
∞ ∞
c0 ( XT ; Q) = Eˆ 0 ⎡ ∫ π j e − rt dt + ∫ (π j ′ dq j ) e − rt dt − I × e − rT ⎤.

⎣ 0 T ⎦
The first term in the expectation is a perpetuity value that is independent
of the investment strategy choice. The equation above can simplify to
c0 ( XT ; Q) = V0 (Q) + B0 (T ) [vT (Q) − I ]. (10.11)
To determine the optimal investment strategy, we need to determine the

optimal joint cutoff value X n* = X*n (Q) that maximizes the expression
above. This is found at the point where v*(Q) = v ( X*; Q) satisfies
v* (Q)
= Π* (Q), (10.12)
I
where Π*(Q) = Π ( X n *; Q), with Π (⋅; Q) being the profitability index
(function) given by
ε B ( XT )
Π ( XT ; Q ) = . (10.13)
ε B ( XT ) + ε v ( XT ; Q )
In equation (10.13), the elasticity measures ε B(⋅) and ε v(⋅; Q) are given by
ε B( XT ) = − BX (T ) ×
XT
,
B0 (T )
XT
ε v( XT ; Q) = − vX (Q) × ,
v ( XT ; Q )
where BX (⋅) = ∂B ∂XT and vX (Q) = ∂v ∂XT . This expression is analogous
to equation (9.38) derived earlier for a monopolist having the option
to invest incrementally in capacity. A significant difference exists,
however. Here the incremental value change (due to capacity addition),
vT , is lower than the incremental value increase in the case of a monopoly
320 Chapter 10
due to the presence of competing firms acting as a negative externality.

Given that all firms invest simultaneously, when firm j increases its
capacity by a certain amount (dq j), the equilibrium value is not affected
solely by firm j’s capacity increase but also by the entire industry’s capac-
ity expansion (dQ) as all rivals follow suit at the same time.
Case of Multiplicative Shock

Suppose now that the total uncertain profit flow, π j ( X t ; Q), consists of
a deterministic reduced-form component, π j (Q), and an industrywide
multiplicative shock that follows an Itô process as per equation (10.1).
The stochastic profit flow for firm j is now given by
π j ( X t ; q j , Q− j ) = X t π j ( q j , Q− j ).
Following Grenadier (2002), assume that incremental production costs
are negligible or that firms maximize revenues. The deterministic profit
then equals firm j’s quantity, q j, multiplied by the market-clearing price,
p (Q):13
π j (Q) = π j (q j , Q− j ) = q j p (Q).
Since all firms invest simultaneously and by the same increments, total
industry capacity rises by n times this increment when joint investment
occurs. In other words, when each firm j increases capacity by dq j, the
industry increases total capacity by dQ = n dq j , so Q = nq j at all times.
Since the (inverse) demand function is downward sloping, the market
price decreases in proportion to dQ. The first-order derivative of firm
j’s profit function is π j ′ (Q) = p (Q) + q j p′ (Q). Since all firms are sym-
metric and q j = Q n, this simplifies to
dπ j Q
π j ′ (Q) ≡ (Q) = p(Q) + p′ (Q). (10.14)
dq j n
We can now specify the incremental forward value given in equation
(10.10). Since the shock is multiplicative, equation (10.10) obtains as
vT ( q j , Q− j ) = [π j ′ dq j ]V[ XT ],
where V[ XT ] denotes the perpetuity (expected discounted) value of the

shock from time T going forward and π j ′ is the incremental profit given
in equation (10.14). The optimal investment trigger X n* (Q) for each firm
13. We assume the (inverse) market demand function is downward sloping and twice
continuously differentiable.
in an oligopoly in equilibrium with n symmetric firms obtains from equa-

tions (10.12) and (10.14) as
Π* i
V [ X n*(Q)] = , (10.15)
p (Q) + (Q n) p′ (Q)
where i is the investment cost per unit of capacity.

The result above is fairly general and tractable. The value expression
in equation (10.15) depends on the industry structure through the
number of firms, n. Two polar cases are of interest: (1) monopoly, with
n = 1, and (2) perfect competition, where n → ∞. To illustrate, consider
the case of geometric Brownian motion based on equation (10.3)
where the perpetuity value, V [ X n*(Q)], the expected discount factor,
B0 (T ), and the elasticities readily obtain.14 In this case the perpetuity
value is obtained from equation (A.30) in the appendix as
V [ X n*(Q)] = X n*(Q) δ , where δ ≡ k − g = r − ĝ. The optimal investment
trigger for each of the n oligopolist firms is obtained from equation
(10.15) as
Π*i
X n*(Q) = , (10.16)
π j ′ (Q) δ
where π j ′ (Q) is given in equation (10.14), and Π* = β1 (β1 − 1) is the
profitability index in case of geometric Brownian motion.
For a monopolist, being a special case of the expression in (10.16) with
n = 1,
Π*I
X 1*(Q) = ,
π ′ (Q) δ
with π ′ (Q) = p(Q) + Qp′(Q). This confirms the investment trigger for the
monopolist based on the profitability index investment rule derived in
chapter 9, equation (9.40). The preceding general model for oligopoly is
in line with previous literature on real options, including the case of
monopoly.
Example 10.2 Oligopoly with Isoelastic Demand

Suppose again that the shock process follows the geometric Brownian
motion of equation (10.3), but that now firms face an (inverse) demand
function of the constant-elasticity form
14. Pindyck (1988) also assumes a multiplicative industry stock that follows a geometric
Brownian motion, that capital has no scrap value, and unit production costs are negligible
in a monopoly context. We can thus compare these results.
322 Chapter 10
p (Q) = Q−1 ε p ,
where −ε p is the price elasticity of demand.15 The first-order derivative

of the demand function is p′ (Q) = − (1 ε p ) Q− (1 ε p )− 1 (< 0 ). When this value
is substituted into equation (10.14) and π j ′ (Q) into equation (10.16), the
optimal investment trigger for each of the n oligopolist firms in the case
of isoelastic demand becomes
⎛ nε p ⎞ 1 ε p ⎛ ⎛ nε p ⎞ 1 ε p
= ⎜ r + β1σ 2 ⎞⎟ i ⎜
1
X n*(Q) = Π* i δ ⎜ Q Q . (10.17)
⎝ nε p − 1⎟⎠ ⎝ 2 ⎠ ⎝ nε p − 1⎟⎠
This confirms the result obtained in Grenadier (2002), equation (21).

Under certain conditions for the constant elasticity of demand (see foot-
note 15), ∂X n* (Q) ∂Q ≥ 0. Therefore the investment trigger increases
with existing capacity so that a small firm is more reactive to small shocks
and likely to invest earlier than a firm with large capacity. An industry
with a high level of existing capacity is less likely to invest in added
capacity. Figure 10.2 illustrates the sensitivity of the investment trigger
to the number of firms n for a given installed industry capacity Q. It
confirms that the investment trigger decreases with the number of firms,
so that more competition hastens rather than delays investment.16 This
holds under most typical demand functions and stochastic process speci-
fications.17 For a very large number of firms (approximating perfect com-
petition) the option to wait to invest almost vanishes.18 Appendix 10A
provides an alternative derivation based on dynamic programming.
10.3 Perfect Competition and Social Optimality
The general model above for analyzing investment in capacity can also
be used to obtain the polar case of perfect competition as the number
15. We assume that ε p > 1 n > 0 .
16. The investment trigger in equation (10.17) has the following first-order derivative:
∂ X n* X *(Q)
(Q) = − n (< 0 ) .
∂n n ( nε p − 1)
This result contrasts with the previous case involving lump sums. There we assumed that
firms select their Nash equilibrium actions at each stage. Here the profit is given exoge-
nously by a function continuous in capacity Q.
17. See Grenadier (2002) for derivation of the first-order derivative of the trigger function
under other stochastic processes and demand functions.
18. It is still not correct to say that in perfect competition the NPV rule holds. The asymp-
tote to the optimal trigger value curve is the trigger in perfect competition. This is not
tantamount to the NPV rule as the profitability index in perfect competition is constant
and higher than 1.
Optimal trigger
value
80
60
Monopoly (n = 1)
Duopoly (n = 2)
40
Oligopoly (n = 5)
20
0
1 2 3 4 5 6
Initial installed industry capacity (Q)
(a)
Expected
Optimal trigger investment time
value (years to investment)
60 80
60
Expected investment time
40
40
Optimal trigger
20
20
0 0
1 2 3 4 5 6 7 8 9 10
Number of firms (n)
(b)
Figure 10.2
Sensitivity of the optimal investment strategy (trigger) in oligopoly
Assume isoelastic demand p(Q) = Q−1 ε p , with constant ε p = 2 . The discount rate is k = 12
percent, growth g = 8 percent, and volatility σ = 20 percent. Investment cost i = 100 (per
firm). For panel b, initial installed industry capacity Q = 2.
324 Chapter 10
of firms, n, increases. Consider again the case of geometric Brownian

motion as in equation (10.3). The investment trigger of a firm operating
in perfect competition can be obtained as the limit of X n*(Q) from equa-
tion (10.16) as n approaches infinity:
Π* i δ Π*i
X ∞ *(Q) = lim X n*(Q) = lim = , (10.18)
n →∞ n →∞ p (Q) + (Q n) p′ (Q) p (Q) δ
where the profitability index Π* is given in equation (10.6). The optimal
threshold in perfect competition is thus defined explicitly in terms of the
current industry capacity Q, the market-clearing price p (Q) given
the existing capacity, the profitability index Π*, the capital investment
cost i , and the opportunity cost of waiting δ . Equivalently, in perfect
competitive equilibrium, the return on investment satisfies the
modified Jorgensionian rule of investment obtained from equation
(10.18) as
p (Q) X ∞ * (Q) 1
= Π*δ = r + β1σ 2.
i 2
This is analogous to equation (9.25) seen in the monopoly case. The

preceding general oligopoly model with n firms thus makes it possible to
analyze a continuum of oligopolistic structures including the classic polar
cases of monopoly and perfect competition.
The analysis above relates to a number of key results in the real
options literature. The connection between the socially optimal invest-
ment threshold and the trigger obtained under perfect competition was
first noted by Leahy (1993). Leahy showed that firms’ optimal exercise
strategies exhibit some form of myopia in that a perfectly competitive
firm should invest at the same time as a myopic (or monopolist) firm
ignoring potential future capacity expansions by rivals, considering the
market price dynamics as exogenous. A myopic firm behaves as if indus-
trywide production capacity (going forward) remains fixed and that the
future price process is solely driven by exogenous shocks, not by rival
capacity adjustments. Such myopia makes firms behave as if they are the
last entrant setting their optimal investment trigger in isolation. Leahy
(1993) compares this investment strategy with the one formulated by a
social planner imposed on decentralized firms. Myopic investment poli-
cies turn out to be socially optimal. These rather striking results have an
important implication: the optimal investment behavior by firms in
perfect competition is the same as the one ignoring the effect of rivals’
capacity expansion decisions.
Grenadier (2000b) additionally analyzes the effect of completion

delays (time to build) on firm investment behavior in perfect competition
extending the work of Leahy (1993).19 Baldursson and Karatzas (1996)
consider capacity expansion decisions involving non-Markovian stochas-
tic processes, establishing the correspondence among perfect competi-
tion, myopic strategies, and social optimality for a larger family of
processes using a probabilistic approach to stochastic control theory.
Baldursson (1998) considers both expansion and downsizing decisions,
comparing the results obtained in Nash equilibrium with the choice of a
social planner. Some special cases admit closed-form solutions. Dixit
(1991) further examines investment behavior in a perfectly competitive
market with exogenous price ceilings.20
Conclusion
We analyzed here oligopolistic market structures considering the invest-

ment decision of firms when they invest all at the same time and by the
same lump sum or increment. We first considered a case where firms
make lumpy investments and agree to cooperate on joint investment
timing. We then extended the analysis to settings where firms can expand
capacity by any small or incremental amount. We discussed also the
special case of perfect competition, noting the optimality of myopic
behavior that ignores rivals’ capacity expansion decisions.
Selected References
Pindyck (1988) paves the way for the analysis of irreversible investment
in incremental units of capital. Leahy (1993) introduces strategic
19. The presence of completion delays or time to build still allows use of a Markov state
space provided one uses a new, simplified Markov state that keeps track of both assets in
place and capacity under construction, an aggregate index of “committed capacity.”
20. Back and Paulsen (2009) discuss the appropriateness of the Nash or open-loop equi-
librium concept employed in models of oligopoly and perfect competition (e.g., Grenadier
2002; Baldursson 1998; Baldursson and Karatzas 1996). Open-loop strategies allow firms to
respond to the resolution of uncertainty with respect to the exogenous shock but not to
the observed actions by rivals. Optimal open-loop strategies form a Nash equilibrium as
part of the open-loop equilibrium. If firms could in effect respond to their rivals’ actions
(i.e., formulate closed-loop strategies), the equilibrium strategies obtained by Grenadier
(2002) would fail to be subgame perfect. If firms were to pursue such Nash equilibrium
open-loop strategies even though they observe their rivals’ actions and can revise their
strategies accordingly, they would face the risk of preemption. Formulating the dynamic
capacity-expansion problem in closed-loop strategies is rather difficult. Back and Paulsen
show that in the limit, the perfect competition outcome derived in Leahy (1993) is part of
a perfect closed-loop equilibrium.
326 Chapter 10
considerations to this setting and points out their irrelevance in the

context of perfect competition. Grenadier (2002) extends the analysis
considering oligopolistic industry structures and completion delays.
Grenadier, Steven R. 2002. Option exercise games: An application to the

equilibrium investment strategies of firms. Review of Financial Studies
15 (3): 691–721.
Leahy, John V. 1993. Investment in competitive equilibrium: The optimal-
ity of myopic behavior. Quarterly Journal of Economics 108 (4):
1105–33.
Pindyck, Robert S. 1988. Irreversible investment, capacity choice and the
value of the firm. American Economic Review 78 (5): 969–85.
Appendix 10A: Derivation Based on Dynamic Programming
An investment opportunity is commonly treated in the real options lit-

erature as being analogous to a perpetual American call option written
on a real asset. When the underlying asset is not affected by other inves-
tors’ exercise policies, a reasonable assumption in highly competitive
markets, we can analyze such investment opportunities by means of
contingent-claims analysis. Under uncertainty the underlying profit flow
has both an exogenous (demand) and an endogenous (strategic) value
component. Here we sketch a derivation based on dynamic program-
ming to obtain the partial differential equation and boundary conditions
derived by Grenadier (2002).21
Consider an oligopoly consisting of n symmetric firms competing over
a single, nonstorable homogeneous product. The output produced by
firm j is denoted q j . Q = ∑ j = 1 q j is the total industry output, and Q− j
n
denotes the output produced by all other firms except firm j. Output is
assumed infinitely divisible. The uncertainty is modeled by X t , an exog-
enous industrywide demand shock process. Suppose that the exogenous
shock is of the multiplicative form and follows the Itô process of equa-
tion (10.1). For simplicity we disregard variable unit production costs
obtaining:
π j (Q) = X t π j (Q) = X t q j p (Q). (10.19)

21. The appendix at the end of the book is more precise on how to derive HJB equations
and the relevant boundary conditions. We refer more analytically minded readers to this
appendix.
In such a symmetric oligopoly, firms increase output all at the same time
in response to a favorable market development, so at all times
Q
qj = ∀j = 1, . . ., n.
n
Firms at any time may invest in extra capacity, each increasing their
output by a small increment dq j. Investing in added capacity involves
a capital expenditure by firm j of I ≡ i × dq j, where i ( > 0 ) is the price
of one unit of capacity. Firms share a perpetual American call option
to invest with underlying asset being the stream of incremental profit
flows from increased capacity and exercise price the added capital invest-
ment cost I .
The optimal exercise strategy can be found in terms of trigger poli-
cies. Firm j will exercise its option to invest in added capacity the first
moment a specified investment threshold is reached by the stochastic
process X t . This threshold, denoted by X n* (Q), is a function of the
number of firms and the total industry capacity, Q. In Nash equilibrium,
firm j determines its optimal investment strategy taking other firms’
(optimal) strategies as given. The value of the firm if it follows the Nash
equilibrium strategy to invest when X* ≡ X n * (Q) is first reached is
denoted as c ≡ c ( X 0 , X *; Q).
Over a small time period of length dt , the return to firm j consists of
(1) the profit flow from existing capacity π j ( X t ; Q), analogous to a
“dividend yield,” and (2) the expected value increase or “capital gain,”
E ( dc ). In equilibrium, the instantaneous total expected return should
equal the continuously compounded cost of capital. This leads to the
following Bellman equation in continuous time (or HJB equation):
π j ( X t ; Q) dt + E (dc ) = rcdt. (10.20)
From Itô’s lemma given in equation (A1.2), the change in the value of
firm j over an infinitesimal time period dt is given by
dc = ⎛⎜ cX gt + cXX σ t ² ⎞⎟ dt + cX σ t dzt
1
(10.21)
⎝ 2 ⎠
with gt ≡ g( X t ), σ t ≡ σ ( X t ), zt being a standard Brownian motion. The

first- and second-order derivatives in equation (10.21) are the derivatives
of c ( X 0 , X *; Q) with respect to X 0. When taking expectation, the second
right-hand term in equation (10.21) drops out since E [ dzt ] = 0. After
substituting the result derived from Itô’s lemma in equation (10.21) into
328 Chapter 10
the HJB equation (10.20), we obtain the following partial differential

equation:
π j ( X t ; Q) + cX gt + cXX σ t 2 = rc.
1
(10.22)
2
This equation describes the option value dynamics under the optimal
investment policy. Firm j’s optimal investment strategy is to increase
capacity when the shock variable X t reaches the threshold level X*. The
investment opportunity value c must satisfy the equation above, subject
to specific boundary conditions, discussed below.
Value-Matching Condition
If firm j invests in dq j capacity units, its value will be
c( X 0 , X*; q j + dq j , Q− j ) − I .
When the state variable reaches the threshold X*, firm j is indifferent
between investing or keeping open its option to wait, so that
c ( X*, X*; q j + dq j , Q− j ) − I = c ( X*, X*; q j , Q− j ),
yielding
cq j ( X*, X*; q j , Q− j ) = i , (10.23)
where cq j (⋅, X*; q j , Q− j ) ≡ ∂c (⋅, X*; q j , Q− j ) ∂q j .

If we assume that symmetric firms invest at the same time and by the
same increments, at optimal exercise,
c ( X*, X*; q j , Q− j + dQ− j ) = c ( X*, X*; q j , Q− j ).
This leads to
cQ− j ( X*, X*; q j , Q− j ) = 0, (10.24)
where cQ− j ( X*, X*; q j , Q− j ) ≡ ∂c ( X*, X*; q j , Q− j ) ∂Q− j . Conditions (10.23)

and (10.24) are the value matching conditions.
Smooth-Pasting Condition
At the optimal investment trigger point, the smooth-pasting condition

for cq j holds, namely
cX ( X*, X*; q j + dq j , Q− j ) = cX ( X*, X*; q j , Q− j ),

obtaining
∂c X
( X*, X*; qj , Q− j ) = 0. (10.25)
∂q j
This boundary condition is the super-contact or smooth-pasting
condition.22
No general analytical solution exists for partial differential equation
(10.22) subject to boundary conditions (10.23), (10.24), and (10.25).
Special choices for the stochastic process, however, such as the geometric
Brownian motion, make the analysis amenable to closed-form
solutions.
22. Rigorously speaking, this condition is the super-contact condition since it is of second
order. Sometimes the term smooth-pasting condition is used in this context. Smooth-
pasting condition is a first-order condition that here applies to the first-order derivative of
the value function with respect to the capacity level. Refer to Dumas (1993) for details.
Leadership and Early-Mover Advantage
11
In the previous chapter, models of simultaneous investment among oli-

gopolists were discussed. These models assumed that investment timing
was decided collectively (or by a social planner able to enforce its invest-
ment-timing decision). Here we consider strategic interactions among
firms, so collusive simultaneous investment is ruled out as a Nash equi-
librium of the investment game. Investment may occur sequentially, par-
ticularly if the leader has distinctive capabilities with sufficiently high
competitive advantage that makes it possible to disregard the competi-
tor’s investment decision.1 Section 11.1 discusses the basic deterministic
game-theoretic framework of Reinganum (1981a) that shows why
sequential, rather than simultaneous, investment emerges as the equilib-
rium when duopolist firms hold a shared investment option. The follow-
ing sections extend this basic, deterministic framework allowing for a
market evolving stochastically. Sections 11.2 and 11.3 focus on the option
to invest in a duopoly and in an oligopoly setting, respectively. Section
11.4 deals with the option to expand production capacity. Such invest-
ment-timing games can help explain firm leadership and early-mover
advantage.
11.1 A Basic Framework for Sequential Investment in a Duopoly
In part I of the book we considered separately the two main underlying

theories, real options analysis and game theory. In chapter 9 on the
1. We focus here on models involving open-loop strategies; that is, firms precommit and
are not permitted to revise their strategies in view of rivals’ actions over the play of the
game. In such cases preemption does not occur. It is simpler first to deal with option games
involving no risk of preemption as in open-loop models. Reinganum’s (1981a, b) approach
to open-loop equilibrium provides the basic (deterministic) setting underlying option
games involving sequential investment, such as Joaquin and Butler (2001). Reinganum
(1981a) shows that simultaneous investment does not arise in equilibrium in such games.
332 Chapter 11
investment option of a monopolist, we elaborated how one can obtain

analytic solutions for certain real options problems (e.g., the option to
invest and the option to expand) when the option holder faces no com-
petition or when the investment opportunity is protected by high struc-
tural entry barriers. Although standard real options analysis gives
interesting insights into how a monopolist firm should behave, it does
not adequately address situations when real options are “shared” among
several rivals. Nonetheless, the methodology we mastered along the way
to solve such decision-theoretic models will serve us well as a first build-
ing block for analyzing such shared option games. The second building
block is game theory and industrial organization, with a particular focus
on games of timing. These settings are typically modeled in continuous
time, so it is useful to develop some understanding of game theory in
continuous time before dealing with uncertainty in integrated real-
options and game-theoretic models.
Two key articles that have had a major impact on this field are those
by Reinganum (1981a) and Fudenberg and Tirole (1985). Both deal with
investment timing when there is no stochastic uncertainty regarding the
payoffs firms will receive upon acting. Although these authors explicitly
deal with technology adoption, their results and insights are tractable
and applicable to other classes of problems, such as timing of market
entry or of (lumpy) capacity expansion. We extend these results within
the real options framework and apply them to provide insights into the
strategic investment challenge under market uncertainty.2 In contrast to
Fudenberg and Tirole (1985), Reinganum’s (1981a) model does not
require the use of mixed-strategy equilibria in continuous time and is
less technical as a starting point. We present it first and discuss Fuden-
berg and Tirole’s model in the upcoming chapter.
Assume that firms’ investment strategy consists in choosing an invest-
ment date a priori and committing to it. Since for now we assume that
there is no stochastic uncertainty concerning the underlying market
development, assuming a fixed investment schedule is reasonable.
Suppose that two identical firms (firms i and j) are active in the market
(at time t = 0) and behave rationally by selecting profit-maximizing
outputs. Both firms have the option to make an investment (e.g., in capac-
ity expansion) and increase their profits accordingly (existing market
model). Supposing that we deal with capacity expansion, it is clear that
capacity expansion by one of the firms is made at the expense of its rival:
2. For a treatment of option games with a focus on technology adoption, see Huisman
(2001).
Leadership and Early-Mover Advantage 333
as price declines, the rival firm whose capacity has remained fixed loses
revenues, while the expanding firm may earn higher profits due to the
combined effect of increased quantity (market share) and lower price.3
The problem for the option holder lies in selecting the right time to stop
waiting and initiate the expansion project. The duopolists have an infinite
planning horizon and can choose to invest at anytime. Firms face the
same interest rate r.4 Assume a constant investment cost I . At the begin-
ning of the game, each firm earns a profit denoted π 0, growing (com-
poundly) over time at a constant growth rate g (percent) per unit time,
with g < r. There is an incentive to delay, making the investment at a time
when the market is larger and more profitable.5
A differentiating feature between Reinganum’s (1981a) model and
our option games approach is that Reinganum does not consider uncer-
tainty relating to the underlying process. In Reinganum’s framework the
investment time is deterministic. The notion of investment strategy is
thus somewhat different: rather than selecting an investment threshold
XT and investing at the (random) time T when this trigger has first been
reached, the problem here simplifies to selecting a certain time T ( ≥ t0 )
at which the firm invests. This brings out a key difference between deter-
ministic game-theoretic models of timing (e.g., Reinganum 1981a; Fuden-
berg and Tirole 1985) and option models of investment timing under
uncertainty (e.g., McDonald and Siegel 1986; Dixit and Pindyck 1994).
In the deterministic game-theoretic models the investment strategy
directly relates to the investment timing, whereas in option models of
investment under uncertainty the investment trigger is a strategic choice
parameter that, in turn, defines the random time of investment. For option
games a necessary useful step is to consider that players select an invest-
ment trigger, rather than a predetermined investment timing directly.
Consider first the deterministic case. The investment strategy for firm
i here consists in choosing a time Ti (Ti ≥ t0) at which to invest and incur
the sunk investment cost I . By contrast to the previous chapter where
we assumed competitors invest (collusively) simultaneously, here the two
firms are symmetric but may choose distinct investment times (Ti and
3. This holds if there are negative externalities from capacity expansion or, equivalently, if
the inverse demand function is downward sloping.
4. Assuming no arbitrage opportunities in a complete market, the appropriate discount
rate is the risk-free interest rate, r.
5. Reinganum (1981a) models the incentive to delay investment in a setting involving a
constant profit flow and an investment cost decreasing over time. Here these assumptions
are reversed: profits are growing with time and investment cost is constant whether invest-
ment occurs today or in the future, independently of the discounting effect. The net effect
on the incentive to wait is analogous.
334 Chapter 11
Tj). When the first of the two thresholds (min {Ti , Tj }) is reached, at least
one of the firms invests. Three industry structures may occur:
1. No one invests in additional capacity. When no firm has yet invested

in additional capacity, each firm already earns at time t a profit amount-
ing to π 0 exp ( gt ), with π 0 ≥ 0. This industry structure occurs for t such
that t0 ≤ t ≤ min {Ti , Tj }.
2. Only one firm invests. If the lowest investment time threshold is
reached, but not yet the second one, there emerges an industry structure
involving a “leader” and a “follower” wherein only one firm (the leader)
expands capacity. The leader earns a higher profit (π L > π 0) as it benefits
from capacity expansion, the follower being unfavorably affected by its
rival’s investment through negative externalities, such as price decrease
in Cournot quantity competition. The follower receives a lower profit
π F ( < π 0 ).6 There are two types of possible leader–follower industry
structures: for Ti ≤ t ≤ Tj, firm i is the leader and firm j the follower; for
Tj ≤ t ≤ Ti, the roles are reversed.
3. Both firms invest (expand capacity). If both time thresholds are
exceeded, both firms invest in additional production capacity. For
t ≥ max {Ti , Tj } ≥ 0 both firms earn at time t a profit equal to π C e gt,
with π L > π C > π F. The leader suffers somewhat from a capacity expan-
sion by its rival.7
Table 11.1 summarizes the profits for the duopolist firms depending on
the time elapsed. Note that the profit firms earn depends on their rival’s
investment strategy. The value (payoff) is consequently affected by stra-
tegic interactions. The optimal investment strategies must thus be part
of an industry Nash equilibrium.
Suppose further that there is a higher incentive to invest as a leader
than as a follower; that is, the value increment from leadership (π L − π 0 )
is larger than the value increment from followership (π C − π F ). Suppose
as well that no firm has an incentive to invest right at the outset.8
Consider next the time thresholds of the leader (TL) and the follower
(TF ). Which player actually becomes the leader or the follower is dis-
cussed later. Suppose a weak ordering of firm roles with firm i being
6. These profit flows substitute for the initial profit flow π 0. They do not represent the
additional profit from the new investment, but the overall profit after the new investment.
In case of capacity expansion, π L is the total profit of the leader stemming from the old
and the new capacities, and π F from the old capacity of the follower. L stands for leader
and F for follower. Note that the notions of leader and follower here are different than in
a Stackelberg game setting.
7. The subscript C stands∞for competition.
8. To ensure this, we set ∫ 0 π 0 e −(r − g )t dt − I < 0 .
Table 11.1
Profits for capacity-expanding duopolists depending on timing
Profits
Time Industry structure Firm i Firm j
t ≤ min {Ti , Tj } No one invests π 0 e gt π 0 e gt

Ti ≤ t ≤ Tj π L e gt π F e gt
Only one invests
Tj ≤ t ≤ Ti π F e gt π L e gt
t ≥ max {Ti , Tj } Both firms invest π C e gt π C e gt
Note: π L > π C > π F and π L > π 0 > π F .
the leader. This occurs if Ti ≤ Tj. In the “history” of the game (with
t0 = 0 < Ti = TL), the leader will go through three different time stages
characterized by distinct profit flows.9 When the market is far from
being sufficiently profitable for a new investment to occur (for
t ≤ min {Ti , Tj }), the leader earns π 0 exp ( gt ) at time t. The present value of
the deterministic profits earned before the leader invests in additional
TL TL
capacity at time TL is ∫ π 0 e gt e − rt dt = ∫ π 0 e −δ t dt with δ ≡ r − g ( > 0 ) being
0 0
some form of dividend yield or opportunity cost of waiting. In the fol-
lowing stage, when Ti ≤ t ≤ Tj, firm i gains a leader status earning π L e gt
at time t. The value of being (during that period) the stand-alone
TF
investor in new production capacity is ∫ π L e −δ t dt. In the third stage
TL
(t ≥ max {Ti , Tj } or t ≥ Tj ≥ Ti), firm i competes head-on with firm j,
earning duopoly profits π C e gt.10 The value for firm i in this stage where
∞
both duopolists have expanded capacity is ∫ π C e −δ t dt. The leader incurs
TF
at time of investment (TL) the given investment outlay I , which must be
discounted back at the present time.11 The present value accruing to the
leading firm i (in case t0 < TL) is the sum of the values in each of the three
stages:
9. If firms invest at the same time, meaning Ti = Tj , the second region (Ti , Tj ) reduces to a
null set.
10. The leader does not have a sustainable competitive advantage (first-mover advantage)
through being the sole investor in the previous stage; that is, it earns exactly the same
profit as its rival in the third stage. Whether a firm has gained a sustainable advantage by
being the first investor is a tricky issue from a game-theoretic viewpoint. This question is
central to understanding the Stackelberg model of duopoly. In the competition stage, the
Cournot outcome for the reduced-form profit may be more realistic than the result
obtained under the Stackelberg leader-follower model since the latter may be time-
inconsistent (see section 8.2 in Tirole 1988). This inconsistency justifies the assumption of
the model by Reinganum (1981a).
11. Since there is no uncertainty concerning the market development, there is no need to
use expectation in the value expression. Models involving uncertainty differ on that
dimension.
336 Chapter 11
TL TF ∞
Li (TL , TF ) = ∫ π 0 e −δ t dt + ∫ π L e −δ t dt + ∫ π C e −δ t dt − I e− rTL . (11.1)
0 TL TF
For the follower there are also three distinguished stages. Table 11.1 also
identifies those stages. The value of firm j as a follower is given by
TL TF ∞
Fj (TL , TF ) = ∫ π 0 e −δ t dt + ∫ π F e −δ t dt + ∫ π C e −δ t dt − I e− rTF . (11.2)
0 TL TF
By symmetry, firm j (firm i)’s value as leader (follower) is identical.

As before, the value function of the firm is strictly concave in its own
action due to the contrarian effects of growth (g > 0) and discounting
(r > 0). The condition δ ≡ r − g > 0 ensures that the investment time is
finite. The optimal investment time is found at the point where the
first-order derivative of the value function equals zero. In other
words, TL* ( > 0 ) is such that
∂Li
(TL*, TF ) = − (π L − π 0 ) e−δ TL* + rI e− r TL* = 0 ,
∂TL
or
⎛ π L − π 0 ⎞ e gTL* = r ,
⎜⎝ ⎟ (11.3)
I ⎠
with TL* = ln (rI (π L − π 0 )) g. This is the Jorgensonian rule for expanding
investment under certainty. At the optimal time of investment, the
project’s excess return on investment equals the cost of capital, or
equivalently one should invest in additional capacity the first time the
project’s excess return on investment exceeds the cost of capital, r.
Alternatively, one can obtain from equation (11.3) the optimal time for
the leader TL* based on the following profitability index investment rule:
⎛ VL − V0 ⎞ e gTL* = b ,
⎜⎝ ⎟ (11.4)
I ⎠ b−1
where b ≡ r g . The optimal investment time for the follower can be deter-
mined and interpreted similarly:
⎛ π C − π F ⎞ e gTF * = r V − VF ⎞ gTF *
or ⎛⎜ C =
b
⎜⎝ ⎟⎠ ⎝ ⎟⎠ e . (11.5)
I I b−1
In this case as well, it is optimal for the follower to invest at the
time when the excess return on investment equals the interest rate, r.
TL* and TF * are not explicit (reaction) functions of the rival’s investment
time.
Consider also a third time threshold TP * at which the two firms are
indifferent between being a leader investing at TP * or a follower with the
rival investing at TP *:12
Li (TP *, TF *) = Fi (TP *, TF *). (11.6)
Before this time, that is for Ti < TP *, a firm is better off delaying invest-
ment than investing right now since Li (Ti , TF *) < Fi (Ti , TF *). After this
indifference point (Ti > TP *) there is an incentive to become leader
as Li (Ti , TF *) > Fi (Ti , TF *). It also holds that TP * < TL* < TF *.13
To determine the Nash equilibria, we need to consider the best-reply
functions for firms i and j. Suppose that firm j selects beforehand an
investment time Tj strictly higher than TP *. During the period (TP *, Tj )
there exists a first-mover advantage for firm i, in that firm i is
better off investing now as a leader than delaying investment
further; in such a case firm i optimally chooses to invest at time TL* as
per equation (11.4) above. If, however, firm j were to invest early,
before time TP * (Tj < TP *), firm i will wait, optimally investing as a fol-
lower at time TF * as given in equation (11.5). If firm j chooses to invest
at exactly time TP *, firm i maximizes its value by either selecting TL* as
in equation (11.4) or TF * as in equation (11.5). Thus the reaction function
of firm i with respect to the investment time chosen by its rival, firm j, is
given by
⎧TF * if Tj < TP *,
⎪
Ri (Tj ) ≡ Ti * (Tj ) = ⎨{TL*, TF *} if Tj = TP *,
⎪T * if Tj > TP *.
⎩ L
The reaction functions for firms i and j are illustrated in figure 11.1, with
firm j’s best-reply function being obtained symmetrically.
As seen in figure 11.1, there are two Nash equilibria in pure strategies.
The best-reply functions intersect at two distinct points: (TL*, TF *) and
(TF *, TL*). The first Nash equilibrium is that firm i invests as a leader
and firm j as a follower, namely (TL *, TF *) *. The second one is that firm
j takes the lead with firm i following suit, namely (TF *, TL*) *. These two
12. The subscript P stands for preemption. This point is discussed in detail in the following
chapter.
13. Set f (T ) ≡ Li(T , TF *) − Fi(T , TF *) . f (⋅) is continuous and strictly increasing on (t0 , TF *) .
By assumption, Li(t0 , TF *) < Fi( t0 , TF *) or f (t0 ) < 0 . As noted, the leader enjoys a first-
mover advantage with Li(TL*, TF *) > Fi(TL*, TF *) or f (TL*) > 0. By strict monotonicity, the
root of f (⋅)—which, according to equation (11.6), corresponds to the (preemption) point
TP *—obtains to be unique with t0 < TP* < TL*.
338 Chapter 11
Firm i’s
strategy Ti
Firm i ’s
best-reply
function
Ri (Tj)
TF *
(TF*, TL*)*
TP*
Firm j’s
best-reply
function
Ri (Ti)
TL*
(TL*, TF*)*
TL* TP* TF * Firm j’s strategy Tj
Figure 11.1
Best-reply functions for symmetric firms i and j
Nash equilibria share a common feature: they both involve sequential

investment where one firm invests as leader and the second one as fol-
lower. Such a sequential ordering is coined diffusion by Reinganum
(1981a) who applied this framework to the analysis of the adoption of
new technologies by competing firms. Time TL* is determined by the
modified Jorgensonian rule of investment in equation (11.4), whereas
TF * satisfies equation (11.5).
Which of the two Nash equilibria in pure strategies is the most reason-
able to expect is not specified a priori. Note the difference between
this model and the situation in chapter 10. Previously we assumed
that symmetric firms invest simultaneously. Here, in contrast, given
the pure-strategy equilibria for symmetric firms—based on the model
assumptions of Reinganum (1981a)—simultaneous investment never
happens due to strategic interaction. Simultaneous investment is not a
pure-strategy Nash equilibrium in a duopoly with identical firms and
can only be sustained by collusive behavior in the marketplace. Another
interesting outcome is that the values the firms receive are decreasing
in the order of entry, meaning that the leader receives a higher
value than the second entrant in equilibrium.14 The leader thus enjoys a
first-mover advantage stemming from the monopoly “rents” it earns
before the rival’s expansion.
As suggested by Reinganum (1981a), this deterministic analysis can
be generalized in three directions:
• It can be extended to an oligopoly consisting of n firms (rather than
two firms in a duopoly). Such a situation is discussed by Reinganum
(1981b). Although such an analysis is more involved, the end result is
essentially the same: there are several Nash equilibria in pure strategies
but none involves simultaneous investment. Each Nash equilibrium
involves a sequential ordering of firms’ investment.15
• It can be extended to asymmetric firms, as in Flaherty (1977).
• It can be extended by considering stochastically evolving profit values
(π 0, π L, π F, and π C).
In the following sections we discuss these extensions and provide

refinements allowing for uncertainty in market development. We also
extend the analysis by assuming asymmetric firms to allow for a more
natural (focal-point) ordering of firms’ investment timing.16 Finally, we
extend the previous analysis to the case of a large oligopoly facing uncer-
tain market development.
11.2 Duopoly with Sequential Investment under Uncertainty
In this section we consider the option to invest in a duopoly under uncer-

tainty (with stochastic profits) and examine the industry dynamics
when one of the firms has a substantial competitive (e.g., cost)
advantage justifying a natural leader–follower industry structure. Joaquin
and Butler (2000) follow a similar analysis based on a specific sto-
chastic process—geometric Brownian motion—assuming that (certain)
14. By definition of the Nash equilibrium, L (TL*, TF *) ≥ L (TF *, TF *) . Since firms are sym-
metric, L (TF *, TF *) = F (TF *, TF *). Since the follower’s value is increasing in its rival’s
entry time, F (TF *, TF *) > F (TL*, TF *), and so the value decreases in the order of entry
L (TL*, TF *) > F (TL*, TF *) .
15. Within a sequence of n firm investments, roles are interchangeable. Thus there are n!
pure-strategy Nash equilibria.
16. If Pareto optimality is defined from the firms’ perspective, the Pareto-optimal sequence
corresponds to the open-loop sequence with the advantaged firm investing first. In chapter
12 we show that for large firm asymmetry, the outcome of the Pareto-optimal investment
sequence corresponds to the outcome of the perfect equilibrium in closed-loop strategies.
To avoid technical discussions early on, we assume for now that the investment sequence
with the advantaged firm investing first is more “natural” or “focal” as being Pareto
optimal. As shown later, this assumption is reasonable when asymmetry is substantial,
namely if the difference among firms is higher than a certain threshold.
340 Chapter 11
profits are Cournot outcomes in simultaneous quantity competition.

Their model is therefore a special case of the one we elaborate herein.
The approach herein is general and tractable to different stochastic pro-
cesses and market demand functions.
Consider two firms in a duopoly sharing an option to export to a
developing country (where they are not yet present) by expanding the
size of their domestic production plant (new market model). The main
source of uncertainty here is the exchange rate at which firms repatriate
profits from the foreign country into domestic currency. Suppose that
due to a cost advantage one of the firms (firm i) is more likely to become
a leader. When the market is just large enough for only one player, firm
i due to its competitive advantage is the first (only) one to invest; the
follower (firm j) will wait for the market to develop further before decid-
ing whether to also invest. When the market is too small, no one invests
and the two firms earn no profits. At the market’s early stage, only one
firm (the leader) can invest and earn positive economic profits. Firm i
invests, earning monopoly rents, while the follower waits, receiving
nothing for the time being. When the market becomes more mature (i.e.,
large enough to accommodate both firms), the follower also enters and
both compete in the foreign marketplace, earning Cournot duopoly
profits. Table 11.2 summarizes the profits in the resulting three stages.
Uncertainty enters as a multiplicative stochastic exogenous shock (the
exchange rate) X t , which follows a (time-homogeneous) Itô process
according to the stochastic differential equation
dX t = g ( X t ) dt + σ ( X t ) dzt. (11.7)
The value of the process at the beginning (i.e., at time t0 = 0) is denoted

by X 0. We assume as before that stochastic profits can be decomposed
into two components, the multiplicative shock X t and a deterministic
profit component, π L or π C. We proceed by considering the follower’s
Table 11.2
Profits for duopolist firms in three development stages
Stochastic profits Certain profits
Time Industry structure Firm i Firm j Firm i Firm j
t ≤ TL No one invests 0 0 0 0

TL ≤ t ≤ TF Only one invests (firm i leads) π Li 0 π Li 0
t ≥ TF Both firms invest π Ci π Cj π Ci π Cj
optimal strategy first as it does not depend on the leader’s market-entry

choice. We analyze the leader’s strategy formulation subsequently.
Investment Decision of the Second Entrant (Follower)

The follower contemplates investing in the foreign country when the
trigger exchange rate it has chosen, XT , is first reached at random time
{ }
T ≡ inf t ≥ t0 ⏐ X t ≥ XT . The forward net present value at time T is
NPVT ≡ VT − I with VT ≡ V ( XT ) . For X 0 ≤ XT , the expected present
value accruing to the follower Fj (⋅), given that it selects the strategy to
invest at time T , is
Fj ( XT ) = NPVT B0 (T ) = (VT − I ) B0 (T ). (11.8)
The follower may either invest immediately (at time t0 = 0) and get the
static NPV0 ≡ V0 − I or defer the investment until time T , receiving today
Fj ( XT ) as per (11.8) instead. The firm has an option to postpone invest-
ment and will optimally invest when the investment trigger X F * that
maximizes the follower’s value Fj (⋅) in equation (11.8) is first reached,
provided this critical target value has not previously been reached (i.e.,
provided that X 0 ≤ X F *). The optimal trigger X F * for the follower satis-
fies the first-order condition
V*
= Π ( X F *), (11.9)
I
where, as before, Π ( XT ) measures the profitability of the strategy
that prescribes to invest at a specified trigger level XT . This measure is
given by
ε B ( XT )
Π ( XT ) = . (11.10)
ε B ( XT ) + ε V ( XT )
Π ( X F *) is the profitability required when the firm formulates the optimal
investment strategy. Equation (11.9) above shows that the follower can
choose its trigger myopically, meaning its investment trigger is exactly
the same as the one it would have chosen as a monopolistic option holder
earning π Fj ( X t ) in perpetuity from time TF * on.
The value of the option for follower firm j given that it follows
the optimal investment strategy given in equation (11.9) reads
therefore
Fj ( X F *) = [Π ( X F *) − 1] IB0 (TF *), (11.11)
{ }
where TF * = inf t ≥ 0⏐ X t ≥ X F * and Π ( X F *) − 1 is the excess profitabil-
ity index (higher than zero). This is the same value expression for the
342 Chapter 11
monopolist in equation (9.20). The follower thus invests as if it were a

monopolist ignoring rivals.
Investment Decision of the First Entrant (Leader)

The value of the leader, however, is linked to the follower’s decision
concerning investment timing. When the incumbency profits are suffi-
ciently high for the leader to profitably enter (but not large enough for
the follower to invest), it will earn temporary monopoly profits until the
follower also enters. If X 0 < X L, the history of the market for the leader
is characterized by three sequential stages.
• In the first stage (t0 ≤ t ≤ TL), the leader earns no profit (while no one
invests).
• In the second stage (T L ≤ t ≤ TF *), the leader invests at time TL and
earns temporary monopoly profits until the follower (firm j) also invests
at future (random) optimal time TF *.
• Once the follower has also entered the market (t ≥ T F *), the leader
receives reduced-form duopoly profits.
There is a discontinuity in the leader’s profit function at the time the

follower’s investment takes place: before TF * the leader receives monop-
oly profits but just after the rival enters the leader’s profit jumps down
to competitive duopoly rents (π Ci (⋅) < π Li (⋅)).17 The leader’s value—given
that it invests at time TL (and that t0 < TL)—is the sum of the values
earned in these stages. It is given by18

Li ( X L , X F *) = Eˆ 0 ⎡ ∫ π Li ( X t ) e − rt dt + ∫ π Ci ( X t ) e − rt dt − I e− rTL ⎤.
TF * ∞
⎣⎢ TL TF * ⎦⎥
(11.12)
In the first stage [ t0 , TL ), no one invests and the leader earns zero
profit; in the second stage [TL, TF *), the leader receives stochastic monop-
oly rents π Li (discounted back to present time t0 = 0); in the third stage
[TF *, ∞ ), profits are eroded due to the arrival of competition with profits
reduced to duopoly competition rents π Ci. Alternatively, one can re-
formulate equation (11.12) as
Li ( X L , X F *) = f1(TL ) − f2 (TF *) (11.12′)
where the functions f1(⋅) and f2(⋅) are given by

17. There is no sustainable first-mover competitive advantage for the first entrant.
18. Ê0[⋅] stands for the risk-neutral expectation conditional on the information available
at time t = 0 .
f1(TL ) = Eˆ 0 ⎡ ∫ π Li ( X t ) e − rt dt ⎤ − I B0 (TL ) = [VTL (π Li ) − I ] B0 (TL )

∞
⎣ TL ⎦
= NPVTL B0 (TL )
f2 (TF *) = Eˆ 0 ⎡ ∫ (π Li − π Ci ) ( X t ) e − rt dt ⎤ = [VTF * (π Li − π Ci )] B0 (TF *).

∞
⎣ TF * ⎦
Note that function f2 (⋅) drops out in the first-order derivative of
Li (⋅, X F *). In other words, the profit in the second period (duopoly profit)
does not impact the leader’s optimal investment strategy X L* or, equiva-
lently, the trigger is selected myopically. The first-order condition leads
to the following profitability-index formula:
V * = Π ( X L*) I ,
with Π (⋅) defined as in equation (11.10). The Nash equilibrium value

(expanded NPV) of the leader is thus
Li ( X L*, XC *) = [VTL * (π Li ) − I ] B0 (TL*) − VTF *(π Li − π Ci ) B0 (TF *) (11.13)
for X 0 < X L*. The option value for the first entrant (leader) consists of
two terms. The first term, [VTL * (π L ) − I ] B0 (TL*), is the standard deferral
option value for a monopolist since the profit as leader in the second
time period (TL * ≤ t ≤ TF *) equals the monopoly rent. The forward NPV,
VTL * (π L ) − I , received at random time TL* is discounted back with use of
the expected discount factor linked to the optimal investment time TL*
of the leader, B0 (TL*). This expanded NPV for the leader (as monopo-
list) is, however, eroded due to the competitive (follower’s) arrival.19
Two effects must be accounted for. On one hand, the first entrant loses
its monopoly profit stream in perpetuity when the second entrant decides
to invest (at random time TF *); on the other hand, from that time
on, it earns competitive duopoly profits in perpetuity. This second
(competitive-erosion) component, VTF * (π L − π C ), is discounted back with
use of the expected discount factor B0 (TF *), which depends on when the
second entrant invests—not on the investment decision of the first
entrant. This is the reason why the second component “disappears” when
one computes the first-order derivative of the leader’s function and why
the investment trigger is selected myopically in this setup. Figure 11.2
presents the market structure regions depending on the value reached
by the exogenous stochastic demand shock X t .
Consider an application from the energy sector. Suppose that two
European electric utilities, Enel of Italy and Eon of Germany,
19. Note that VTF *(π L − π C ) is positive as π L > π C.
344 Chapter 11
No investment Monopoly Duopoly
−∞ XL* XF * ∞
Figure 11.2
Exogenous demand regions and market structure
Firms are operating under the indicated market structures once the exogenous demand
shock variable ( X t ) enters one of these demand regions.
Table 11.3
Profits in asymmetric Cournot duopoly
Industry structure Monopoly profits Duopoly profits
Leader π Li =
(a − ci ) ²
π Ci =
(a − 2ci + c j )2
4b 9b
Follower NA π Cj =
(a − 2c j + ci )2
9b
contemplate investing in an eastern European market, sharing an option

to invest. The local currency has had an annual drift of g percent and is
expected to move forward similarly, though realized future growth will
likely fluctuate around this long-term average depending on the volatility
σ . Suppose that the exchange rate follows geometric Brownian motion
of the form
dX t = ( gX t ) dt + (σ X t ) dzt, (11.14)
where zt is a standard Brownian motion.20 The (deterministic) profit

component in local currency is driven by the (inverse) linear demand
function
p (Q) = a − bQ, (11.15)
where Q is total industry output. Each firm’s strategy once in the market
consists in selecting its output given its rival’s strategy. Equilibrium
(reduced-form) profits are Cournot duopoly outcomes as obtained previ-
ously in chapter 3. They are summarized in table 11.3.
The case above corresponds to a continuous-time extension of the
model of Smit and Trigeorgis (1997) by Joaquin and Butler (2000), which
provides valuable insights into real-world investment games. Here the
sequence of investment is driven by cost asymmetry in the industry. If
20. For technical reasons (finiteness of the first-hitting time), we assume that gˆ ≡ r − δ > (σ 2 2).
one of the two firms invests first, it will enter at the time when the leader’s
optimal investment threshold is first reached. The first entrant will tem-
porarily earn monopoly profits up to the random time when the fol-
lower’s trigger value X F * is reached. Thereafter, as both firms are
operating in the market, they will earn asymmetric Cournot profits. The
first entrant will earn Cournot duopoly rents, just as its rival.
Such sequential investment is characteristic of an industry with asym-
metric costs. In such a sequential game there exist two Nash equilibria
in pure strategies: (1) the low-cost firm enters first and the high-cost firm
second and (2) the high-cost firm enters first and the low-cost firm
second. The reader can intuit which of the two equilibria is likely to
occur. As discussed in the discrete-time analysis in the Cournot setup,
use of Schelling’s (1960) focal-point argument suggests a more likely
Nash equilibrium solution for this sequential investment game. The two
competing firms may agree that the Pareto-optimal equilibrium is a focal
point of the game. Social optimality is reached when the low-cost firm
invests first since higher cumulative profits are reached. A social planner
would have an incentive to promote this equilibrium and enforce it on
the two firms.21
Suppose that here firm i has a substantial cost advantage ensuring it
the position of cost leader. Firm j is the follower. In this case the equi-
librium value for firm j as follower from (11.11) is
β1 β1
⎛πj ⎞⎛ X ⎞ ⎛ X ⎞
Fj ( X F *) = ⎜ C X F * − I ⎟ ⎜ 0 ⎟ = (Π* −1) I ⎜ 0 ⎟ , (11.16)
⎝ δ ⎠ ⎝ X F *⎠ ⎝ X F *⎠
where β1 (in the risk-neutral case) is given by

αˆ ⎛ αˆ ⎞
2
r
β1 = − + ⎜ ⎟ +2 2 ( > 1) (11.17)
σ 2 ⎝ σ 2⎠
σ
with αˆ = gˆ − (σ 2 2), ĝ = r − δ , Π* = β1 ( β1 − 1) is the profitability index
and the investment trigger X F * satisfies the modified Jorgensonian rule
of investment,
⎛ β ⎞ 9 bδ π Cj X F * 1
XF * = ⎜ 1 ⎟ I , or = r + β1σ 2 . (11.18)
⎝ β 1 − 1 ⎠ ( a − 2 c H + cL ) 2 I 2
The equilibrium value for the leader (firm i) from (11.13) is (for X 0 < X L*);
then
21. Later in chapter 12 it is shown that this focal-point equilibrium is obtained as a perfect
equilibrium in mixed-strategies if the cost advantage of the low-cost firm is sufficiently
high.
346 Chapter 11
β1 β1
⎛πi ⎞⎛ X ⎞ X *⎤ ⎛ X ⎞
Li ( X L*, X F *) = ⎜ L X L* − I ⎟ ⎜ 0 ⎟ − ⎡⎢(π Li − π Ci ) F ⎥ ⎜ 0 ⎟ ,
⎝ δ ⎠ ⎝ X L* ⎠ ⎣ δ ⎦ ⎝ X F *⎠
(11.19)
with δ ≡ k − g = r − ĝ ( > 0 ) being a form of convenience or dividend yield,

and X L* such that
⎛ β ⎞ 4 bδ π Lj X L* 1
X L* = ⎜ 1 ⎟ I , or = r + β1σ 2 . (11.20)
⎝ β1 − 1⎠ (a − cL )2 I 2
The two equations above confirm the results obtained by Joaquin and
Butler (2000). They are analogous to equation (9.25).
Example 11.1 Duopoly

Consider two firms competing in quantity. The linear (inverse) demand
in equation (11.15) is characterized by a = 50 and b = 5. The duopolists
face cost asymmetry: the unit cost for the low-cost producer is cL = 18,
and cH = 20 for the high-cost firm. The investment cost (exercise price)
I amounts to &500 m. The risk-free rate is r = 6 percent. The opportunity
cost of delaying or dividend yield is δ = 4 percent. The risk-neutral
drift for the foreign country is thus gˆ ≡ r − δ = 0.02. The volatility of
the exchange rate is σ = 0.10 and αˆ = gˆ − (σ 2 2) = 0.015. Given these
parameters, the elasticity of the investment option based on equation
(11.17) is
2 (0.06 )
2
+ ⎛⎜
0.015 0.015 ⎞
β1 = − ⎟ + ≈ 2.27.
0.10 2 ⎝ 0.10 ⎠
2
0.10 2
The investment trigger of the second-entrant obtained from equation
(11.18) is
2.27 ⎞ 9 × 5 × 0.04
X F * = ⎛⎜ × 500 = 2.05.
⎝ 2.27 − 1⎟⎠ ( 50 − 2 × 20 + 18 )2
From equation (11.20), the investment trigger for the low-cost firm is
X L * = 0.70.22 By substituting these values into the expanded-NPV
expression for the follower and the leader in equations (11.16) and
(11.19), one gets the deferral option value of the two firms as a function
of the initial value X0. Figure 11.3 shows simulated results for this example.
The y-axis represents the value functions of the leader and the follower
22. We consider here the focal-point equilibrium where the first entrant is the low-cost
firm and the high-cost firm is the second entrant. Readers may derive the second Nash
equilibrium as an exercise.
Project value
(in millions of euros)
1,250
1,000
E-NPV
750 leader
500
E-NPV
follower
250
NPV
follower
0
0.0 0.5 1.0 1.5 2.0 2.5
XL* XF*
Initial value X0
Figure 11.3
Leader and follower values in asymmetric duopoly
The deterministic linear demand and profit function parameters are a = 50, b = 5, cL = 18 ,
and cH = 20 . The parameters of the stochastic (risk-neutral) process (GBM) are r = 6
percent, δ = 4 percent, and σ = 10 percent. Investment cost is I = 500.
in equilibrium, with the low-cost firm being the leader and the high-cost
firm the follower, for the relevant exchange-rate regions. A kink in the
leader’s value at the follower’s investment trigger X F * = 2.05 is readily
seen. The shape of the value function for the follower is similar to the
one in the case of a monopolist having a deferral call option; this stems
from the myopic stance of the follower. The follower’s NPV is tangent
to this curve at XF*.
When the cost differential between the two firms gets very high
(approaching infinite), the result of the previous model reduces to
McDonald and Siegel’s (1986) result for the investment-timing
problem of a monopolist. In this case the high-cost firm never enters
and the low-cost firm (as first entrant) enjoys monopoly profits in
perpetuity.
The preceding model of sequential investment may be realistic than
the previous models involving simultaneous investment—which assumed
simultaneous investment is the industry equilibrium. The asymmetric
model presented here stresses the importance of asymmetric variable
348 Chapter 11
costs and cost leadership in investment timing games.23 In addition to the

traditional, profit-flow benefits a firm obtains from following a generic
cost-leadership strategy, the asymmetric nature of the cost advantage has
a critical impact on the firms’ future behavior and investment strategies
and is therefore also beneficial from a dynamic perspective. A delayed
competitive entry may result due to a substantial cost advantage enjoyed
by the leader, resulting in higher firm value.
11.3 Oligopoly with Sequential Investment under Uncertainty
In this section we generalize the insights from the previous duopoly

model involving sequential investment under uncertainty to the case of
an oligopoly consisting of n active firms. Here the firms’ investment roles
are given exogenously and the investment game is characterized by a
sequence of investments where roles are pre-assigned to firms. This
“natural” sequential investment may result, for instance, from “substan-
tial” cost asymmetries among firms active in the industry.24 The uncertain
profit accruing to firm i (i = 1, . . ., n ) is denoted by π i ( m), where m is the
number of firms which have already invested. The initial value of the
stochastic process is X 0. The risk-free interest rate is r and option-
holding firms have the same beliefs about the underlying exogenous
shock evolution (drift and diffusion terms). If firm i has already
invested, its profit will drop if a new rival firm enters the market,
causing discontinuity in the profit flow. Formally, π i ( m) is such that
π i ( m + 1) ≤ π i ( m) for all m = 1, . . ., n − 1.25 The investment cost (exercise
price) I i is specific to firm i ( i = 1, . . ., n).
Firm i’s investment strategy consists in choosing a future target value
X i ( ≥ X 0 ) for the stochastic variable X t and investing when this
23. When the low-cost firm is the first entrant (as ∂X Li* ∂ci > 0 and ∂X Fj * ∂ci < 0 ), a
decrease in cost creates a multiple cost advantage for the low-cost firm: (1) it lowers its
investment trigger such that it is more likely to invest earlier, (2) it increases the investment
trigger of the second entrant (high-cost firm) such that the first entrant enjoys temporary
monopoly profits for a longer period (it enters earlier and faces competition later), (3) it
increases its profits as Cournot duopolist in the second stage once the high-cost firm
enters.
24. See the discussion in note 16 above.
25. In case of quantity competition in a Cournot oligopoly, the certain equilibrium profits
for an oligopoly with m identical firms are given in equation (3.20) as
( )
2
1 a−c
π C ( m) = .
b m+1
In case of an additional multiplicative shock, this deterministic profit flow can be readily
transformed to a stochastic profit flow by multiplying by X t .
investment trigger is first reached at random time Ti. The value of firm i
when it follows the strategy to invest upon first reaching X i is
denoted by Fi ( X i , X − i ), where X − i stands for the investment triggers of
all other firms except firm i. What really matters is to determine the
investment trigger X i * when firm i should optimally invest. In Nash
equilibrium, X i * maximizes Fi (⋅, X − i *) given that rivals also act optimally
following investment triggers X − i *. In such an oligopoly game where
followers’ entries affect the investment value of incumbent firms, the
values of all entrants (except the last one) depend on when and how
many other firms enter afterwards. Assuming X 0 < X i *, the value for firm
i is given by

Fi ( X i , X − i ) = Eˆ 0 ⎡ ∫ π i (i ) e − rt dt − I i e − rTi + ∫ π i (i + 1) e − rt dt + … +
Ti +1 Ti + 2
⎢⎣ Ti Ti +1
∞
∫Tn π i ( n) e− rt dt ⎤⎦
⎡ n Tm+1
( ⎤
= Eˆ 0 ⎢ ∑ ∫ π i ( m) B0 ( t ) dt ⎥ − I i B0 (Ti )
⎣ m=i Tm
⎦
)
where Tn+ 1 = ∞ by convention and B0 (Ti ) is the expected discount factor

appropriate to discount flows received at random time T into today’s
value (time t0 = 0). The value of firm i (ith investor) obtains as26
n
Fi ( X i , X − i ) = [VTi ( i ) − I i ] B0 (Ti ) − ∑ [V Tm ( m − 1) − VTm ( m)] B0(Tm ),
m= i +1
(11.21)
where VTm ( m) is the perpetuity value to firm i valued at future (random)

time Tm when the mth active firm enters. The expression in equation
26. Letting T ≡ (T1 , . . ., Tn ) and
⎡ n
g (T ) = Eˆ 0 ⎢ ∑
⎣ m =i
(∫ Tm+ 1
Tm )⎤
π i (m) B0 (t )dt ⎥,
⎦
one obtains
n
g (T ) = Eˆ 0 ⎡⎢ ∫ π i ( n) B0 (t ) dt ⎤⎥ + ∑ Eˆ 0 ⎡∫ {π i ( m − 1) − π i ( m)} B0 ( t ) dt ⎤ − Eˆ 0 ⎡∫ π i ( i ) B0 ( t ) dt ⎤ .
∞ Tm Ti
⎣ 0 ⎦ m=i+1 ⎣⎢ 0 ⎦⎥ ⎣⎢ 0 ⎦⎥
∞
Let VT ( n) ≡ Eˆ 0 ⎡⎢∫ π i ( n ) BT (t ) dt ⎤⎥ . From equation (A.45) in the appendix we have
⎣ T ⎦
Ê0 ⎡⎢ ∫ π ( X t ) B0( t ) dt ⎤⎥ = V0 − B0(T ) VT .

T
⎣ 0 ⎦
Hence
⎧ n
⎫ n
g (T ) = ⎨V0(n) + ∑ [V0(m − 1) − V0( m)] − V0 (i )⎬ + ∑ B0(Tm ) [VTm (m) − VTm ( m − 1)] + B0(Ti ) VTi (i ) .
⎩ m =i +1 ⎭ m= i + 1
Recognizing that the term in brackets {⋅} is zero, we see that equation (11.21) above results.
350 Chapter 11
(11.21) can be interpreted as follows. At time Ti, firm i invests and receives
the forward net present value, VTi (i ) − I i, consisting of the perpetuity
profit value VTi (i ) minus the investment cost (I i) incurred by firm i at that
time. Given that the investment occurs at random time Ti, the appropri-
ate expected discount factor is B0 (Ti ). Subsequently, at each random
time Tm ( m ≥ i + 1) when a new competitor enters, the incumbent firm
i has to give up or “exchange” its perpetuity profit value under the old
industry setting (with m − 1 operating firms) for a new, reduced perpetu-
ity value under the new industry structure (with m firms). The value of
this “exchange,” VTm ( m − 1) − VTm ( m) , occurring at each random entry
time Tm is discounted to the present time (time t0 = 0) by the expected
discount factor B0 (Tm ). This occurs for all subsequent competitive arriv-
als, hence the summation. In effect the second term in equation (11.21)
represents the present value of competitive erosion. Note that this com-
petitive loss does not depend on the investment time Ti of firm i and is
consequently independent of firm i’s investment strategy. It only depends
on the timing of other rival firm entries (T− i). In this sense it can be
treated as exogenous by firm i. When firm i selects its optimal investment
strategy, terms depending on its followers’ investment strategies drop
out. Therefore firm i can behave in a myopic way and choose its optimal
strategy regardless of followers’ investment time schedules. The optimal
investment triggers are given by the usual first-order condition that holds
for myopic firms in equilibrium, namely
V* − I ε ( X *)
=− V i . (11.22)
V* ε B( X i *)
The optimal investment rule is, equivalently,
V * = Π ( X i *) I , (11.22′)
where the elasticity of the discount factor, of the forward value and the
profitability index are given, respectively, by
XT
ε B ( XT ) = − BX ( XT ) × ,
B0 ( XT )
XT
ε V ( XT ) = −VX ( XT ) × ,
VT ( XT )
ε B ( XT )
Π ( XT ) = .
ε B ( X T ) + ε V ( XT )
Suppose that the industrywide shock X t is multiplicative (e.g., being an

exchange rate) and follows the geometric Brownian motion of equation
(11.14). The stochastic profit flow then is π i ( m) = X t π i ( m) and the elas-
ticity of the terminal value becomes ε V = −1. The elasticity of the expected
discount factor ε B is β1. The optimal investment trigger for firm i, X i *,
from equation (11.22′) is then given by
Π*I
Xi * = , (11.23)
Vi (i)
where Vi (i) ≡ π i ( i ) δ and Π* ≡ β1 ( β1 − 1). For geometric Brownian
motion, B0 (T ) = ( X 0 XT ) 1 . In case X 0 ≤ X i *, the expanded net present
β
value under the optimal investment strategy for firm i (ith investor) is
thus
β1 β1
⎛ X0 ⎞ n
⎛ X0 ⎞
⎝ X i * ⎟⎠ m∑
F ( X i *, X − i *) = ⎡⎣Vi (i) X i * − I i ⎤⎦ ⎜ − ⎡⎣Vi (m − 1) − Vi (m) ⎤⎦ X m* ⎜
=i+1 ⎝ X m* ⎟⎠
(11.24)
The first right-hand term represents the option value to wait to invest
by a monopolist. Since π i ( m) ≥ π i (m + 1) for all m = 1, . . ., n − 1, it obtains
Vi (m − 1) − Vi (m) ≥ 0 for all m = 2, . . ., n, so that the second right-hand
term in equation (11.24) is negative. This term represents the present
value of exogenous competitive erosion that negatively affects the option
value of a stand-alone monopolist option holder.
Example 11.2 Duopoly Investment Case

Consider the duopoly case (n = 2) we analyzed previously. The perpetuity
duopoly value of the high-cost firm is lower than that of the low-cost firm
and therefore the investment trigger of the follower X F * is higher. The
follower will invest later when the trigger X F * is first reached; from equa-
tion (11.23) with n = 2, this is
Π* I
XF * = ,
VF ( 2 )
where VF (2) is the present value of Cournot profits in a duopoly
(n = 2 ) received by the high-cost firm (follower) in perpetuity. From
equation (11.24) with n = 2, the expanded NPV for the second entrant
(follower) is
F ( X F *) = ⎡⎣VF ( 2 ) X F * − I ⎤⎦ B0 (TF *) ,
352 Chapter 11
where B0(TF *) ≡ ( X 0 X F *) 1 and VF (2 ) = π CF δ . This confirms the result

β
for the follower obtained in a duopoly in equation (11.16) previously.

The leader’s investment threshold obtains similarly
Π* I
XL * = ,
VL (1)
with VL (1) being the perpetuity value of monopoly profits for the leader.
The expanded NPV for the leader (in case X 0 ≤ X L* ≤ X F *) is
L ( X L*, X F *) = ⎡⎣VL (1) X L* − I ⎤⎦ B0 (TL*) − ⎡⎣VL (1) − VL (2)⎤⎦ X F * B0 (TF *),

(11.25)
with B0 (TL*) ≡ ( X 0 X L*) 1 , VL (1) = π L δ , VL (2 ) = π C δ . The expression

β
above confirms the result for the leader derived previously in the duopoly
case in equation (11.19).
11.4 Option to Expand Capacity
Consider now the duopoly case where firms are already operating in the
market and have the opportunity to invest in additional capacity. Box
11.1 gives some flavor to the problem of expanding capacity in lump sum
or incrementally in the context of commercial airlines.
For expositional simplicity, suppose stochastic profits consist of deter-
ministic reduced-form profits (given in table 11.4) times a multiplicative
shock X t following the geometric Brownian motion of equation (11.14).
Denote by firm i the leader and firm j the follower.
Following analogous steps as before (and assuming X 0 ≤ X Li* ≤ X Fj *),
it can be seen that the leader and follower’s expanded NPVs are as
follows:27
Li ( X Li*, X Fj *) = V0i X 0 + ⎡⎣(Δ 1VLi ) X Li* − I i ⎤⎦ B0 (TLi*) + (Δ 2 VLi ) X Fj * B0 (TFj *) ,

(11.26)
Fj ( X Li*, X Fj *) = V0j X 0 + ( Δ 1VFj ) X Li* B0 (TLi*) + ⎡⎣( Δ 2 VFj ) X Fj * − I j ⎦⎤ B0 (TFj *),

where the optimal investment triggers are given by
27. In the preceding formulation, firms may have distinct deterministic profit values and
investment costs. To allow for a natural ordering of firms, the leader must have competi-
tive advantage with respect to both the product-stage competition (profit values) and
access to the market (investment cost). The firm may have a disadvantage with respect
to one of these and still be a leader if its overall advantage overweights its specific
disadvantage.
Box 11.1
Lump-sum versus incremental capacity expansion—or big versus small expansion in
aircraft fleet
In August 2004, Virgin Atlantic Airways announced it will increase its fleet
with the addition of 13 Airbus 340 aircraft, a large four-engine airplane
that seats more than 300 passengers (The New York Times, August 6, 2004).
The airline had an option for an additional 13 such big planes. This expan-
sion would nearly double Virgin’s fleet in an effort to beat rival British
Airways (BA). Virgin would “like to fly every route British Airways flies,”
Sir Richard Branson, Virgin’s chairman stated. The first planes would fly
Australian and Carribean routes, competing directly with BA. The company
plans to add 6,000 jobs as it expands, he said. The airline had previously
ordered six huge Airbus A380 planes, which seat more than 500 passen-
gers. Virgin’s new deal represents “a big increase in capacity,” said Chris
Avery, an airline analyst. Other analysts said that Sir Richard’s big order
was a big gamble, given the uncertain future for European airlines.
By contrast, Air Canada, which emerged from bankruptcy protection
just half a year earlier, announced in April 2005 that it would buy new lean
Boeing aircraft that are more modern and fuel efficient (The New York
Times, April 26, 2005). The agreement included firm orders for 14 Boeing
787 Dreamliner jets, with options and purchase rights for 46 more 787s.
Boeing said it would be the largest deal so far for its new Dreamliner
aircraft if Air Canada buys all 60 planes. Robert Milton, chairman of Air
Canada’s parent company, said the new fleet “would save the company
hundreds of millions of dollars” by lowering its fuel costs and eliminating
the need to upgrade its current aging wide-body aircraft. The company
plans to dedicate the aircraft primarily to long-distance one-stop flights
between Canada and destinations in Asia, including China and India. The
company would also expand its international cargo service, eliminating
costly stopovers in Alaska. “They are trying to reinvent themselves,” said
Richard Aboulafia, an aviation analyst. “If you are striving for the best,
this is how you would do it.”
These airlines’ different business models and strategies, a heavy lump-
sum capacity expansion commitment with large aircraft vs. a more incre-
mental and flexible strategy with more lean aircraft to be more adaptive
to an uncertain business environment, are also reflective of the different
business strategies of the two main commercial aircraft manufacturers,
Airbus and Boeing, discussed in box 1.2 of chapter 1.
Sources: The New York Times, August 6, 2004, “Virgin Air Picks Airbus
Over Boeing”; and April 26, 2005, “Air Canada, Out of Bankruptcy, to Buy
Up to 96 Boeing Planes.”
354 Chapter 11
Table 11.4
Profits in duopoly with expanded capacity option (existing market model)
Deterministic profits
t ≤ Ti No one invests π 0i π 0j
Ti ≤ t ≤ Tj Only one invests (leader) π Li π Fj
t ≥ Tj Both firms invest π Ci π Cj
Note: π > π > 0, π > π 0i > 0, π Cj > π Fj > 0, π 0j > π Fj > 0.

i
L
i
C
i
L
Π*I Π* I
X Li * = ; X Fj * = , (11.27)
Δ 1VL
i
Δ 2 VFj
with
⎧ Δ 1VLi ≡ VLi − V0i
⎪Δ V i ⎧ V0i ≡ π 0i δ ; V0j ≡ π 0j δ
⎪ 2 L ≡ VCi − VLi ⎪ i
⎨VL ≡ π L δ ; VF ≡ π F δ ,
i j j
⎨ ,
⎪ Δ 1VF ≡ VFj − V0j
j
⎪VCi ≡ π Ci δ ; V ≡ π δ
j j
⎪⎩Δ 2 VFj ≡ VCj − VFj ⎩ C C
and Π* = β1 ( β1 − 1) is the profitability index reached at the level of

optimal investment.
The value expressions for the leader and for the follower in equation
(11.26) above can be interpreted as follows. At time t0 = 0, the leader
(firm i) receives the deterministic perpetuity profit value from being
already active in the market (V0i ) multiplied by the initial value of the
shock X0. When it invests in additional capacity at time TLi*, it effectively
exchanges its old perpetuity profit value for a higher perpetuity value
VLi, which mirrors firm i’s temporary “monopoly” profit stream during
the period TLi * ≤ t ≤ TFj *. To make this “exchange,” firm i incurs an invest-
ment outlay I i. The leader’s investment occurs at random time TLi*, so the
extra value is discounted at the appropriate expected discount factor
B0 (TLi *). Subsequently, at random time TFj * when the follower also
invests in added capacity, the leader gives up its previous perpetuity
profit value VLi for the lower perpetuity value of profits as a Cournot
duopolist when both firms have expanded capacity, VCi . At the random
times of added capacity investment, TLi* and TFj *, the deterministic profits
are multiplied by the value of the stochastic shock (exchange rate),
namely by X Li* and X Fj *.
The interpretation for the follower value in equation (11.26) is anal-

ogous. At time t0 = 0, the follower receives the certain perpetuity value
corresponding to no additional capacity investment; that is, it earns V0j
multiplied by the initial value of the shock X 0 . Once the leader
has invested, the follower is affected adversely due to the negative
externalities of the leader’s investment; the follower effectively gives
up its old perpetuity value in exchange for a lower one (VFj ≤ V0j).
When the follower subsequently invests at random time TFj *, it pays
the investment cost I j and “substitutes” its old follower profit value VFj
for the new Cournot–Nash equilibrium profit value VCj in a “simulta-
neous” game.28
Oligopoly Case
Consider now the more general oligopoly case involving n firms active
in the market (existing market model), of which m ( ≤ n) firms have
already invested in additional capacity. At the outset (time t0 = 0) no firm
has invested in additional capacity. Let π i ( m) represent the profit of firm
i provided that m out of the n active firms have invested in additional
capacities. Firm i may receive profits from the existing market even
if it has not yet invested in additional capacity, meaning π i ( m) ≥ 0 for
m = 0, . . ., i − 1. Once again, there are negative externalities (reduced
equilibrium profit values) resulting from competitive arrivals, so that
π i ( m + 1) ≤ π i ( m) for all m = 1, . . ., n − 1. Investment costs are firm-
specific, with I i denoting firm i’s investment cost. An investment strategy
for firm i consists in selecting a target value X i and investing when this
trigger is first hit. We again assume that uncertain profit is made of two
components: a certain profit flow and a stochastic multiplicative shock
X t (exchange rate) following the geometric Brownian motion given in
equation (11.14).
The value of firm i (ith firm) with an option to expand capacity is
given by
Tm+1
n
Fi ( X i , X − i ) = ∑π ( m) Eˆ 0 ⎡⎢ ∫T X t B0 ( t ) dt ⎤ − I i B0 (Ti ), (11.28)
⎦⎥
i
m= 0 ⎣ m
resulting in
n
Fi ( X i , X − i ) = Vi ( 0 ) X 0 − ∑ ⎡⎣Vi ( m − 1) − Vi ( m)⎤⎦ X m B0 (Tm ) − I i B0 (Ti ),
m=1
(11.29)
28. Given the time inconsistency of the Stackelberg quantity model that assumes that the
stage output by the Stackelberg leader is not on its reaction curve, the Cournot quantity
model is best as reduced-form profit in such a setting.
356 Chapter 11
where T0 = t0 = 0, Tn+ 1 = ∞ (by convention), and Vi ( m) = π i ( m) δ for

m = 0, . . ., n.29 Firm i optimizes its value by selecting the investment
trigger Xi at the point where the first-order derivative equals zero. The
first-order derivative is
∂Fi
( X i , X − i ) = ΔVi ⎡⎣ B0 (Ti ) + X i BX ( X i ) ⎤⎦ − I i BX ( X i )
∂X i
with ΔVi ≡ Vi (i ) − Vi ( i − 1) and BX = ∂B ∂X i . Given the presumed
“natural” sequencing of investment, the investment timing decision of
the ith firm is independent of its competitors’ investment strategies.
Effectively, each firm can behave myopically and invest as if it were a
monopolist; the only difference lies in the perpetuity profit value func-
tions, which differ depending on the industry structure. The optimal
investment rule for firm i prescribes to invest when the investment value
X i ΔVi exceeds the investment cost I i by a factor Π* = β1 ( β1 − 1) > 1.
This optimal investment strategy can be restated based on the modified
Jorgensonian rule of investment: “invest when the project’s additional
return on investment X t Δπ i I (with Δπ i ≡ π i ( i ) − π i ( i − 1)) equals or
exceeds the firm’s interest rate (r) plus an additional term capturing the
impact of irreversibility in an uncertain world (r + (β1σ 2 2)).”
Example 11.3 Duopoly Expansion Case

Consider again the special case of only two incumbent firms active in the
market (n = 2), holding a shared option to invest in additional capacity.
From above equation (11.27), the investment trigger for the follower
(firm j) is given by
Π*I
X Fj * = ,
Δ 2 VFj
29. From equation (11.28), it obtains
n
Fi ( X i , X − i ) = ∑ π i (m) Eˆ 0 ⎡ ∫ X t B0 (t ) dt − ∫ X t B0 (t ) dt ⎤ − I i B0 (Ti )
Tm+ 1 Tm
m= 0
⎢
⎣ 0 0 ⎦⎥
n
π i (m)
=∑ ⎡ X 0 − X m+1B0 (Tm+1 ) − X 0 + X m B0 (Tm )⎤⎦ − I i B0 (Ti )
m= 0 δ ⎣
n
= ∑ Vi ( m) ⎡⎣ B0 (Tm ) X m − B0 (Tm+1 ) X m+1 ⎤⎦ − I i B0 (Ti ) .
m= 0
Since lim XT →∞ B ( X 0 ; XT ) V ( XT ) = 0 (as δ > 0), the value of firm i for a given target X i is
n n+ 1
Fi ( X i , X − i ) = ∑ Vi (m) ⎡⎣ B0 (Tm ) X m ⎤⎦ − ∑ ⎡⎣Vi (m − 1) X m B0 (Tm )⎤⎦ − I i B0 (Ti ) .
m= 0 m=1
Equation (11.29) obtains by summation.

where Δ 2VFj ≡ VCj − VFj , VCj ≡ π Cj δ and VFj ≡ π Fj δ , with δ ≡ k − g = r − ĝ.

The investment trigger of the leader (firm i) is
Π*I
X Li* = ,
Δ 1VLi
where Δ 1VLi ≡ VLi − V0i , VLi ≡ π Li δ , and V0i ≡ π 0i δ . The value for the fol-
lower (firm j), assuming X 0 ≤ X Li* ≤ X Fj *, from equation (11.29) with
n = 2 is
Fj ( X Fj *) = V0j X 0 + (Δ 1VFj ) X Li* B0 (TLi*) + ⎡⎣(Δ 2VFj ) X Fj * − I j ⎤⎦ B0 (TFj *)
and for the leader (firm i)
Li ( X Li*) = V0i X 0 + ⎡⎣( Δ 1VLi ) X Li* − I i ⎤⎦ B0 (TLi*) + ( Δ 2VLi ) X Fj * B0 (TFj *),
with Δ 1VFj ≡ VFj − V0j and Δ 2 VLi ≡ VCi − VLi. The result above confirms the
results obtained in equation (11.26) for the duopoly case.
Conclusion
In this chapter we have shown how the pure-strategy Nash equilibria in

investment games can exhibit a sequencing of investment timing. More-
over in the present context, even for a priori symmetric firms, early inves-
tors enjoy an early-mover advantage as their value function as leader
exceeds their later entrants’ value. When a firm has a “substantial” com-
petitive (e.g., cost) advantage over its rivals, the sequence of investment
may involve a natural ordering, with the lowest cost firm entering first.
We analyzed the option to invest in a new market as well as the option
to expand (by a lumpy amount) an existing market, deriving the optimal
value and trigger strategies for competing firms in oligopoly. In the next
chapter we revisit the main result according to which early movers can
enjoy first-mover advantages by allowing firms to use mixed strategies.
Selected References
The formulation of games of sequential investment timing has been

introduced by Reinganum (1981a,b) in a deterministic setting. Joaquin
and Butler (2000) discuss an asymmetric duopoly quantity competition
model where firms are ordered in their entries. Their model is a contin-
uous-time version of Smit and Trigeorgis’s (1997) discrete-time asym-
metric duopoly model.
358 Chapter 11
Joaquin, Domingo C., and Kirt C. Butler. 2000. Competitive investment

decisions: A synthesis. In Michael J. Brennan and Lenos Trigeorgis, eds.,
Project Flexibility, Agency, and Competition: New Developments in the
Theory and Application of Real Options. New York: Oxford University
Press, pp. 324–39.
Reinganum, Jennifer F. 1981a. On the diffusion of new technology: A
game-theoretic approach. Review of Economic Studies 48 (3): 395–405.
Reinganum, Jennifer F. 1981b. Market structure and the diffusion of new
technology. Bell Journal of Economics 12 (2): 618–24.
Smit, Han T. J., and Lenos Trigeorgis. 1997. Flexibility and competitive
R&D strategies. Working paper. Columbia University.
12 Preemption versus Collaboration in a Duopoly
In the previous chapter we analyzed oligopoly models involving suf-

ficient competitive advantage or asymmetry such that firm roles (who
is the leader and who the follower) were arguably rather clear and
determinable a priori. When firms are nearly identical, however, there
are multiple Nash equilibria in pure strategies and the more likely
outcome of the game cannot be readily determined.1 When no firm
has a clear competitive (e.g., cost) advantage, there appears to be a
“coordination problem” in determining who acts first and becomes the
leader. Mixed strategies may give further insights and help determine
what might happen when firms are not sufficiently distinct. Fudenberg
and Tirole (1985) provide a solution for this coordination problem
using symmetric mixed-strategy equilibria in a deterministic, continu-
ous-time setting. We discuss this approach next and subsequently extend
the analysis to option game situations under uncertainty, deriving impli-
cations for investment strategies and optimal investment timing in
competitive settings. For simplicity, we focus the discussion on duopo-
listic markets.
The chapter is organized as follows. In section 12.1 we present the
original deterministic model by Fudenberg and Tirole (1985) to help
analyze preemption versus cooperation. We then extend this in more
complex settings to account for stochastic market uncertainty. We discuss
the option to invest in a new market in section 12.2, and the option to
expand an existing market in section 12.3. Throughout the chapter, we
look at the impact of firm asymmetry on the equilibrium investment
behavior of firms.
1. Investments are still made in sequence but in an industry with n firms there are n! dif-
ferent pure-strategy Nash equilibria.
360 Chapter 12
12.1 Preemption versus Cooperation
Consider first the simpler deterministic case when there is no uncertainty

concerning the underlying market. In the previous chapter we discussed
how the model by Reinganum (1981a) might fit certain option game situ-
ations, especially those involving a natural sequencing of investment. In
the present chapter where coordination problems are explicitly addressed,
we apply a refinement of Reinganum’s model of investment timing pro-
posed by Fudenberg and Tirole (1985) who adopt a continuous-time
mixed-strategy approach.
The model by Reinganum was based on certain simplifying assump-
tions. Reinganum (1981a), as well as Scherer (1967), consider invest-
ment-timing decisions based on the notion that firms are precommitted
to invest at a certain (deterministic) future time and whatever happens
they are to stick to their plans. This assumption may be justified in
some cases when implementing an investment decision is fairly time-
consuming or when altering the investment plan is prohibitively costly.
Reinganum finds that there is a sequencing of investments even if firms
are identical, namely one of the firms (the leader) invests first and the
other (follower) invests later. In a duopoly setup where firms decide on
their investment timing beforehand, there exist two pure-strategy Nash
equilibria (of the sequential-investment type) that involve a first-mover
advantage.2 This setup changes if there is a sufficiently large competitive
advantage by one of the duopolists; a natural leader-follower equilibrium
results where the firm with a large competitive advantage invests first as
part of a focal-point equilibrium.
Preemption is ruled out in Reinganum’s (1981a) model given the
assumed precommitment to a stringent investment timing schedule by
both firms. Preemption is, however, possible in Fudenberg and Tirole’s
(1985) approach. This form of rivalry results from the strategic timing
interplay between competitors eager to capture the lion’s share when
there is a first-mover advantage. If there is a large first-mover advantage
tapped by the leader, both firms will want to invest as the leader to
grasp this advantage. In this strategic setting, precommitment to a fixed
investment-timing schedule seems rather unrealistic. Precommitment
(open-loop) equilibria fail to capture the fact that firms may be tempted
2. The first-mover advantage refers to the investment stage only, not the market or
commercialization stage. In a given region the leader’s value exceeds the follower’s since
the former earns first-stage monopoly rents (new market model) or higher incumbency
rents (existing market model). In the duopoly competition stage both profit flows are equal.
Preemption versus Collaboration in a Duopoly 361
to undermine their rivals and preempt them to obtain a higher value.

The precommitment outcome does not make as much sense in settings
where firms can instantaneously respond to their rivals’ actions and do
not pay prohibitively high costs if they revise their planned investment
schedule. Even if firms had to precommit to a strict investment-timing
schedule, the existence of an early-mover advantage may still lead to
timing rivalry as each firm tries to precommit first, announcing its com-
mitment decision promptly to alter the rival’s investment schedule.3 This
results once again in a coordination problem between option holders: if
precommitment to an investment-timing schedule is not enforceable,
both firms will attempt to be the first entrant to seize the first-mover
advantage. In order to incorporate this feature of endogenously deter-
mined firm roles in equilibrium, we need to resort to the closed-loop
equilibrium concept of investment timing games.4 To tackle this coordi-
nation issue, Fudenberg and Tirole (1985) refine Reinganum’s model by
relaxing the assumption of precommitment to a pre-specified future
time.5
The revised setup by Fudenberg and Tirole (1985) makes it possible
to determine firm roles endogenously, in contrast with the focal-point
argument used in chapter 11 where firm roles are determined exoge-
nously in case of a large competitive advantage. Their model implies that
a firm can only become a leader by actually investing first, not simply by
having some prior cost advantage. Leadership is not an inherited “quality”
but the result of a move as the actual first investor. Endogenous firm
roles imply that in making its investment timing decision, a firm should
compare now (i.e., at each time and state) the relative values of being a
leader, a follower, or a simultaneous investor—not simply consider the
3. This situation does not emerge in the model by Reinganum (1981a) since firms are
assumed to precommit to an investment plan simultaneously.
4. Fudenberg and Tirole (1985) introduce two notions along which they differentiate their
model from Reinganum’s (1981a, b). Reinganum formulates open-loop strategies where
the firms’ investment decisions do not depend on the previous play by rivals but only on
calendar time; these are essentially myopic strategies selected regardless of rival’s reactions.
By this assumption the industry equilibrium is a Nash equilibrium in open-loop strategies,
namely an open-loop equilibrium. Fudenberg and Tirole (1985) instead consider closed-
loop strategies that permit the firms to condition their play on previous actions given the
history of the industry. They also require that at every state/ subgame the industry could
possibly reach (even off the equilibrium path) the continuation strategies form a Nash
equilibrium going forward. That is, they require that the optimal closed-loop strategies
form a perfect equilibrium. The underlying solution concept is known as perfect closed-
loop equilibrium.
5. The equilibrium concept used in case of preemption was introduced by Fudenberg and
Tirole (1985) for symmetric players and by Simon (1987a, b) for asymmetric players. We
here deal only with the case involving identical players and symmetric investment
strategies.
362 Chapter 12
value of leadership at the beginning of the game, as was done in the

previous chapter (where roles were pre-assigned).6
We next discuss the coordination problem in the deterministic case as
originally analyzed by Fudenberg and Tirole (1985). To address the
above coordination problem, the authors use continuous-time mixed
strategies and derive the perfect closed-loop equilibrium.7 They adopt a
new formalization (presented in appendix 12A) enabling studying such
games of timing.8 Strategy is redefined in terms of two functions in order
to describe appropriate continuous-time mixed strategies. A first term
Gi ( t ) tracks whether firm i has invested before (or at) time t given that
the other firm has not yet invested, while a second term qi ( t ) measures
the instantaneous probability or “intensity” of investing at time t.9 Con-
sider first two identical firms following symmetric strategies. L (⋅), F (⋅),
and C (⋅) are, respectively, the values of being the leader, the follower, or
a simultaneous Cournot duopolist (discounted back to the outset, time
t0).10 For firm i or j, the payoffs and action choices at time t (for
Gi (t ) = Gj (t ) = 0) are depicted in strategic form as shown in figure 12.1.
The strategic-form game is repeated in “rounds,” with no time elapsing
between “rounds.” At each “round,” firms play randomly.11 The probabil-
ity of occurrence of various industry structures can be determined from
the strategic-form representation as illustrated in box 12.1.
Preemption will occur if at some time t ( ≥ t0 ) there is a first-mover
advantage, that is, if there exists at least a small time interval (includ-
ing t) such that the value received by the leader is larger than the
6. An option to wait by the leader contradicts the model assumptions.
7. Deriving mixed-strategy equilibria in continuous time as the limit of discrete-time
mixed-strategy equilibria leads to some information loss as discussed in Fudenberg and
Tirole (1985, pp. 389–92). Their strategy formulation makes it possible to circumvent this
problem by introducing a second function in the strategy definition.
8. Fudenberg and Tirole (1991, sec. 4.5) give a brief overview on timing games including
wars of attrition.
9. qi(⋅) is called atoms function in the optimal control literature. Essentially the control and
action taken at time t consumes no time to take and implement. qi(⋅) allows capturing
information that is lost when considering Gi (⋅) only. See appendix 12A for a precise defini-
tion of the strategy space.
10. More precisely, L ( t ) is the payoff for the firm that succeeds in preempting its rival
at time t ≥ t0 (the “leader”), F ( t ) is the payoff for the preempted firm that invests at a
later date (the “follower”), and C (t ) is the individual payoff for each of the two firms if
they invest simultaneously at time t. For the sake of generality, we do not characterize
the payoffs as functions of model primitives; they may describe new market, existing
market (discussed next), or technology adoption models (as in Fudenberg and Tirole,
1985).
11. The two-by-two matrix shown in figure 12.1 represents a repeated game that takes no
time to repeat or a game in which rounds are played instantaneously with no discounting.
This representation is allowed by the definition of qi(⋅) as an atoms function.
Firm j
Invest qj (t) Wait 1 – qj (t)
Simultaneous Sequential
investment investment
Invest
qi (t) C (t) L (t)
C (t) F (t)
Firm i
Sequential No investment
investment (waiting)
Wait
1 – qi (t)
F (t) Repeat
game
L (t)
Figure 12.1
Strategic form of the investment timing game at time t
qi( t ) measures the instantaneous investing “intensity” by firm i at time t.
value received as a follower, meaning L (t ) > F ( t ). In such a situation

there is an incentive for a firm to preempt its rival and become the
leader. A different type of coordination problem involving a war of
attrition may occur if instead there is a second-mover advantage, that
is, if there exists an interval of time t ( ≥ t0 ) such that F (t ) > L ( t ). A
continuous-time game-theoretic model involving a war of attrition was
developed by Hendricks, Weiss, and Wilson (1988). Here we focus on
preemption. A number of cases are interesting to consider further:
(1) L(TL* ) > C(TC* ) with TL* ≡ arg max t ≥ t0 L ( t ) and TC * ≡ arg max t ≥ t0 C ( t ),
and (2) L(TL* ) ≤ C(TC* ). The first case involves preemptive timing equi-
libria, while the second allows for tacit collusion outcomes that are
beneficial to both firms.
12.1.1 Preemption
Preemption is characteristic of markets with a large first-mover advan-

tage and high excess profits to be earned by the firm that enjoys tempo-
rary monopoly rents. Even when firms may cooperate by waiting to
invest at a later date, TC *, receiving C (TC *), they have no incentive to do
so, instead investing earlier at TL* to become the leader, receiving a
higher value L (TL*) > C (TC *). In case of investment in a new market the
above inequality clearly holds. The follower value is not negatively
364 Chapter 12
Box 12.1
Probability of occurrence of various industry structures
Given investment intensity qi (t ) ≡ qi , for firm i one can determine the prob-
ability of occurrence of certain events at time t . For example, the probabil-
ity that firm i is the market leader ( pLi) equals the probability of firm i
being the leader now, qi (1 − q j ), plus the probability of waiting and becom-
ing the leader in the next “round,” (1 − qi ) (1 − q j ) pLi.a This leads to the
following recursive expression:
pLi = qi (1 − q j ) + (1 − qi ) (1 − q j ) pLi ,
yielding
qi (1 − q j )
pLi = (12.1.1)
qi + q j − qi q j
with qi , q j ≠ 0. Identical firms are assumed to follow symmetric (mixed)
strategies (q = qi = q j ). In this case equation (12.1.1) reduces to
1− q
pL ≡ pLi = pLj = . (12.1.2)
2−q
The probability that firm i is the follower (with firm j being the leader) is
1 − pLj. From figure 12.1 the probability of simultaneous investment by both
firms as Cournot duopolists, pC, is given by the probability of immediate
simultaneous investment by both firms, qi q j , and the probability of both
firms waiting until the next “round” and simultaneously investing then.b
This probability satisfies pC = qi q j + (1 − qi ) (1 − q j ) pC , or
qi q j
pC = (12.1.3)
qi + q j − qi q j
for qi , q j ≠ 0. In case of symmetric strategies, the expression above simpli-
fies toc
q
pC = (≥ 0). (12.1.4)
2−q
a. Over an infinitesimal time interval, we can reasonably assume that no change in
the market environment will occur so that pLi is stationary over such a short time
period.
b. The subscript C is being used in the text to stand for Cournot competition or
cooperation, depending on the context. The connection between these notions will
be made clearer in later sections.
c. For q ≠ 0 , the probability that both firms invest simultaneously is strictly positive.
For q = 0 , the probability of simultaneous investment is zero, so equation (12.4)
holds for all values of q ∈[0, 1].
Present
(time-0) value
A
L(t)
B
F L(t), F (t), C(t)

F (t)
C
D
E G C(t)
TP* TL* TF * TC* Time (t)
Figure 12.2
Preemption case: L(TL *) > C(TC *)
L (t ) is the expected value of being the leader; F (t ) of being the follower; C ( t ) of simulta-
neous investment as a Cournot duopolist. The graph is based on the technology-adoption
problem described in Fudenberg and Tirole (1985) with specific assumptions and does not
necessarily accurately represent the new market model discussed here.
affected by the leader’s investment decision (π F = π 0 = 0) and the value

of simultaneous Cournot investment equals the value of being a follower.
Figure 12.2 illustrates this preemption case, described in Fudenberg and
Tirole (1985), showing the present (time-0) expected value of being a
leader (L), a follower (F ), or investing simultaneously as a Cournot
duopolist (C).12
In the graph above, TF * is the investment time for the follower. Once
the follower enters and both (symmetric) firms compete in the market
as Cournot duopolists, they earn the same profits hence values are equal-
ized. TP * is the earliest (or first) time that the values of being a leader or
{
a follower are equal, that is, TP * ≡ inf 0 ≤ t ≤ TL *⏐L (t ) = F (t ) . In the }
region TP * < t < TF * there is a first-mover advantage that the leader can
exploit; that is, the leader’s value curve is above the follower’s or
L ( t ) > F ( t ). TC * is the later investment time that maximizes joint invest-
ment value under simultaneous investment (i.e., it maximizes C (⋅)).13
12. For the sake of generality, the payoffs accruing to the players are, for the time being,
expressed in a generic form.
13. The optimal investment times (except the preemption point) can be determined by use
of the Jorgensonian rule of investment (see chapter 11).
366 Chapter 12
Provided that L (TL*) > C (TC *), or point A is above B, neither firm
can do better than receiving the leader value L (TL*) at point A. Ignor-
ing strategic interactions, each firm would like to invest exactly at
optimal time TL* that maximizes the leader’s value. Given the coor-
dination problem resulting from the lack of a natural leader-follower
entry sequencing, a simultaneous investment by both firms as Cournot
duopolists at time TL*, or point C, would be detrimental to both firms
since C (TL*) < F (TL*) < L (TL*). As a result of the first-mover advan-
tage, each firm will try to preempt its rival and invest just before the
rival does.14 This preemption process would continue and will stop at
time TP * when the expected values of being a leader or a follower
are exactly equal, namely when L (TP *) = F (TP *). We refer to TP * as
the preemption time. Prior to this (t < TP *), L ( t ) < F ( t ) so no one has
an incentive to invest earlier than the preemption time TP * as pre-
emption at this stage is not a value-enhancing strategy. Fudenberg
and Tirole (1985) refer to this phenomenon above arising in the case
of timing rivalry or preemption as “rent equalization.” At the preemp-
tion time TP *, there is neither a first- nor second-mover advantage
for either firm. Competing firms are just indifferent between being
the first or the second investor, meaning “rents” are equalized. Box
12.2 discusses an analogous problem in the context of the first recorded
auction for the highest “prize.”
At the preemption time TP * one of the firms will invest first. Since the
rival firm is worse off by investing now than by waiting, that is,
C (TP *) < F (TP *) or point G is below D, it is optimal for the rival to wait
until optimal time TF * when being a follower results in a higher value. In
the preemption case, the perfect (closed-loop) equilibrium results in an
ordering of firm roles with deterministic adoption times, TP * (for the
leader) and TF * (for the follower). However, compared with the (open-
loop) model we discussed in chapter 11 based on Reinganum (1981a),
the investment timing trigger for the first-mover is no longer the myopic
investment time, TL*, but the preemption time, TP *. This investment
trigger does not directly maximize the leader’s value but rather is the
outcome of strategic interactions that in equilibrium result in indiffer-
ence between the leader and the follower roles. In this context one of
the firms (the leader) invests at preemption time TP * and the other (fol-
lower) invests at a later date (at TF *).
14. If firm j would invest at TL*, firm i will want to invest at time TL* − ε (where ε is an
infinitesimal amount). Firm j will then invest just before that, at time TL* − 2ε , and so on
and on.
Box 12.2
The first auction and first-mover advantage
The “Father of History,” Herodotus, made the first written reference to an

auction in the first book of The Histories as follows:
Once a year in every village all the maidens as they attained marriageable age were
collected and brought together into one place, with a crowd of men standing around.
Then a crier would display and offer them for sale one by one, first the fairest of
all; and then, when she had fetched a great price, he put up for sale the next most
attractive, selling all the maidens as lawful wives. Rich men of Assyria who desired
to marry would outbid each other for the fairest; the ordinary people, who desired
to marry and had no use for beauty, could take the ugly ones and money besides;
for when the crier had sold all the most attractive, he would put up the one that
was least beautiful and offer her to whoever would take her as wife for the least
amount, until she fell to one who promised to accept the least; the money came
from the sale of the attractive ones, who thus paid the dowry of the ugly.
(Source: Herodotus, The Histories, I:196 [describing a custom of Eneti in Illyria],
fifth century BC.)
Besides documenting the first known auction, this reference introduces
the notion of first-mover advantage in this context. “Maidens” are ranked
in decreasing value in terms of beauty, with the first “bidder” receiving the
“fairest maiden,” gaining a first-mover advantage. This suggests (as in
chapter 11) an ordering of advantages, with the last “entrant” getting the
“maiden of least fairness.”
Rich Assyrians outbid each other in an attempt to obtain the highest
“prize.” Albeit rich, Assyrians might bid no more than the “fairest maiden”
was worth. The “rent equalization” principle might apply here. The first-
mover advantage might go away as rich Assyrians would outbid each other
up to the point where they are indifferent between receiving the “fairest
maiden” for a high price or receiving the next “fairest maiden” for a lower
price. This suggests an extension of the rent-equalization principle to more
than two “prizes” or roles, namely leader and follower. At the end of the
process, the Assyrian left with the “maiden of least fairness” is compen-
sated by a monetary payoff so that roles are equally attractive.
As shown in figure 12.2, the optimal investment triggers arising out of

this strategic equilibrium are ranked as follows15
TP * ≤ TL* ≤ TF * ≤ TC *.
The payoff for firm i in each region depends both on the intensity (prob-
ability) of investment by firm i, qi ( t ), and that of rival firm j, q j ( t ). Let
us next determine the equilibrium mixed-strategy investment qi * (t ) of
15. This can be shown by way of contradiction. Suppose TP* > TL* and TP * < TF *.
Since F (⋅) is increasing in [t0 , TF *] and by definition of TP*, it follows that
L (TP *) = F (TP *) ≥ F (TL*) > L (TL*). This is in contradiction with the definition of TL*.
For the inequality TC * ≥ TF *, see the proof of lemma 4.2 in Huisman (2001, p. 91).
368 Chapter 12
firm i in the subgame starting at time t ∈[TP *, TF *]. The strategic-form

representation of figure 12.1 helps illustrate this. A formal description of
the subgame perfect equilibrium is given in appendix 12B.1. In a Nash
equilibrium mixed-strategy profile, each player is willing to randomize
so that it is indifferent, given the mixed strategy played by its rival,
between its own pure-strategy choices (here “invest” or “wait”). We
suppose that in equilibrium, firm i invests with probability qi * = qi * ( t )
and adopt firm j’s point of view. If firm j decides to invest, it will operate
as a Cournot duopolist with probability qi * and as a leader with probabil-
ity 1 − qi *. If firm j delays investment, it will receive F j (t ). In other words,
firm j is indifferent among the two pure-strategy actions if16
qi * C j ( t ) + [1 − qi *] Lj ( t ) = F j (t ) .
(invest) (wait)
The resulting equilibrium investment intensity for firm i in the sub-

game starting at time t ∈[TL*, TF *] is
Lj (t ) − F j ( t )
qi ( t ) = φ j ( t ) = . (12.1)
Lj ( t ) − C j (t )
Interestingly a firm’s equilibrium investment intensity, qi ( t ), generally
depends on the value functions (as a leader, follower or Cournot duopo-
list) of its rival, not its own. In the symmetric case, qi ( t ) = q j (t ) = q(t ),
equation (12.1) simplifies to
L (t ) − F (t )
q (t ) = φ (t ) ≡ . (12.2)
L (t ) − C (t )
At the preemption time TP *, each symmetric firm is just indifferent
between being the leader or a follower, meaning L (TP *) = F (TP *), so the
intensity or probability of investing at TP *, obtained from box equation
(12.1.1), is q (TP *) = 0. From equation (12.1.2) the probability that a firm
becomes the leader at the preemption time TP * (for t0 ≤ TP *) is thus
pL = 1 2. At this indifference point it obtains from equation (12.1.4) with
q = 0 that the probability of simultaneous Cournot investment, pC, is
zero. The resulting equilibrium once again leads to a sequencing of firm
investments, with one of the firms investing as a leader (at preemption
time TP *) and the other as a follower (at later date TF *) but here the first
investment takes place earlier than in the open-loop case (TP * < TL*).
16. Here discounting plays no role since we define qi (·) as an atoms function whereby the
action takes no time to implement.
Probability
100%
Monopoly
75%
(firm i)
50% No investment Cournot duopoly
Monopoly
25% (firm j)
0%
t0 TP* TF * ∞
Time (t)
Figure 12.3
Probability of industry structure along market development (for t0 £ TP *)
For t0 ≤ TP *, each symmetric firm has a 50 percent chance to become the

leader over the play of the game as is illustrated in figure 12.3.
For TP * < t0 < TF *, there is a first-mover advantage that each firm wants
to grasp immediately (as L ( t0 ) > F ( t0 )). A coordination-timing problem
arises in determining who leads and who follows suit. Since in this region
we have L (t0 ) > F (t0 ), it results from equation (12.2) that the investment
intensity for symmetric firms is
L ( t0 ) − F ( t0 )
q ( t0 ) = φ ( t0 ) ≡ > 0.
L ( t0 ) − C ( t0 )
Therefore someone will invest in this market with positive probability
q ( t0 ). The probability of simultaneous investment at time t0, obtained
from equation (12.1.4), is also strictly positive ( pC > 0). Thus, if
t0 ∈ (TP *, TF *) coordination may fail to result in an industry equilibrium
where one firm enters as a leader and the other firm follows. This “coor-
dination failure” is detrimental to both firms as C ( t0 ) < F ( t0 ) < L ( t0 );
nonetheless if t0 ∈ (TP *, TF *), simultaneous investment may obtain as an
industry equilibrium. For t0 ≥ TF *, both firms invest simultaneously
resulting in a Cournot duopoly. The resulting market structure for dif-
fering values of t0 is illustrated in figure 12.4.
370 Chapter 12
Probability
100%
Monopoly
(firm i )
75%
50% No investment “Coordination failure” Cournot duopoly
25%
Monopoly
(firm j )
0%
TP* TF * ∞
Starting time (t0)
Figure 12.4
Probability of market structure occurring at the outset (t 0 )
The graph is for illustrative purposes. The value functions actually used for L (⋅), F (⋅), and
C (⋅) may lead to nonlinear curves separating the monopoly regions from the “coordination
failure” region.
There is some persistence of the industry structure over time. If

t0 < TP *, as time passes one firm invests as a leader at time TP * and the
other invests later at time TF *. Just after the preemption time TP *, the
second firm has no incentive to invest immediately as its value as a
Cournot duopolist is lower than that of waiting to invest at time TF * as
a follower. The probability of ending up in a Cournot duopoly in the
region TP * < t < TF * (“coordination failure”) is zero (for t0 ≤ TP * < TF *).
12.1.2 Cooperation in an Existing Market
In the case of an existing market, if the first-mover profit advantage for

the leader, π L − π 0, is low (close to π C − π F ), the gain from preempting its
rival is small. In this case collaboration in terms of a jointly selected
investment timing may be preferable for each firm than the sequential
preemptive sequence discussed above. Such a pattern may emerge when
the follower’s value differs from the simultaneous Cournot investment
value significantly. This happens when the follower is unfavorably
affected in the intermediate region by its rival’s investment. Existing
Present
(time-0) value
L (t), F (t), C (t)

A B
C
L (t)
F
F (t)
C (t)
TP* TL* TF * TC TC* Time t
Figure 12.5
Joint investment/collaboration: C(TC*) ≥ L(TL*)
L (t ) is the expected value of being the leader; F (t ) of being the follower; C ( t ) of simulta-
neous investment as a Cournot duopolist. The graph is based on the technology-adoption
problem described in Fudenberg and Tirole (1985) with specific assumptions and does not
necessarily accurately represent the existing market model.
market models may exhibit such tacit collusion or cooperation among

option holders, while new market models do not since the follower earns
no profit flow in the intermediary region.
Figure 12.5 illustrates such a case of joint investment (collaboration)
potentially resulting in higher benefits than preemption when
C (TC *) ≥ L (TL*), where TC * is the optimal joint investment trigger
from the point of view of the duopolist option holders. Let TC be the
earliest time within [TF *, TC *] when the value of simultaneous (joint)
investment just equals the optimal leader value (point C in figure 12.5),
{ }
that is, when TC ≡ inf TF * ≤ t ≤ TC *⏐C(t ) = L(TL*) . There exists a region
{ }
t ≥ t0 ⏐C (t ) > L (TL*) where the value of simultaneous or joint invest-
ment exceeds the value of being a leader. In this case neither firm has
an incentive to invest earlier than its competitor, which rules out preemp-
tion. In this region both firms invest immediately at time t (rather than
invest earlier at TL* for a lower value), resulting in numerous simultane-
{ }
ous investment equilibria ( t ≥ t0 ⏐C (t ) > L (TL*) ). Although there is a
continuum of joint-investment equilibria starting at time TC , one of them
appears most reasonable. The equilibrium involving joint investment at
time TC * Pareto-dominates all other joint-investment equilibria. As
372 Chapter 12
suggested by Fudenberg and Tirole (1985), TC * is the most attractive

among all possible equilibria. A formal description of the tacit collusion
perfect equilibria (including the Pareto-superior one) is provided in
appendix 12B.2.
For TF * < t < TC , the value of being a leader is higher and there is a
first-mover advantage leading to preemption. This creates a motive to
invest before one’s rival, resulting in a sequential preemptive ordering
equilibrium where the leader invests at TP * and the follower at TF *. Con-
sequently, if L (TL*) ≤ C (TC *), there exist two classes of equilibria: the first
class is the sequential ordering equilibrium discussed earlier with invest-
ment times TP * and TF *;17 the second is a continuum of joint-investment
equilibria for t ≥ TC, the most reasonable of which is joint investment at
common time TC * that maximizes joint profits.18
12.2 Option to Invest in a New Market under Uncertainty
The previous analysis based on Fudenberg and Tirole (1985) was devel-
oped in a deterministic environment. It provides useful insights into how
firms interact in games of timing and how preemption or tacit collusion
may result, but it does not address the coordination or entry sequencing
problem under (exogenous) market uncertainty. The preceding deter-
ministic setting needs to be extended, leveraging the insights from real
options analysis to add more realistic guidance to strategic investment
under uncertainty. We address this challenge in sections 12.2 and 12.3.
Section 12.2 discusses entry into a new market, and section 12.3 extends
the analysis to cases where firms earn an initial profit flow before expand-
ing investment (existing market models). We discuss here coordination
issues arising in new market models, first when firms are identical and
follow symmetric investment strategies, and then consider the impact of
firm asymmetry on the optimal investment strategies. In case of entry into
a new market, the follower—which is not operating at the outset—does
not suffer a profit value drop upon entry by the rival. The values of the
17. If TP * < t0 < TF *, two types of industry equilibrium may emerge. The first is a sequential
preemptive equilibrium with one firm investing at time t0 and the other at TF *; the
leader and follower roles can be reversed. This type of structure occurs with positive prob-
ability 2 pL , with pL obtained from equations (12.1.2) and (12.2). The second is simultane-
ous investment at the outset ( t0 ), occurring with positive probability pC obtained from
equations (12.1.4) and (12.2).
18. From the Jorgensonian rule of investment, TC * = 1 g × ln (rI (π C − π 0 )), provided that
the market grows at a constant growth rate g (per unit time). Here r is the discount
rate, π 0, π C are, respectively, the profit flows before and after both firms have invested,
and I is the required investment outlay.
follower and of the simultaneous Cournot investment are equal. Thus,

cooperation or tacit collusion (described in previous section 12.1.2) does
not occur.
12.2.1 Symmetric Case
The first model of option games extending Fudenberg and Tirole’s (1985)
framework under uncertainty was developed by Smets (1991) in the
context of multinational firms. Smets discusses the case of a duopoly
where two firms have a shared option to make an irreversible investment
to enhance their incumbency profits. We discuss Smets’s (1991) actual
model in the next section as it deals with the option to expand an existing
market. We introduce here a simplification of that model involving the
option to invest in a new market. This simplified model was discussed in
Dixit and Pindyck (1994) and Nielsen (2002).19
Consider two identical firms that follow symmetric (mixed) strategies.
Assume that the “risky” profit flow π consists of a certain or determin-
istic profit flow component, π ( = π L , π C ), and a multiplicative stochastic
process component, X t , accounting for industrywide shocks. The uncer-
tain profit flow is thus π = X t π , where X t follows the geometric Brown-
ian motion
dX t = ( gX t ) dt + (σ X t ) dzt , (12.3)
with constant drift g and instantaneous volatility σ . π L ( ≥ 0 ) stands for

the deterministic profit flow of the first investor (leader) when it is the
only firm in the market, and π C ( ≥ 0 ) the deterministic profit flow earned
by each firm when they are both operating as Cournot duopolists. The
profit flow of the monopolist (π L) is higher than that of a Cournot duopo-
list (π C). As before, there is no lasting first-mover advantage with respect
to the profit flow; at the time the follower invests, the profit of the leader
drops and subsequently equals that of the follower.
Consider first the problem faced by the follower. Suppose that the
leader has already invested and currently the second investor contem-
plates entry. The optimal investment trigger for the follower (F ) is given
by the markup rule (see chapter 11, equation 11.9)
VC X F *
= Π* (> 1) (12.4)
I
19. Fudenberg and Tirole’s (1985) model presented earlier is an existing market model in
a deterministic setup. The models by Smets (1991), Grenadier (1996), and Huisman and
Kort (1999) involve an option to expand (existing market models).
374 Chapter 12
with VC ≡ π C δ , Π* ≡ β1 (β1 − 1), and β1 given by

αˆ ⎛ αˆ ⎞
2
r
β1 = − + ⎜ ⎟ +2 2 ( > 1) (12.5)
σ 2 ⎝ σ 2⎠
σ
with αˆ = gˆ − (σ 2 2), ĝ = r − δ , r being the risk-free interest rate, and I
being the investment cost. Equivalently, X F * is the first threshold at
which the return on investment equals the modified Jorgensonian dis-
count rate,
πC XF * 1
= r + β1σ 2 .
I 2
At this threshold, X F *, the follower is indifferent between investing

or keeping its deferral option alive (value-matching condition).
The optimal trigger X F * is reached at random time TF *, with
{ }
TF * ≡ inf t ≥ 0⏐ X t ≥ X F * . The value for the follower pursuing the
optimal investment strategy is given by
⎪⎧(VC X F * − I ) B0 (TF *) if X 0 < X F *,

F( X 0 , X F *) = ⎨ (12.6)
⎪⎩VC X 0 − I if X 0 ≥ X F *,
with the expected discount factor given by
β1
⎛ X ⎞
B0 (TF *) ≡ ⎜ 0 ⎟ . (12.7)
⎝ X F *⎠
For X 0 < X F *, the follower receives no profit prior to investing. The

entire value consists solely of its option to defer the investment. For
X 0 ≥ X F *, the follower has a dominant strategy to invest immediately,
receiving the committed project value or static NPV, VC X 0 − I .
When considering endogenous firm roles, it is contradictory to assume
an option to defer for the leader since firms take the lead by actually
investing first, thereby killing their option to defer. As a result, since the
leader will invest early (at t0), there is no need to determine an optimal
investment timing trigger X L* for the leader. Thus the expected discount
factor for the term representing the defer option value does not appear
in the leader’s value expression—contrary to the case in equation (11.19).
This is a major difference between the model we discussed in chapter 11
and the model presented here. When firm roles are endogenous, the
value of investing I and becoming leader at the outset (in state X 0) is
⎧⎪(VL X 0 − I ) − (VL − VC ) X F * B0 (TF *) if X 0 < X F *,
L ( X0 ) = ⎨ (12.8)
⎪⎩VC X 0 − I if X 0 ≥ X F *,
with VL ≡ π L δ and B0(TF *) as given in equation (12.7). For X 0 < X F *,

the value of investing now (at t0) as the leader equals the net present
value as a monopolist, VL X 0 − I , minus the discounted value difference
(competitive value erosion) resulting from the rival’s entry at random
time TF *. Once the leader has invested at current time t0 , it has no
further growth investment opportunities and merely suffers from any
adverse developments in the market, such as entry by the follower. For
X 0 ≥ X F *, both firms invest immediately (simultaneously) as Cournot
duopolists: for symmetric firms the value of the leader and the follower
are equal(ized), both earning VC or a net present value VC X 0 − I . A
special case is discussed next.
Example 12.1 Symmetric Preemption

Suppose that two firms share the option to invest in a new market for
a fixed investment cost I = 100. If both firms enter, they compete in
quantity (Cournot competition) and face deterministic linear demand
p(Q) = 50 − 5Q. Firms have symmetric variable production cost, c = 10.
According to the analysis in chapter 3 (see table 3.2, panel A), a monopo-
list firm would make excess profit equal to
(a − c )2 ( 50 − 10 )2
πL = = = 80.
4b 4×5
In Cournot competition, each firm would earn
( a − c )2 (50 − 10 )2
πC = = ≈ 35.56 .
9b 9×5
Deterministic profits are subject to an exogenous multiplicative shock
that follows a (risk-adjusted) geometric Brownian motion with ĝ = 5
percent and σ = 10 percent. The risk-free rate is r = 7 percent (and the
dividend yield is δ = 2 percent).
The value of being a monopolist forever in perpetuity is
πM 80
VL = = = 4, 000 ,
δ 0.02
while Cournot duopoly value is
πC
VC = ≈ 1, 778 .
δ
Note that αˆ = gˆ − (σ 2 2) = 0.05 − (0.01 2) = 0.045, and
376 Chapter 12
αˆ ⎛ αˆ ⎞
2
r
β1 = − + ⎜⎝ 2 ⎟⎠ + 2 2
σ 2
σ σ
2
+ ⎛⎜
0.045 0.045 ⎞ 0.07
=− ⎟⎠ + 2 × ≈ 1.35.
0.01 ⎝ 0.01 0.01
The required profitability index is
β1 1.35
Π* = ≈ ≈ 3.84 .
β1 − 1 1.35 − 1
We can now determine the follower’s entry threshold from equation
(12.4):
I 100
X F * = Π* C
≈ 3.84 × ≈ 0.22.
V 1778
The entry threshold for the leader in case of preemption cannot be
readily obtained. Given the parameter values obtained above, we can,
however, specify the follower’s and leader’s values from equations (12.6)
and (12.8), respectively, as a function of the starting value X 0 . By rent
equalization, the leader’s threshold is obtained at the process value X P *
that equalizes L( X P *) = F ( X P *, X F *), that is, X P * ≈ 0.057.
Figure 12.6 illustrates these value functions for the follower and the
leader as given in equations (12.6) and (12.8). For X 0 ≥ X F *, both firms
enter the market immediately earning the same economic profits (π C),
for a net present value VC X 0 − I . For X P * < X 0 < X F *, the leader’s value,
L ( X 0 ), exceeds the follower’s, F ( X 0 , X F *), as the leader enjoys a higher
profit while being the sole firm active in the market. For X 0 < X P *, the
option value as a follower exceeds the net present value of investing
early as a leader. The leader incurs an investment cost I prohibitively
large compared to the profit flow accruing to it and the value of invest-
ment commitment is largely negative. At the preemption time TP *
( X P * ≈ 0.057), the value as a leader exactly equals the value as follower
(rent equalization). In this case (with X 0 ≤ X P *) the two firms are indif-
ferent at time TP * between being the leader or the follower and would
accept to be the leader (respectively, the follower) randomly, for example,
on the flip of a fair coin. The actual first investor will get the leader’s
value and the follower will wait until the follower’s trigger X F * (≈ 0.22 )
is first reached. There are two equilibria where the firm roles are
permuted.
L (⋅), F (⋅, XF*)

400
300
200 Leader’s value

L(⋅)
100 Follower’s value

F (⋅, XF*)
0
0.05 0.10 0.15 0.20 0.25 0.30
XP* XF * ≈ 0.22
Initial value (X0)
(100)
Figure 12.6
Values and investment thresholds for the leader and follower in a new market
Assume Cournot quantity competition with linear (inverse) demand p (Q) = 50 − 5Q. Firms
have symmetric variable production cost, c = 10 . Investment cost is I = 100 for both firms,
ĝ = 5 percent, r = 7 percent, δ = 2 percent, and σ = 10 percent. Threshold values are derived
in example 12.1.
A formal description of the perfect equilibrium strategy profile is

given in appendix 12B.1. For very low values of the stochastic process,
there is no advantage gained from investing first. Considering mixed
strategies, at the preemption time TP * the investment probability (inten-
sity) is q(TP *) = φ ( X P *) = 0. Since equation (12.1.2) still holds in the
stochastic case, the probability that each firm takes the lead at the
preemption point X P * is pL = 1 2. Moreover at random time TP *
the probability of a simultaneous investment (determined as the stochas-
tic variant of equation (12.1.4)) is pC = 0. The expected value for the
leader at the preemption point equals F ( X P *, X F *). In expectation no
firm is better off in this region ( X P * < X t < X F *) since the expected value
for each firm (even as the actual leader) equals the value of the
follower.20 If the market starts at low levels ( X 0 < X P *), the industry
20. Let V( qi , q j ) be the expected value as a function of the equilibrium strategies of the
option-holding firms. It obtains V( qi , q j ) = pL ( L + F ) + pCC . From equations (12.1.2) and
(12.1.4), it results that V(qi , q j ) = [ L + (1 − q ) F − q ( L − C )] ( 2 − q ). From equation
(12.2), V(qi , q j ) = F obtains.
378 Chapter 12
Probability of
industry structure
100%
75% Monopoly
(firm i)
50% No investment Duopoly
Monopoly
25% (firm j)
0%
X0 0.05 0.10 0.15 0.20 0.25 0.30
XP* ≈ 0.06 X F * ≈ 0.22
~
Market development (Xt)
Figure 12.7
Market structure evolution ( X 0 < X P *)
Assume Cournot quantity competition with linear (inverse) demand p (Q) = 50 − 5Q and
symmetric marginal cost, c = 10 . Investment cost is I = 100 , ĝ = 5 percent, r = 7 percent,
δ = 2 percent, and σ = 10 percent. Threshold values are derived in example 12.1.
structure evolution along the market development might be as seen in

figure 12.7.
If the market starts at a value X 0 higher than the preemption point
but lower than the follower’s investment trigger (i.e., X P * < X 0 < X F *),
however, the value as a leader strictly exceeds the value as a follower. In
this case the probability to invest (from equation 12.2 or 12.23 in
appendix 12C.1) is positive (q ( X 0 ) > 0), and both firms invest simultane-
ously with positive probability ( pC = q ( 2 − q) > 0). If simultaneous
Cournot investment occurs due to a “coordination failure,” each
firm would receive lower value C ( X 0 ).21 The industry structure emerging
at starting time t0 for different starting values X 0 is illustrated in
figure 12.8.
21. Dixit and Pindyck (1994) disregard this risk, assuming that each firm becomes leader
with probability one-half. Their result that each firm becomes leader over the flip of a fair
coin, however, only holds if the market starts at a low value ( X 0 ≤ X P* ).
Probability of
industry structure
100%
Monopoly
(firm j)
75%
50% No investment “Coordination failure” Duopoly
25%
Monopoly
(firm i)
0%
X0 0.05 0.10 0.15 0.20 0.25 0.30
Low XP* ≈ 0.06 Intermediate X F * ≈ 0.22 High
Initial value (X0)
Figure 12.8
Market structure emerging at the beginning of the game X 0
Assume Cournot quantity competition with linear (inverse) demand p (Q) = 50 − 5Q and
symmetric marginal cost c = 10 . Investment cost is I = 100 , ĝ = 5 percent, r = 7 percent,
δ = 2 percent, and σ = 10 percent. Threshold values are derived in example 12.1.
The leader will only invest (at time TP *) if the current profit flow pro-
vides a sufficiently high return on the invested capital.22 Therefore the
standard NPV rule does not hold in case of preemption.23
12.2.2 Asymmetric Case
In the intermediate demand region, many option games typically involve

coordination problems in determining who is the leader or follower. In
pure strategies there is only one type of equilibrium characterized by a
leader-follower ordering whereby firm roles are permuted. In chapter 11
22. At the preemption trigger X P*(< X F *), L ( X P *) = F ( X P *, X F *) ( > 0 ). From equations
(12.6) and (12.8), L ( X P *) − F ( X P *, X F *) = (VL X P * − I ) − [VL X F * − I ] ( X P * X F *)β1 ; therefore
β
VL X P * = I + [VL X F * − I ] ( X P * X F *) 1 > I . This confirms the result shown in Dixit and
Pindyck (1994, p. 313).
23. Assuming the follower does not make any profit (i.e., there is full preemption as in the
case of a technology firm acquiring a perpetual patent), Lambrecht and Perraudin (2003)
argue that the NPV threshold corresponds to the preemption point.
380 Chapter 12
we solved this coordination problem by use of a focal-point argument

for asymmetric settings when one firm has a substantial competitive
advantage. Using subgame perfect mixed strategies makes it possible to
solve this coordination problem more generally. Here we illustrate these
insights in the case of an asymmetric duopoly without relying on a focal-
point argument.
We previously discussed perfect equilibrium in case of symmetric
duopolists. In such a case identical firms can be reasonably assumed to
follow symmetric mixed strategies. Here, following Días and Teixeira
(2010), we extend the previous (new market) model to account for pro-
duction cost differentials.24 Assuming asymmetry among firms is more
realistic and descriptive of many duopolies. When firms are asymmetric
(e.g., have asymmetric variable or fixed costs), they may follow asym-
metric mixed strategies.
Assume again that the “risky” profit flow π consists of a deterministic
component π and a multiplicative stochastic shock, X t , following the
geometric Brownian motion of equation (12.3). Firms are characterized
by distinct profit flows depending on the industry structure. These are
summarized in table 12.1.
Consider first the investment decision by the second investor (firm
j ). The follower does not fear subsequent investment and therefore
selects its investment strategy myopically. The optimal investment trigger
for firm j as a follower, X Fj *, as in (12.4), is given by the first-order
condition
VCj X Fj *
= Π*, (12.4′)
I
Table 12.1
Deterministic profit flows for asymmetric duopolists
Certain profits
0 ≤ t ≤ min {Ti , Tj } No one invests 0 0

Ti ≤ t ≤ Tj 0 π Lj
Only one invests (leader)
Tj ≤ t ≤ Ti π Li 0
t ≥ max {Ti , Tj } Both firms invest π Ci π Cj
24. Días and Teixeira (2009, 2010) provide a review of option games in continuous time.
Días and Teixeira (2009) discuss a chicken game applied to oil exploration. Pawlina and
Kort (2006) study asymmetry in a setting where firms differ in the magnitude of the
required investment outlay.
where VCj ≡ π Cj δ and Π* ≡ β1 ( β1 − 1). Equivalently, in equilibrium the

modified Jorgensonian rule of investment prescribes to invest at the first
(random) time the process X t exceeds X Fj *, where X Fj * satisfies the rela-
tionship X Fj * π Cj I = r + (β1σ 2 2). The optimal investment trigger for firm
i as a follower is determined symmetrically. The value for firm j as fol-
lower (given its optimal investment strategy), similar to (12.6), is
⎧⎪(VCj X Fj * − I ) B0 (TFj *) if X 0 < X Fj *,
F j ( X 0 , X Fj *) = ⎨ j (12.9)
⎩⎪VC X 0 − I if X 0 ≥ X Fj *,
with B0 (TFj *) = ( X 0 X Fj *) and β1 as given in equation (12.5). For X 0
β1
higher than the threshold max {X Fi *, X Fj *}, each firm has a dominant
strategy to invest immediately, resulting in a Cournot duopoly.
The leader (firm i) has no option to wait in case of endogenous firm
roles. If it invests now (at time t0), it receives the value of an irreversible
investment commitment given by
⎪⎧(VL X 0 − I ) − (VL − VC ) X F * B0 (TF *) if

j j
i i i
X 0 < X Fj *,
Li ( X 0 ) = ⎨ (12.10)
⎩⎪VC X 0 − I
i if X 0 ≥ X Fj *,
with VLi ≡ π Li δ and VCi ≡ π Ci δ .

Consider again the quantity competition game discussed in earlier
chapters involving a high-cost firm (denoted henceforth as firm H) and
a low-cost firm (firm L). Two cases can be distinguished depending on
whether the cost advantage is large or small. Example 12.2 illustrates
these two cases.
Example 12.2 Asymmetric Preemption

We extend example 12.1 to allow for asymmetry between firms. We
here consider asymmetry in terms of variable production costs, rather
than in terms of fixed investment costs. Again, demand is linear with
p(Q) = 50 − 5Q but subject to a multiplicative demand shock (GBM) with
ĝ = 5 percent and σ = 10 percent. The risk-free rate is r = 7 percent, so
δ = 2 percent.
Firm L has a cost advantage, with cL = 10 < cH = 15. In asymmetric
Cournot quantity competition (see table 3.2., panel B, in chapter 3), the
high-cost firm would earn
(a − 2cH + cL )2 ( 50 − 2 × 15 + 10)2
π CH = = = 20.
9b 9×5
The perpetuity value for the follower is VCH = π CH / δ = 20 0.02 = 1, 000.
From this value and the required profitability index Π* derived in
382 Chapter 12
example 12.1, we can determine the high-cost firm’s investment thresh-

old as a follower:
I 100
X FH * = Π* × H
≈ 3.84 × ≈ 0.38 .
VC 1, 000
As a monopolist, the low-cost firm (L) would earn
(a − cL )2 ( 50 − 10)2
π LM = = = 80 ,
4b 4×5
which yields value VLM = 80 0.02 = 4, 000 in perpetuity. The low-cost
firm’s threshold as a myopic leader is
I 100
X LL* = Π* × ≈ 3.84 × ≈ 0.10 .
VML 4, 000
In Cournot competition, the low-cost firm makes an excess profit of
(a − 2cL + cH )2 (50 − 2 × 10 + 15)2

π CL = = = 45 ,
9b 9×5
resulting in a perpetuity value of VCL = 45 0.02 = 2, 250. The low-cost

firm’s threshold as a follower is
I 100
X FL* = Π* × L
≈ 3.84 × ≈ 0.17 .
VC 2, 250
If the high-cost firm’s disadvantage reduces to cH = 12 , we have
(a − 2cH + cL )2 (50 − 2 × 12 + 10 )2
π CH ′ = = = 28.8 ,
9b 9×5
or perpetuity value VCH ′ = 28.8 0.02 = 1, 440. In this case the follower will
invest earlier, at X FH * ≈ 3.84 × (100 1, 440) ≈ 0.27 (< 0.38). The leader’s
threshold cannot be readily obtained but results from rent equalization.
12.2.3 Size of Competitive (Cost) Advantage
Below we consider distinct magnitudes of cost advantages and their

impact on preemption and coordination in the form of joint or collabora-
tive investment.
Large Cost Advantage

Consider as in example 12.2 the case of a large cost disadvantage,
cH − cL = 5. In this case (see figure 12.9), assuming that firms pursue their
Firm H value
( )
LH(⋅), F H ⋅, XFH*
400
300
200
Firm H as a follower
100
Firm H as a leader
0
0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45
XFL * ≈ 0.17 XFH* ≈ 0.38
(100) Initial value (X0)
Figure 12.9
Project value as a leader or follower for the high-cost firm ( H )
The demand function is p (Q) = 50 − 5Q . Costs are asymmetric, with cL = 10 and cH = 15.
I = 100 , ĝ = 5 percent, r = 7 percent, δ = 2 percent, and σ = 10 percent. Threshold values are
derived in example 12.2.
value-maximizing strategies, the high-cost firm (H) never has any first-
mover advantage since its leader value curve is always located below its
follower value curve. That is, for a cost differential higher than a given
threshold, the low-cost firm (L) does not have to ever fear preemption
by its competitor because the high-cost firm can never be better off
preempting it; the high-cost firm thus will wait as a patient follower until
the optimal threshold X FH * is first reached.25 The low-cost firm can there-
fore select its optimal investment trigger myopically, ignoring the invest-
ment policy of its rival. This is analogous to the open-loop equilibrium
discussed in chapter 11 obtained using the focal-point argument in select-
ing among two pure-strategy Nash equilibria. This result confirms that
the focal-point equilibrium considered earlier is appropriate and char-
acteristic of certain industry situations where heterogeneity or asym-
metry among firms is sufficiently high. Figure 12.9 depicts the project
value as a leader or follower (as a function of the initial value X 0) for
25. High-cost firm H ’s value as leader is low because in equilibrium the low-cost firm
enters early, making it difficult for firm H to earn sufficient temporary monopoly profits.
A lower cost disadvantage would make firm L invest later. Firm H ’s value curve as leader
would then come “closer” to its value curve as follower and may eventually cross it.
384 Chapter 12
the high-cost firm H given its optimal investment threshold X FH *. The

value of high-cost firm H is nonsmooth at X FL* when the low-cost firm
enters.
The optimal investment threshold for the follower (high-cost firm H)
X FH * satisfies the profitability criterion
VCH X FH *
= Π*, (12.4′′)
I
resulting in follower value from (12.9) of
⎧(V H X H * − I ) ( X 0 X FH *)β1 if X 0 < X FH *,
F H ( X 0 , X FH *) = ⎨ HC F (12.11)
⎩VC X 0 − I if X 0 ≥ X FH *.
In case of a large cost differential, the optimal investment trigger for the
leader (L) or low-cost firm, X LL*, is determined by the same decision-
theoretic techniques as before. It satisfies
VLL X LL*
= Π*. (12.4′′′)
I
As there is no risk of preemption by its rival in this case, the expected
discount factor representing the deferral option in the leader’s value
expression re-appears. The leader’s value (starting in state X 0) is
⎧(VLL X LL* − I ) ( X 0 X LL*)β1 if X 0 < X LL*,
⎪
⎪ − (VLL − VCL ) X FH * ( X 0 X FH *)
β1
⎪
LL( X 0 , X LL*) = ⎨(VLL X 0 − I ) − (VLL − VCL ) X FH * if X LL * ≤ X 0 < X FH *,
⎪
⎪ × ( X 0 X F *)
H β1
⎪V L X − I X 0 ≥ X FH *.
⎩ C 0 if
(12.12)
If X 0 ≥ X FH * = 0.38, both firms invest simultaneously as Cournot duopo-

lists. The value curves for both firms are depicted in figure 12.10. The
expanded-NPV for the high-cost firm (follower) exceeds its immediate-
commitment NPV for X 0 < X FH *. The expanded-NPV for the low-cost
firm (leader) lies above that of the follower.
Small Cost Advantage

Consider now the case where the cost differential is not large. Assume
that either firm can acquire a first-mover advantage in the investment
stage. That is, there exists a region for X t such that LH ( X t ) > F H ( X t ). In
this case, from the stochastic equivalent of (12.1), the high-cost firm will
(
LL(⋅), F H ⋅, XFH * )
1,000
800
600
E-NPV for the low-cost

firm (leader)
400
E-NPV for the high-cost
firm (follower)
200
0
0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45
XLL * ≈ 0.10 XFH* ≈ 0.38
Initial value (X0)
Figure 12.10
Value curves of the low- and high-cost firms for large cost advantage
The demand function is p (Q) = 50 − 5Q, cL = 10 , cH = 15 , I = 100 , ĝ = 5 percent, r = 7
percent, δ = 2 percent, and σ = 10 percent. Threshold values are derived in example 12.2.
invest with a (strictly) positive probability qH (t ). As the investment prob-

ability (density) of the low-cost firm is also positive, a coordination
problem—potentially inducing a “coordination failure” in the form of
joint investment—may arise.
In contrast to the previous case involving a low-cost firm with a large
cost advantage enabling it to ignore the risk of preemption by the weaker
rival, here a preemption threat emerges that can induce an earlier invest-
ment by the low-cost firm. The threat of preemption arises because firms
are not precommited, and strategic interactions are accounted for via
mixed (closed-loop) strategies.
Owing to this threat of competitive preemption, firm i cannot simply
{ }
wait until TLi * ≡ inf t ≥ 0⏐ X t ≥ X Li* to invest. To see this, suppose that
firm i decides to invest at the myopic investment trigger of the leader
X Li* ( < X Fj *). It could then be preempted by firm j investing at an earlier
threshold, which would force firm i to invest even earlier, and so on. The
ensuing preemption war would end when the rival’s rents are equalized.
The preemption point for firm i is such that
386 Chapter 12
{ }
X Pi * = inf X t < X Fj *⏐Lj ( X t ) = F j ( X t ) .
Firm j would not be willing to select a lower investment trigger than X Pi *

at which a second-mover advantage rather than a first-mover advantage
would result for it; that is, Lj ( X j ) < F j ( X j ) if X j < X Pi *. In the intermedi-
ate demand region where there is a risk of preemption, the coordination
problem can be solved by use of mixed strategies. A formal description
of the solution is given in appendix 12C.1.
Three possible industry structures may emerge. The probability of
occurrence of each can be determined from equations (12.1.1) and
(12.1.3′) and from the investment density in equation (12.21) given in
appendix 12C.1. Preemptive investment timing sequences where one firm
temporarily earns monopoly profits arise with positive probability (two
distinct orderings). Firm i becomes leader with probability pLi, with firm
j being the follower. Conversely, firm j takes the lead with probability
pLj. The probabilities for the leader-follower orderings from (12.1.1) are
qi (1 − q j ) q j (1 − qi )
pLi = and pLj = (≠ pLi ). (12.13a)
qi + q j − qi q j qi + q j − qi q j
A third possible industry structure occurs when firms invest simultane-

ously as Cournot duopolists; from (12.1.3) this occurs with probability
qi q j
pC = . (12.13b)
qi + q j − qi q j
If one of the firms, firm L, has a cost advantage over its rival, cL < cH, its
investment intensity will be higher than its rival’s, that is, qL ( X 0 ) ≥ qH ( X 0 ).
This results in pLi ≥ pLj; hence the low-cost firm is more likely to be the
leader. Nonetheless, it might still happen that the high-cost rival enters
first and the low-cost firm invests second (with probability pLH ≥ 0). In
the intermediate region (with X PL* < X 0 < X FL* and X PH * < X 0 < X FH *),
both firms’ investment densities are strictly positive. Therefore there
is a positive probability of simultaneous joint investment, resulting
in lower value for both firms since F L ( X 0 , X FL*) > C L ( X 0 , X CL*) and
F H ( X 0 , X FH *) > C H ( X 0 , XCH *). Depending on the parameters of the
investment triggers and on the starting demand region, the resulting
industry structures may differ. We distinguish two subcases.
A. Low-cost firm’s preemption point above leader’s myopic trigger

If the starting value is lower than the low-cost firm’s myopic investment
trigger, meaning X 0 ≤ X LL*, the low-cost firm invests as a leader when
X LL* (< X LH *) is first reached. The high-cost firm invests later as a follower
{ }
at random time TFH * ≡ inf t ≥ t0 ⏐ X t ≥ X FH * . If X LL* ≤ X 0 ≤ X PL*, the
low-cost firm’s myopic threshold is exceeded and there is no preemption
threat from the high-cost firm. The low-cost firm invests immediately (at
t0) and the high-cost firm waits to invest until random time TFH *. If
X PL* < X 0 < X FH *, there exists a preemption threat and both firms have a
first-mover advantage. The low-cost firm invests as the (sole) leader with
probability
qL (1 − qH )
pLL = > 0, (12.14a)
qL + qH − qL qH
as a follower with probability
qH (1 − qL )
pFL = pLH = > 0, (12.14b)
qL + qH − qL qH
or as a simultaneous Cournot investor with probability
qL qH
pC = > 0, (12.14c)
qL + qH − qL qH
where the equilibrium investment densities are qL = φ H ( X 0 ) and
qH = φ L( X 0 ), with φ j (⋅) defined in appendix 12C.1, equation (12.2.1).
If X 0 ≥ X FH *, both firms invest immediately resulting in a Cournot
duopoly with asymmetric payoffs.
B. Low-cost firm’s preemption point below leader’s myopic trigger

If X 0 < X PL* ≤ X PH *, both firms will wait. When X PL* is first reached at
time TPL*, the low-cost firm invests as a leader; before this point there is
no investment. The high-cost firm invests at time TFH *. If X PL* < X 0 < X PH *,
there is a coordination problem. Three industry structures may emerge.
The low-cost firm becomes the leader and the high-cost firm enters as
follower at time TFH *, with probability pLL as given in equation (12.14a).
The high-cost firm takes the lead and the low-cost firm becomes follower
and invests at time TFL*, with probability pFL = pLH as per equation (12.14b).
Simultaneous Cournot investment occurs with probability pC, as per
equation (12.14c). If X PH * < X 0 < X FH *, the low-cost firm invests immedi-
ately and the high-cost firm waits until time TFH *. If X 0 ≥ X FH *, both firms
invest immediately resulting in a Cournot duopoly. This is illustrated in
figure 12.11.
In the asymmetric case described above, the preemption equilibrium
where the leader invests earlier at time TPL* (instead of at the myopic
388 Chapter 12
( ) (
LL(⋅), F H ⋅, XFH * , LH(⋅), F L ⋅, XFL * )
600
500
400
Firm L as follower
300
Firm L as leader
200
100 Firm H as follower

Firm H as leader
0
0.05 0.10 0.15 0.20 0.25 0.30 0.35
X PH* X PL* X FL* ≈ 0.20 X FH * ≈ 0.27
(100)
Initial value (X0)
Figure 12.11
Value curves of the low- and high-cost firms for small cost advantage
Here ( X PL * < X LL *) . The demand function is given by p (Q) = 50 − 5Q, cL = 10 , cH = 12 ,
I = 100 , ĝ = 5 percent, r = 7 percent, δ = 2 percent, andσ = 10 percent. Threshold values are
derived in example 12.2.
trigger TLL*) occurs if the cost advantage of the low-cost firm is relatively
small. When this is the case, firms must take account of the strategic
interaction (preemption threat), leading to earlier investment. As the
cost difference (asymmetry) approaches zero, the result converges to the
symmetric case where firm values are equalized (rent dissipation). By
contrast, the open-loop sequential ordering equilibrium (where the
leader invests when the myopic trigger X LL* is first reached) results if
there is a sufficiently large cost advantage for the low-cost firm. In this
case the low-cost firm acts myopically as if it has a proprietary investment
option (as a monopolist) with no threat of preemption by its rival and
invests at random time TLL*. Nonetheless, its option value is eroded by
the subsequent competitor’s entry, occurring at random time TFH *.
The analysis above helps stress the importance of attaining sufficient
cost advantage in a dynamic setting. In a static setting, such an advantage
enables the firm to extract more value from the market than its competi-
tor. From a dynamic viewpoint, it also allows it to extract monopoly
rents for a longer period of time. If the cost advantage is sufficiently
large, it renders the threat of preemption by the weaker rival irrelevant.
The highly cost-advantaged firm can confidently invest at the myopic

random time TLL*, ignoring its rival’s entry timing altogether, though it is
still subject to damage from competitive erosion. If its cost advantage is
small, however, it needs to enter at an earlier preemption time TPL* due
to strategic interaction and timing rivalry (closed-loop equilibrium).
12.3 Option to Expand an Existing Market
We next consider expansion decisions in an existing market involving

two firms already active in the marketplace. Both firms have a “shared”
option to make an irreversible investment to increase their current profit
flow by expanding their existing market. For example, the firms may have
the possibility to adopt a new, more efficient technology that improves
the quality or reduces the production cost of their existing products
through enhanced processes. Without loss of generality, we focus on the
situation where firms have the opportunity to invest in additional pro-
duction capacities. In section 12.3.1 we consider the symmetric duopoly
case, and outline the results for the asymmetric case in section 12.3.2.
12.3.1 Symmetric Case
Suppose that the stochastic profit flow is again made of two components:
X t is a multiplicative exogenous industry shock modeled as a geometric
Brownian motion as per equation (12.3), while π (= π 0 , π L , π F , π C ) indi-
cates the deterministic (reduced-form) profit flow under a given industry
structure. Upon expanding its production capacity by making additional
investment I , a firm can potentially make a higher profit π L ( > π 0 ). Once
the leader has invested in additional capacity, the follower—previously
on an equal footing with the leader (earning π 0)—will experience a lower
profit π F (< π 0 ) if it has not also invested in new capacity. If both firms
have invested, they will face once again symmetric Cournot competi-
tion—though now duopoly profits are higher than under the old industry
structure (π C > π 0) due to enhanced production.26 The leader suffers
from capacity additions by its rival as π C < π L. Suppose that there is a
higher incentive to invest as a leader rather than as a follower in that the
profit value increment from leadership (π L − π 0) is larger than the profit
increment received as follower upon expanding capacity (π C − π F ). The
26. Boyer, Lasserre, and Moreaux (2010) model capacity expansion more explicitly in a
model where capacities can be expanded repeatedly in lump sums. They obtain, under
certain circumstances, that the deterministic profit under symmetric capacity expansion is
lower than under the initial industry capacity. In this case tacit collusion takes the form of
simultaneous investment being delayed forever.
390 Chapter 12
above described differences with respect to profit values drive somewhat

different results for “existing market models” involving the option to
expand capacity compared to “new market models” involving merely the
option to invest. In particular, the drop in the follower’s profit between
the old industry structure (π 0) and the industry state following the lead-
er’s added investment (π F) may induce collaborative (tacit-collusion)
equilibrium. This feature also held in Fudenberg and Tirole’s (1985)
deterministic setting discussed above. This effect is not present when
firms are not yet invested (wait to invest).
The optimal joint-investment trigger X C * at which collaboration (or
tacit collusion) results in joint-value maximization satisfies
(VC − V0 ) X * = Π *, (12.15)
C
I
where VC ≡ π C δ and V0 ≡ π 0 δ are the perpetuity values of the deter-
ministic profit flows π C and π 0, δ ≡ k − g = r − ĝ, and Π* ≡ β1 (β1 − 1) is the
profitability index, with β1 given in equation (12.5). When the firms
choose to invest in additional capacities simultaneously, they both effec-
tively “exchange” their current profit flow π 0 for the higher profit π C. The
resulting positive value increment in case of joint investment is VC − V0 .
The profit flow for the follower decreases once the leader has invested.
The investment trigger for the follower is driven by the value differential
between the region where it has not yet invested and the region where
it is once again on an equal footing with the leader (after expansion)
invests. This value differential is VC − VF. The (myopic) investment trigger
for the follower, X F *, satisfies
(VC − VF ) X * = Π*, (12.16)

F
I
where VF ≡ π F δ is the perpetuity profit value as a follower.
Under the new market model involving the option to invest discussed
in the previous section, the follower earns no profits while waiting to
invest, that is, π F = π 0 = 0. Hence it suffers no damage when the leader
invests. For this reason the trigger values, X F * and XC *, were the same.
Moreover the value curve of the follower coincided with the joint-
investment value curve. Thus, in the case of new market models, joint
investment and collaboration (tacit collusion) do not emerge as possible
equilibria. By contrast, in the existing market model involving the option
to expand capacity, X F * < XC *.
In a Pareto-dominant equilibrium, firms would coordinate (or tacitly

collude) and refrain from investing until the stochastic state variable X t
has reached the larger threshold XC * ( > X F *) given in equation (12.15).
We refer to this Pareto-superior joint-investment equilibrium as “col-
laborative” or “tacit collusion” equilibrium (with subscript C). Among
all possible joint-investment equilibria, it is the more plausible.
The value functions as a leader, follower, or collaborator are given by
⎧⎪(VL X 0 − I ) − (VL − VC ) X F * B0 (TF *) if X 0 < X F *,
L ( X0 ) = ⎨ (12.17a)
⎩⎪VC X 0 − I if X 0 ≥ X F *,
⎪⎧VF X 0 + ⎡⎣(VC − VF ) X F * − I ⎤⎦ B0 (TF *) if X 0 < X F *,

F ( X 0 , X F *) = ⎨
⎩⎪VC X 0 − I if X 0 ≥ X F *,
(12.17b)
⎧⎪V0 X 0 + ⎡⎣(VC − V0 ) XC * − I ⎤⎦ B0 (TC *) if X 0 < XC *,
C ( X 0 , XC *) = ⎨
⎪⎩VC X 0 − I if X 0 ≥ X C *,
(12.17c)
where for GBM B0(TF *) = ( X 0 X F *) 1 and B0 (TC *) = ( X 0 XC *) 1 , with β1

β β
as in equation (12.5). It is interesting to examine two benchmark cases.

In the first case, there is a first-mover advantage; namely the leader’s
value from immediate investment, L ( X 0 ), exceeds the collaboration
value from jointly waiting until the common trigger XC *, C ( X 0 , XC *),
which corresponds to the first case considered in the deterministic setting.
In the second case, such a first-mover advantage does not exist and
L ( X 0 ) ≤ C ( X 0 , XC *).
A. First-mover advantage and preemptive investment

In this case, where L ( X 0 ) > C ( X 0 , XC *), the probability of having
invested depends on the overall industry history. For low past values of
the process, no firm has already invested, but if the process value gets
higher than the preemption point X P *, at least one firm will have
expanded capacity. It is not clear, however, which firm will actually be
the first investor.
For very low state value X t , there is no advantage to investing first. At
time TP * the values as leader and follower are equal. At this preemption
time qi (TP *) = 0 (from equation 12.21 in appendix 12C.1) and the prob-
ability of firm i being leader and firm j being follower is 1/2, as seen from
equation (12.1.2). The probability of simultaneous investment from
equation (12.1.4) is zero. The expected value for the leader is L ( X P *).
The perfect equilibrium strategy profile is given in appendix 12C.1.
392 Chapter 12
For state values in the intermediate region, X P * < X 0 < X F *, the value
as leader exceeds the value as follower. From equation (12.23) in appen-
dix 12C.1 the probability of investing is strictly positive with a positive
probability of simultaneous investment. If such a “coordination failure”
happens, each firm receives the lower joint value C ( X 0 , X C *). No firm is
better off since the expected value for each firm (even for the actual
leader) equals the value of the follower. For X 0 ≥ X F *, the equilibrium
outcome is joint investment at time t0. The value to each firm corresponds
to the net present value from immediate investment commitment,
C ( X 0 , XC *) = VC X 0 − I.
B. Collaborative investment
In the case when the collaborative value exceeds the leadership value,
C ( X 0 , XC *) ≥ L ( X 0 ), there are many symmetric equilibrium strategies.
These can be divided into two classes. The first class consists of the
sequential role orderings described in case A. The second class consists
of strategies where firms invest simultaneously in a collaborative fashion.
This second class of equilibrium strategies forms a continuum; these
equilibrium profiles are described in appendix 12C.2. The interpretation
is basically the same as in the deterministic case. Simultaneous invest-
ment as part of a collaborative equilibrium will take place the first time
the common threshold that maximizes joint value is reached (the Pareto-
optimal equilibrium is the most likely among the simultaneous invest-
ment equilibria).
In comparing cases A and B above, it may not be readily clear under
which circumstances investment takes place in a preemptive sequence
or when simultaneous joint investment at a later date occurs as part of
a cooperative relationship.27 As the reader might intuit, the fixed invest-
ment cost I does not alter the relative attractiveness of the preemptive
timing equilibrium outcome compared to the tacit collusion one—it only
affects the level of the investment thresholds but in the same proportion.
In cases of large uncertainty (high volatility σ), a high growth rate g , or
low discount rate (high discount factor), the outcome from strategic
interaction is typically that of the collaborative type. Conversely, for a
low degree of uncertainty, low growth, or a high discount rate (low dis-
count factor), firms may find it appealing to do their utmost to grasp a
first-mover advantage, likely resulting in a preemptive industry equilib-
rium. The speed of investment increases if market conditions favor the
preemptive type of equilibrium.
27. For that it is useful to perform comparative statics analysis as done by Huisman and
Kort (1999) and Huisman (2001, app. B).
12.3.2 Asymmetric Case
As noted, heterogeneity among option holders may change equilibrium

outcomes altogether. First, a myopic (open-loop) sequential investment
equilibrium where the leader invests at time TL* ignoring its rivals may
re-emerge as the industry equilibrium if the cost-advantage of the low-
cost firm is sufficiently high. If the cost advantage is relatively small, the
preemption threat precipitates the investment decision of the low-cost
firm leading it to invest at an earlier time that does not necessarily maxi-
mize its stand-alone value.
Existing market models may additionally exhibit the third type of
equilibrium, that of a joint or collaborative simultaneous investment.
This case is analyzed by Pawlina and Kort (2006).28 Asymmetry
among firms results in distinct beliefs about the optimal joint invest-
ment thresholds, with the low-cost firm having a “collaborative” invest-
ment trigger lower than that of the high-cost firm. Actual investment
thus occurs at the time the lower (low-cost firm’s) trigger is first
reached.
What matters from a strategic perspective is to understand the key
drivers that lead to these different types of equilibria. A primary driver
is the presence of a first-mover advantage, typically a market character-
istic. A second key driver relates to the size of the competitive advantage
by the advantaged firm, a firm characteristic. When the competitive (e.g.,
cost) advantage is relatively small and there is only a slight first-mover
advantage, the outcome tends to be that of a collaborative equilibrium
involving joint investment at a later (random) investment time TCL*.
When no firm has a significant first-mover advantage, it is preferable to
invest simultaneously at a later optimal time, jointly appropriating the
option value of waiting against exogenous demand uncertainty, than to
engage in detrimental timing rivalry resulting in cutthroat preemption.
If the cost advantage is small but there is a substantial first-mover advan-
tage, the low-cost firm may opt to reject the collaborative joint invest-
ment alternative and, driven by fear of preemption, invest early at time
TPL*; the high-cost firm will invest when the follower’s investment
trigger X FH * is first reached. These results are in line with the ones
obtained under firm symmetry in the previous section. If there is both a
sizable first-mover advantage and a substantial cost advantage, the
28. Pawlina and Kort (2006) consider an asymmetric model where firms have different
fixed investment costs. Their results may be extended to cases where firms have asymmetric
variable production costs, as in Días and Teixeira (2010), for the new market model case.
Different variable production costs allow for distinct reduced-form profits.
394 Chapter 12
Large
Sequential
investment
~
(open loop,TL∗)
Competitive
(cost) advantage
Collaborative Preemptive timing

(joint) investment investment
~ ~
(TC∗) (closed loop,TP∗≤TL∗)
Low
Low First-mover advantage Large
Figure 12.12
Investment strategies and different types of equilibria depending on first-mover advantage
and the size of competitive (cost) advantage
“Collaborative (joint) investment” involves simultaneous investment at (random) time
TC * ; In case of “preemptive timing investment,” the leader invests at an early preemption
time TP * ( ≤ TL*); “sequential investment” refers to the (“soft”) case where the leader need
not consider the preemption risk. The separating curves are not necessarily linear.
open-loop sequential investment where the low-cost firm invests as a

monopolist ignoring its rivals will likely be the industry equilibrium.29 In
specific market settings, the open-loop sequential investment is more
likely to occur than either preemption or delayed collaborative simulta-
neous investment.
Figure 12.12 summarizes the different types of equilibrium outcomes
that may result depending on certain market or firm characteristics, such
as the magnitude of the first-mover advantage and the size of competi-
tive (cost) advantage. Collaborative or joint investment refers to the
decision made by duopolists to invest simultaneously at a later random
optimal time TC *; preemptive timing investment is characterized by a
sequential investment where the leader invests at an early time
TP * ( ≤ TL*) due to strategic interactions arising from the threat of pre-
emption (closed-loop equilibrium); sequential investment refers to the
29. The outcome that sufficiently large cost advantage may induce firms to invest in a “soft”
(accommodating) investment sequence that does not exhibit preemption was discussed in
sections 12.2.2 and 12.2.3. Here we put this result in relative perspective and compare it to
the collaborative outcome.
case (discussed in chapter 11) where a firm having a substantial competi-

tive advantage invests myopically as a monopolist at time TL*, ignoring
rival effects (open-loop equilibrium).
Trigeorgis and Baldi (2010) discuss a slightly different option game
setting and derive similar insights. The authors assess the value of optimal
patent leveraging strategies under demand and strategic uncertainty,
illustrating how the magnitude of competitive advantage arising from the
patented innovation and the level and volatility of demand affect the
optimal patent strategy. They show the following:
1. When there is no competitive advantage and rivals are symmetric,

collaboration (e.g., via cross-licensing) is a natural equilibrium across
demand states.
2. When one of the rivals has a large comparative advantage via a supe-
rior patent, a fight mode is likely as the equilibrium strategy. However,
the precise patent leveraging strategy may differ across demand states.
It may range from offensive fighting (via bracketing each other’s patents
resulting in a patent war) if demand is high, to raising a defensive patent
wall by the advantaged firm (to strengthen its relative position and drive
out the rival) if demand is medium (with room for just one firm in the
market), to a defer (patent sleep) strategy maintaining an option on a
future monopoly position should the market recover if current demand
is low, with the disadvantaged rival abandoning the market if demand is
insufficient.
3. In case of a small competitive advantage at intermediate levels of
demand, the firm is better off to pursue a flexible hybrid strategy, switch-
ing from a fight mode (e.g., bracketing) at high demand to collaboration
(licensing out) as demand declines.
Conclusion
In this chapter we provided an overview of several important investment

timing and equilibrium issues arising in option games. We first discussed
the simpler deterministic setting and explained how preemption threat
can impact the optimal investment timing decisions of firms. We subse-
quently discussed how to extend the analysis to take account of uncer-
tainty and strategic aspects arising in real options analysis. We analyzed
in turn the investment timing option (new market model) and the option
396 Chapter 12
to expand (existing market model) in a competitive duopoly setting

under uncertainty.30
We have seen that the presence of a first-mover advantage and the
size of a comparative cost advantage are the main drivers in such stra-
tegic investment decisions. We have shown that an aggressive stance
toward one’s rival (preemption) is not always the preferable modus
vivendi among firms in a duopolist industry. Firms may sometimes find
it preferable to coordinate their entry or investment timing decisions
depending on the state and evolution of the market. Investing in a more
efficient production technology (achieving lower marginal operating
cost) may result in a “soft” ordering (open-loop investment sequence)
where the leader does not suffer from preemption threat. But the pre-
ferred strategy is not obvious as it depends on both market and firm-
specific characteristics that merit closer assessment. This chapter provided
useful insights on when to lead, when to follow, and when to collaborate
with rivals under uncertainty.
Selected References
Fudenberg and Tirole (1985) refine Reinganum’s (1981a) model dis-

cussing continuous-time mixed-strategy equilibria. They set the founda-
tions for deterministic games of timing, including the analysis of
preemption. Smets (1991) extends Fudenberg and Tirole’s framework to
a stochastic setting analyzing an existing market model (expansion
option). Dixit and Pindyck (1994) present a simplified version based on
a new market model (investment timing option). Huisman and Kort
(1999) provide a comprehensive view on this problem. Días and
Teixeira (2010) analyze production cost asymmetries in such a context,
while Pawlina and Kort (2006) consider asymmetric investment costs.
Thijssen, Huisman, and Kort (2002) discuss an extended definition of
strategy spaces that enables handling timing issues in stochastic envi-
ronments. Huisman et al. (2004) review option games contributions
dealing with new versus existing market models in a lumpy-investment
context.
Días, Marco A. G., and José P. Teixeira. 2010. Continuous-time option

games: Review of models and extensions. Multinational Finance Journal
14 (3/4): 219–54.
30. Bouis, Huisman, and Kort (2009) recently investigate such problems in an oligopoly
context with more than two firms.
Fudenberg, Drew, and Jean Tirole. 1985. Preemption and rent equaliza-
tion in the adoption of new technology. Review of Economic Studies 52
(3): 383–401.
Huisman, Kuno J. M., and Peter M. Kort. 1999. Effects of strategic inter-
actions on the option value of waiting. CentER discussion paper 9992,
Tilburg University, The Netherlands.
Huisman, Kuno J. M., Peter M. Kort, Grzegorz Pawlina, and Jacco J. J.
Thijssen. 2004. Strategic investment under uncertainty: Merging real
options with game theory. Zeitschrift für Betriebswirtschaft 67 (3):
97–123.
Pawlina, Grzegorz, and Peter M. Kort. 2006. Real options in an asym-
metric duopoly: who benefits from your competitive disadvantage?
Journal of Economics and Management Strategy 15 (1): 1–35.
Reinganum, Jennifer F. 1981a. On the diffusion of new technology: A
game-theoretic approach. Review of Economic Studies 48 (3): 395–405.
Smets, Frank. 1991. Exporting versus FDI: The effect of uncertainty,
irreversibilities and strategic interactions. Working paper. Yale
University.
Thijssen, Jacco J. J., Kuno J. M. Huisman, and Peter M. Kort. 2002. Sym-
metric equilibrium strategies in game-theoretic real option models.
Discussion paper 2002–81, CentER, Tilburg University, Tilburg, The
Netherlands.
Appendix 12A: Strategy Space and Solution Concept
Players’ strategies are defined in the following fashion. A continuation

strategy si (t ) for firm i in a subgame starting at time t consists of a pair
of strategy functions si ( t ) ≡ (Gi ( t ) , qi ( t )) such that:31
1. Gi (⋅) is a cumulative distribution function reflecting the history of the
industry. It represents the probability that firm i has invested before or
at time t ( ≥ t0 ) given that the other firm has not yet invested.
31. For a more detailed discussion on the definition of strategy space and closed-loop
strategy, refer to Fudenberg and Tirole (1985) or Thijssen, Huisman, and Kort (2002). We
use here the term “continuation strategy” instead of “simple strategy” as in Fudenberg
and Tirole (1985) or Thijssen, Huisman, and Kort (2002) since, in our opinion, the term
“continuation” better captures the fact that the strategy applies to the subgame starting
at t ≥ t0 that is concatenated in the whole game starting at t0 .
398 Chapter 12
2. qi (⋅) represents the instantaneous (mixed) action taken by firm i at

time t. It is a notion of the probability (“intensity” or “density”) with
which firm i invests at time t. qi (⋅) is an atoms function in optimal control
theory. It represents discrete-time mixed-strategy measures which are
lost when one considers only the distribution function Gi (⋅).32
The strategic-form game depicted in figure 12.1 is played as soon as

one of the firms invests with positive probability (qi ( t ) > 0 or q j (t ) > 0),
{ }
namely at time T ≡ min {Ti ,Tj }, where Ti ≡ inf s ≥ t⏐qi ( s ) > 0 or Ti ≡ ∞
if qi ( t ) = q j ( t ) = 0 for all t ≥ t0 . The game is played repeatedly in “rounds”
at time t, with no time elapsing between “rounds.”
A pair of continuation strategies ( si * (t ) , s j * (t )) is a Nash equilibrium
of the game starting at time t if each player’s strategy maximizes her
payoff given the optimal strategy of its rival. A closed-loop strategy
si = {si ( t )}t ≥ t0 is a collection of continuation strategies specifying for
each subgame at time t, which continuation strategy to pursue.33 A pair
of closed-loop strategies ( si *, s j *) forms a subgame perfect Nash equilib-
rium if for every time t ( ≥ t0 ) the pair of continuation strategies
( si * (t ) , s j * (t )) is a Nash equilibrium. The definition above of closed-
loop equilibrium is a continuous-time translation of the subgame perfec-
tion solution concept prescribing that players act optimally (as part
of Nash equilibrium) at every subgame (here, the subgame at future
time t ≥ t0).
Appendix 12B: Perfect Equilibrium in Deterministic Setting
Here we provide a formal representation for the equilibrium investment

density and specify the perfect equilibrium strategy profile. We define
{ }
TP* ≡ inf t ≥ t0 ⏐L(t ) = F (t ) , TF* ≡ arg max t ≥ t0 F (t ), and TC* ≡ arg max C( t ).
32. The way used, for example by Pitchik (1982), to describe a player’s strategy
involves the function Gi (·) as a nondecreasing, right-continuous cumulative probability
that player i has invested conditional on the other player not having invested before.
This approach allows for mixed strategies but is refined by Fudenberg and Tirole
(1985) for two reasons. First, it does not specify what happens in all possible subgames,
hindering the use of the subgame perfect equilibrium concept that prescribes continu-
ation strategies that form Nash equilibrium for all subgames, even those off the equi-
librium path. Second, the function Gi (·) fails to be a continuous-time analogue to the
equivalent discrete-time game of timing because of loss of information when taking
the limit.
33. Fudenberg and Tirole (1985, p. 393) and Thijssen, Huisman, and Kort (2002, p. 11)
impose some intertemporal consistency conditions on the closed-loop strategies.
12B.1 Case L(TL* ) > C(TC* )
Since playing the strategic-form game takes no time, the value for firm
i, V i (qi , q j ), as a function of the instantaneous investing probabilities
qi = qi (t ) and q j = q j ( t ), can be expressed in a recursive manner as
V i ( qi , q j ) = qi q j C i (t ) + qi (1 − q j )Li (t ) + (1 − qi )q j F i (t )
+ (1 − qi )(1 − q j )V i ( qi , q j )
obtaining, for (qi , q j ) ≠ (0, 0),
qi q j C i ( t ) + qi (1 − q j ) Li (t ) + (1 − qi ) q j F i (t )
V i ( qi , q j ) = .
q j + qi − qi q j
The first-order optimization condition gives
∂V i
(qi *, q j *) = 0, or qj * [(1 − qj *) Li (t ) − F i( t ) + qj * C i (t )] = 0.
∂qi
The concavity of V i (⋅, q j ) is confirmed from the second-order derivative.
Applying these conditions to the above (asymmetric) expression leads
to equation (12.1).
The cumulative distribution function for the symmetric equilibrium
when L(TP* ) > C(TC* ) is given by
⎧0 if t < TP *,
G (t ) ( = Gi (t ) = Gj ( t )) = ⎨
⎩ 1 if t ≥ TP *.
Together with the (symmetric) instantaneous investing intensity
(probability)
⎧0 if t < TP *,
⎪
q (t ) = ⎨φ ( t ) if TP * ≤ t < TF *,
⎪1 if t ≥ TF *,
⎩
with φ (⋅) given in (12.2) this constitutes the perfect closed-loop equilib-
rium in the preemption case involving symmetric firms. This equilibrium
strategy is interpreted as follows. In the period prior to the preemption
time TP *, there is no incentive for either firm to invest, so no one invests
(G ( t ) = 0 and q ( t ) = 0 if t < TP *). In the period after the preemption time
TP *, one firm in the industry will invest, such that G( t ) = 1 for t ≥ TP*. For
t > TF *, the follower firm invests. qi (·) indicates the equilibrium intensity
of investment: for a burgeoning market, firms stay out; for t ∈[TP *, TF *]
they mix their investment decision; for a mature market, they invest with
probability 1.
400 Chapter 12
12B.2 Case L(TL* ) £ C(TC* )
In a duopoly with identical firms where L (TL*) = C (TC ) ≤ C (TC *), the
following symmetric strategies result in a perfect equilibrium:
G ( t ) ( = Gi (t ) = Gj ( t )) = {
0 if
1 if
t < T,
t ≥ T,
and
q (t ) = {
0 if
1 if
t < T,
t ≥ T,
(12.18)
for any T ∈[TC , TC *]. Among them, the Pareto-superior equilibrium is

characterized by the following symmetric strategy profiles:
G ( t ) ( = Gi ( t ) = Gj (t )) = {
0 if
1 if
t < TC *,
t ≥ TC *,
and
q (t ) = {
0 if
1 if
t < TC *,
t ≥ TC *.
(12.19)
Appendix 12C: Perfect Equilibrium in Stochastic Setting
12C.1 Case L( X 0 ) > C( X 0 , XC* )
The closed-loop equilibrium investment strategy for firm i again consists

of two functions: a cumulative distribution function Gi (⋅) and an invest-
ment intensity function qi (⋅). In the asymmetric case the perfect equilib-
rium strategy for firm i (firm j’s optimal strategy being obtained
symmetrically) is given by
⎧⎪0 if t < TPi * (or max { X s ; 0 ≤ s ≤ t} < X Pi *),
Gi ( t ) = ⎨
⎩⎪ 1 if t ≥ TP * (or max { X s ; 0 ≤ s ≤ t} ≥ X P *),
i i
and
⎧0 if t < TPi * (or max { X s ; 0 ≤ s ≤ t} < X Pi *),
⎪
qi ( t ) = ⎨φ j ( t ) if TPi * ≤ t < TFi * (or X Pi * ≤ max {X s ; 0 ≤ s ≤ t} < X Fi *),
⎪
⎩1 if t ≥ TFi * (or max { X s ; 0 ≤ s ≤ t} ≥ X Fi *),
(12.20)
where in the intermediate region
Lj (⋅) − F j (⋅)
φ j (⋅) ≡ . (12.21)
Lj (⋅) − C j (⋅)
For the symmetric case the cumulative distribution term simplifies to
⎪⎧0 if t < TP * (or max {X s ; 0 ≤ s ≤ t} < X P *),

G(t ) ( = Gi (t ) = Gj (t )) = ⎨
⎩⎪ 1 if t ≥ TP * (or max { X s ; 0 ≤ s ≤ t} ≥ X P *).
The probability of entering during the next instant t becomes
⎧0 if t < TP * (or max {X s ; 0 ≤ s ≤ t} < X P *),
⎪
q ( t ) = ⎨φ ( t ) if TP * ≤ t < TF * (or X P * ≤ max {X s ; 0 ≤ s ≤ t} < X F *),
⎪
⎩1 if t ≥ TF * (or max {X s ; 0 ≤ s ≤ t} ≥ X F *),
(12.22)
where
L (t ) − F (t )
φ (t ) ≡ . (12.23)
L (t ) − C (t )
The probability of having invested is related to the overall industry
history. For low current values of the process X t , namely for X t such that
max {X s ; 0 ≤ s ≤ t}, no firm has already invested. If the process reaches
values higher than the preemption point X P *, at least one firm has
invested.
12C.2 Case C( X 0 , XC* ) ≥ L( X0 )
Symmetric collaborative (or tacit-collusion) equilibria are pairs of strate-

gies of the form
⎪⎧0 if t < T (or max {X s ; 0 ≤ s ≤ t } < X ),

Gi (t ) = ⎨
⎪⎩1 if t ≥ T (or max {X s ; 0 ≤ s ≤ t } ≥ X ),
and
⎧⎪0 if t < T (or max {X s ; 0 ≤ s ≤ t } < X ),
qi (t ) = ⎨
⎪⎩1 if t ≥ T (or max {X s ; 0 ≤ s ≤ t } ≥ X ),
where X ∈[ XC , X C *] and XC is such that L ( XC ) = C ( XC , XC ) and

T = inf {t ≥ 0 | X t ≥ X }. The choice XC * ∈[ XC , XC *] that maximizes
joint value is Pareto optimal and may be considered more likely
to be implemented in the industry. The Pareto-optimal collaborative
402 Chapter 12
equilibrium consists of the following strategy profiles (for i and j

symmetrically):
⎧⎪0 if t < TC * (or max {X s ; 0 ≤ s ≤ t} < X C *),
Gi ( t ) = ⎨ (12.24)
⎩⎪1 if t ≥ TC * (or max {X s ; 0 ≤ s ≤ t} ≥ XC *),
and
⎪⎧0 if t < TC * (or max {X s ; 0 ≤ s ≤ t} < XC *),

qi ( t ) = ⎨ (12.25)
⎩⎪1 if t ≥ TC * (or max {X s ; 0 ≤ s ≤ t} ≥ XC *).
13 Extensions and Other Applications
In the previous chapters we discussed how to analyze option games

and discussed how they can provide powerful insights into how firms
(should) behave when they face an option to defer investment as well
as strategic interactions, potentially leading to early preemptive invest-
ment. We restricted the discussion primarily to models of complete
information and ignored potential time lags between the investment
decision and effective entry in the market. In this chapter we discuss
extensions of the option games framework that allow for a time lag
or time to build, for technological uncertainty and for information
asymmetry. This chapter also serves to provide an overview of other
important contributions to the analysis of real options and strategic
competition in a dynamic setting.1 The analysis of option games in
such contexts brings about additional insights and helps explain
various real-world industry phenomena, such as waves in real-estate
markets.
Below we review briefly specific research contributions to option
games analysis. Section 13.1 deals with early approaches where competi-
tive entry decisions are treated exogenously. Applications to the real-
estate sector are presented in section 13.2. Section 13.3 elaborates
on multistage R&D or patent strategies. Section 13.4 addresses
information asymmetry among option holders and how it may affect
investment strategies. Models dealing with exit are also addressed
in section 13.5. When a market or industry declines, a firm may wait
for its rival to exit first hoping to enjoy monopoly rents. Situations
where firms can reduce their capacity utilization to cushion against
1. The edited book by Grenadier (2000a) provides a good collection of articles on game-
theoretic option models. Grenadier (2000b) illustrates how the intersection of real options
and game theory provides powerful insights into the behavior of economic agents under
uncertainty with applications in real estate and oil exploration.
404 Chapter 13
market downturns are addressed in section 13.6. Section 13.7 considers

situations where firms make sequential lumpy investment decisions. The
last section provides a broad overview of recent developments in the
field and other extensions or applications.
13.1 Exogenous Competition and Random Entry
Early research focused on aspects of competition that can be modeled

exogenously. This approach helped identify certain major drivers under-
lying option games. Trigeorgis (1991) studies the impact of competition
on optimal investment timing using standard contingent-claims analysis
based on the geometric Brownian motion. Consider an option-holding
firm facing the introduction of close substitute products. Such “competi-
tive arrivals” may reduce the value of the firm’s own investment oppor-
tunity by taking away market share. Competition in this context can be
modeled in one of two ways, depending on whether competitive entry is
anticipated or random:
• Anticipated competitive erosion This can be treated analogous to an
opportunity cost or dividend yield reducing the firm’s incentive to defer
investment.2 If an option-holding firm decides to wait longer, it risks
suffering competitive damage analogous to forgone “dividends,” just as
the holder of a financial call option on a dividend-paying stock forgoes
cash dividend payments if it holds the option and does not exercise early.
If instead the firm invests early and thereby preempts its rivals, it “keeps”
the “dividends” that would otherwise be lost.
• Random rival arrivals Random arrivals of substitute products by
competitors can be modeled via the Poisson term in a mixed-jump-
diffusion process with mean arrival rate λ . At the time of a random rival
entry, the incumbent’s profit value suddenly drops from monopoly rents
to duopoly profits, creating a value discontinuity captured by the jump
term. The mean arrival rate λ represents the random competitive arrival
rate or the instantaneous probability of a random competitive entry
causing a downward jump. Trigeorgis (1991) shows that the value of a
shared investment opportunity characterized by such exogenous random
competitive entry is a weighted sum (or expected value over a Poisson
distribution) of Black–Scholes option values with a dividend yield
2. In market equilibrium the total return of a project ( k ) equals the expected capital gain
( g ) plus the dividend payout (δ ). A higher dividend yield implies a lower proportion of
capital gains, g / k .
Extensions and Other Applications 405
increased by an additional “dividend payout” term whose magnitude

depends on λ (competitive intensity).3
This simplified framework modeling competitive entry exogenously can

help an option-holding firm determine whether to wait despite antici-
pated or random competitive value erosion and assess the value of the
deferral option in the midst of competition erosion. Reiss (1998) devel-
ops a framework to determine whether, and when, a firm should patent
or adopt an innovation in a setting where rivals arrive randomly follow-
ing a Poisson process. She identifies several option exercise strategies
applied in a context where competition is exogenously determined.
The exogenous approach, however, is limited in that it does not explain
what drives competitors’ entry decisions. Competitive arrivals are simply
assumed exogenous driven by some external process in competitive
markets. An endogenous modeling approach focused on explaining the
drivers behind competitors’ entry decisions and strategic interaction
from a game-theoretic perspective is more appropriate for oligopolistic
industries.
13.2 Real-Estate Development
Grenadier (1996) develops a duopoly model involving time lags or “time

to build” that provides insights into the forces that shape certain market
behaviors in the real-estate market. The approach helps explain several
puzzling real-estate phenomena, such as booms and bursts. Real-estate
markets are characterized by sudden large development efforts in some
periods while smoother development patterns are observed in other
periods. The analysis helps identify the factors that make some markets
prone to bursts of concentrated development, explaining why such
markets sometimes experience building booms in the face of declining
demand and property values. Consider two symmetric real-estate
developers having the possibility to refurbish their buildings for an
investment outlay I , increasing their profit stream accordingly. The
two buildings currently yield a constant profit stream of π 0 per unit
of time. If only one building is refurbished, this building will earn a sto-
chastic profit stream of X t π L , with X t following a geometric Brownian
motion (where π L > π 0). This action nevertheless will affect the rival as
the deterministic profit flow for its (nonrefurbished) building changes
3. Trigeorgis (1991) assumes a finite planning horizon, making it possible to use the Black–
Scholes option pricing formula.
406 Chapter 13
from π 0 to π F ( X t ) ≡ π F , where π F < π 0 . If the second developer also

decides to renovate its building, both firms will earn a stochastic profit
stream of X t π C per unit of time (where π C < π L). Grenadier takes into
account that real estate development involves time-to-build delays,
thereby affecting the standard real options investment rule under uncer-
tainty. In many situations, undertaking an investment takes time. There
may be several years between the decision to invest and the time at
which the project gets completed and revenues get generated. Suppose
that refurbishing the old building takes D years until completion. During
this delay period the owner cannot receive rents from the building. The
follower’s optimal threshold previously given by equation (12.4) is now
adjusted to
VC X F *
= Π* e −δ D , (13.1)
I′
where VC ≡ π C δ and I′ is the total cost involved in exercising the option,
namely the investment cost I plus the value of the foregone perpetual
rent stream from the old building, π F δ . The profitability index is again
given by
β1
Π* = . (13.2)
β1 − 1
Depending on initial demand, the equilibrium strategies pursued by
the two developers lead to four distinct scenarios. For Xˆ t < X P * with
Xˆ t ≡ max {X s ; 0 ≤ s ≤ t}, the follower’s value strictly exceeds the leader’s
and no refurbishment investments will take place in equilibrium. At the
preemption threshold, X P *, the two real-estate developers are indiffer-
ent between the leader role or the follower role (rent equalization). In
Grenadier’s model the actual leader is chosen randomly with probability
one half.4 For X P * ≤ Xˆ t < X F *, only one firm invests. For Xˆ t ≥ X F *, both
developers decide to renovate their premises and their values are equal.
A tacit collusion scenario may arise for certain values of the underlying
process.5 Grenadier (1996) establishes the existence of two classes of
equilibria. Depending on initial conditions, some equilibria are charac-
terized by sequential development while others by simultaneous
4. Grenadier (1996) assumes a strictly sequential equilibrium entry ordering where one
firm is selected as leader over the flip of a fair coin. He suggests that this mechanism
resembles real-estate developers applying for permits with only one receiving an initial
approval. Huisman and Kort (1999) point out that this result holds only for X 0 < X P .
5. In reality there exists a continuum of tacit-collusion equilibria. Game theorists (e.g.,
Fudenberg and Tirole, 1985) often assume that the Pareto-efficient equilibrium is selected.
investment. For a burgeoning market (starting at X 0 < X L*), a sequential

investment equilibrium occurs with one firm investing at time TP *
and its rival waiting to invest until time TF *. For a mature market
( X 0 ≥ X F *), the sequential investment equilibrium is ruled out. Both
firms will wait for the Pareto-optimal collaborative trigger XC * to be
reached and invest simultaneously.
Based on this framework, Grenadier (1996) derives a rationale for
certain investment behaviors observed in real-estate markets, such as
investment cascades and recession-induced construction booms (RCB).
During an investment cascade, a number of real-estate projects are being
developed concurrently over a sustained time period. This is measured
by the time interval between refurbishments, namely the median time
span between the leader’s and the follower’s investments. Recession-
induced construction booms characterize periods where, despite an
economic downturn, brand new buildings are being completed and
commercialized. With ( X F *, X C *) being the interval for initial demand,
TF * (TC *) is the first time when X F * ( X C *) is hit. If TF * < TC *, a recession-
induced construction boom (RCB) results as both developers will invest
in fear of being preempted, even though the market demand is low. Prob-
ability P (TF * < TC *) indicates the likelihood of occurrence of a RCB.
Comparative statics for the median time span and for P (TF * < TC *)
enable identifying key drivers for such real-estate market phenomena.
Time to build and depreciation of old buildings have no effect on the
mean time span, but volatility does. Volatile markets are more likely to
exhibit construction cascades. The time-to-build delay is a major driver,
increasing the likelihood of occurrence of recession-induced construc-
tion booms. The inferences above are confirmed by empirical real-estate
studies, helping us understand these puzzling real-estate market phe-
nomena. Based on data relating to more than 1,200 real-estate projects
in Vancouver, Canada, between 1979 and 1998, Bulan, Mayer, and Somer-
ville (2009) provide empirical support to the argument that competition
erodes option value.
13.3 R&D and Patenting Applications
Despite much technological progress made in the last decades, R&D

investment decisions remain challenging. Many technology firms put
technology adoption as a primary goal. At the same time firms face more
competition than ever. Option games can help provide powerful insights
to understand competitive technology-driven industries, giving valuable
408 Chapter 13
investment timing guidance to management. Several authors use option

games to derive insights into how firms should conduct R&D or use their
patents as a strategic weapon. These models help explain how competi-
tion affects firms’ research programs and the portfolio of intellectual
property rights.
Huisman (2001) discusses various types of models of technology adop-
tion. He identifies decision-theoretic models of investment under uncer-
tainty, involving technology adoption policies by a monopolist firm. He
then discusses game-theoretic models in a deterministic setting. Finally,
he combines the two approaches to deal concurrently with both market
as well as competitive uncertainty. Although Huisman (2001) focuses on
technology adoption, some of his insights are tractable and applicable in
other contexts, such as when to enter a foreign market. Huisman dis-
cusses symmetric and asymmetric models and examines the effects of
negative versus positive externalities on the equilibrium outcome. In
technology-driven markets the availability of new technologies is uncer-
tain, so the expected speed of the arrival of new technologies affects the
optimal investment sequence. Huisman and Kort (2004) examine tech-
nology adoption in a duopoly given the possible future arrival of an
improved technology, allowing for uncertain arrival time following a
Poisson process.
Weeds (2002) analyzes a patent race among duopolist firms and the
effect of competitive pressure on firms’ research strategies under a
winner-takes-all patent system. Uncertainty takes two forms: the techno-
logical success of research activity is probabilistic, while the economic
value of the patent evolves stochastically. The author compares equilib-
rium strategies obtained in this setting with a socially optimal bench-
mark, deriving implications for research policy. A central planner can
steer research in one of two ways: allocating R&D investment to decen-
tralized research units or setting up a common aggregate research center
with a single investment policy. Suppose that two identical firms have the
opportunity to launch an R&D project by investing I . The first firm
to succeed will gain an exclusive patent yielding a stochastic profit flow
X t , while the other firm will be left with nothing. A firm’s R&D strategy
sets a profit trigger at which research activity is initiated. Weeds derives
first the optimal behavior imposed by a social planner on two decentral-
ized research units. The social planner would optimally choose to phase
the research. In the socially optimal scenario, one firm (the leader) starts
conducting research in hope of acquiring the patent when profit reaches
a specified threshold level X L*; the follower initiates research later on,
when the socially optimal threshold X F * is first attained. This threshold

is such that
δ + 2λ ⎞
= Π* ⎛⎜
XF *
⎝ λ ⎟⎠
(13.3)
I
with Π * as per equation (13.2). If firms behave as a single centralized
research center, as opposed to independent research units, the optimal
trigger is X C ′, such that X C ′ I = Π* [(δ + 2λ ) λ ]. This threshold XC ′ is
between X L* and X F *. The centralized collaborative research setup
leads to later investment compared to the case of independent research
units (as X L* < XC ′). Weeds (2002) shows that the choice made by a
centralized research unit may be socially suboptimal. This contrasts with
standard antitrust thinking regarding joint research ventures. These
findings challenge conventional policies that aim to foster research
cooperation.
Mason and Weeds (2002) consider further strategic interactions
between option-holding firms. A firm considering being the leader might
be hurt by the follower’s entry (negative externality) or benefit from it
(positive externality, e.g., due to network effects). They consider the
irreversible adoption of a technology whose returns are uncertain when
many firms are active in the market, focusing on the effect of uncer-
tainty and externalities on the type of investment schedule (sequential
vs. simultaneous investment). The combination of preemption and nega-
tive externalities can hasten investment compared to the myopic bench-
mark. Option value is eroded when firms are faced with the fear of
competitive preemption. Two patterns of adoption emerge: sequential
vs. simultaneous investment. With no first-mover advantage and no pre-
emption, the leader adopts the new technology at the simultaneous
cooperative trigger point; otherwise, a preemptive sequential invest-
ment occurs where the follower adopts earlier than the cooperative
solution.
Miltersen and Schwartz (2004) analyze patent-protected R&D invest-
ments with imperfect competition in the development and commercial-
ization of a product. Strategic interactions in this case substantially alter
the investment decisions of a stand-alone firm. Option holders have to
take into account not only the standard factors that directly affect their
own decisions, but also the impact of their competitors’ decisions on their
own investment policy. Competition in R&D can increase aggregate
production and reduce prices. It can also shorten the time necessary to
develop the product and raise the probability of successful development.
410 Chapter 13
These benefits to society are offset by increased R&D investment costs

and lower value from the R&D investment for each firm.
Time-to-build delays can also affect the innovative investment strate-
gies of firms. In R&D, such delays before completion of a project are
rarely known in advance as there is additional uncertainty over the
innovation success. Technological uncertainty is characteristic of many
industries, such as bio-tech, IT, and oil exploration. Weeds (2000) exam-
ines the uncertainty over innovation completion and its impact on the
duopolists’ technology adoption decisions. She considers two-stage R&D
investment processes with completion uncertainty and their implications
for sleeping patents. The firm invests in R&D with the aim to acquire a
patent giving it exclusive access to a new market. If the first-stage innova-
tion is successful, the firm can make an irreversible investment to adopt
the new technology and enter the market. This two-stage investment
opportunity can be viewed as a compound option where the value of the
first-stage research option partly derives from the second-stage com-
mercial investment option. This framework provides a rational explana-
tion for the existence of sleeping patents, that is, patents granted but kept
in a stand-by or “sleep” mode. Policy makers typically regard sleeping
patents as anticompetitive devices employed by dominant firms to erect
entry barriers (blockaded entry). However, in this context sleeping
patents may arise purely from optimizing behavior when option values
coexist with completion uncertainty. Sleeping patents thus do not neces-
sarily indicate anticompetitive behavior. By restricting a firm’s ability to
time entry in the product market (with the possibility to let a patent sleep
if optimal under uncertain conditions), compulsory licensing imposed by
antitrust authorities can actually reduce option values and weaken the
firm’s incentive to conduct research in the first place.
Lambrecht (2000) derives optimal investment strategies for two sym-
metric firms sharing the option to make a two-stage sequential invest-
ment with incomplete information about the rival’s profit. In the first
stage each firm is competing to acquire a patent enabling it to proceed
to the second stage involving commercialization of the invention. The
optimal investment policy for the first stage reveals a trade-off between
the benefit of waiting to invest under uncertainty and the cost of being
preempted. Lambrecht derives a condition under which inventions are
likely to be patented without being put to immediate commercial use.
Sleeping patents are more likely to exist in an R&D portfolio when
interest rates are low, volatility is high, and the second-stage cost is high
relative to the first-stage cost.
Smit and Trigeorgis (1997) analyze an R&D investment problem

where the underlying R&D value is affected by strategic interactions.
Firms choose output endogenously and may have different production
costs as a result of their R&D effort success, their roles (leader or fol-
lower), and their learning experience. Firm incentives to conduct R&D
depend on market and technological uncertainty, the proprietary or
shared nature of R&D benefits, firms’ information asymmetry or learn-
ing experience, and competition versus cooperation (e.g., joint venture)
in the R&D stage.
Garlappi (2004) analyzes the impact of competition on the risk premia
of R&D ventures. Firms are engaged in a multiple-stage patent race
under technical and market uncertainty. The case of a two-stage race
admits a closed-form solution whereby the firm’s risk premium decreases
due to technical progress but increases when a rival pulls ahead. R&D
competition erodes the option value to delay a project, reduces the
completion time, and lowers the failure rate of R&D. It generally causes
higher risk premia.
Azevedo and Paxson (2009) discuss investment in new technologies
whose functions are complementary, determining the leader’s and the
follower’s values and their investment thresholds. At the outset firms
have two technologies with the possibility to adopt both. Their results
challenge the common rule of thumb that a firm should upgrade or
replace its production processes simultaneously if they involve comple-
mentary inputs. Faced with uncertain revenues and technology costs, the
leader and the follower may be better off adopting the technologies at
different times, adopting first the technology with slowly decreasing cost
and later the technology with a more rapid cost decline.
13.4 Investment with Information Asymmetry
Real life is often characterized by information asymmetry among rival

firms. For instance, a firm may have better knowledge of its own cost
structure or the probability of success of its own R&D efforts. Through
their option exercise decisions, investing firms may convey signals to
other firms that enable learning or revision of their prior beliefs. The
development of an office building, the drilling of an exploratory oil
well, or an application by a pharmaceutical company for regulatory
approval of a new drug convey (bad or good) news to competing firms,
which may alter their initially planned behavior accordingly. We discuss
412 Chapter 13
discrete-time option models first, and then present continuous-time

analyses.
Zhu and Weyant (2003a, b) consider two firms facing stochastic linear
(inverse) demand of the form given in equation (7.1) with a = 1, namely
P( X t , Q) = X t − bQ,
where Q = qi + q j is the total industry output and X t is an additive sto-

chastic shock (demand intercept) as in Smit and Trigeorgis (2004). Firms
face linear marginal costs, Ci (qi ) = ci qi . Firm j has complete information,
whereas firm i knows its own cost ci but not its rival’s, believing it to
be cH with probability P or cL with probability 1 − P. Firm i’s expectation
about its rival’s cost is c j = PcH + (1 − P ) cL. If firms invest simultaneously,
firm j selects equilibrium quantity
q*j =
3b
( X t − 2c j + ci )
1
(13.4)
in knowledge of both costs, its own cost being cH or cL. Firm i instead
forms expectations about its rival’s quantity and optimally selects the
output based on the rival’s expected cost c j:
qi* =
3b
( X t − 2ci + cj ).
1
(13.5)
In case of sequential investment decisions, the outcome may be different.

That is, the effect of incomplete information crucially depends on the
order of the investment decisions. If the less-informed party (firm i)
moves first, the sequential incomplete-information equilibrium is derived
analogously to the simultaneous one. However, if firm j invests first, it
will reveal its private cost information through its quantity choice
(Cournot–Nash quantity). Information asymmetry effectively collapses,
so that quantities are chosen as in the complete-information duopoly
game, that is, as if having knowledge of the leader’s cost, cL or cH .
Following continuous-time analysis, Lambrecht and Perraudin (2003)
consider the effect of incomplete information on optimal timing in a
duopoly game where stochastic profit flow X t follows a geometric
Brownian motion. No firm knows the exact realization of their rival’s
investment cost but each has some prior beliefs about it in the form of
a known distribution G( I ). There exists a Bayesian equilibrium that
maps firm i’s investment cost I i into firm i’s investment threshold. Since
both firms are (ex ante) symmetric, firm i’s exercise strategy involves a
mapping from the distribution G( I j ) to a belief Fj ( X j ) for the rival’s

investment trigger. The authors assume that the market is incontestable
once a leader has entered, as is the case when the market is fully pro-
tected by a patent. The patent allows disregarding the entry of the fol-
lower and concentrating solely on the leader’s optimal timing decision
and the interplay between preemption and information asymmetry.
Assuming a distribution function Fj (⋅) for the rival’s investment trigger
X j , firm i updates its beliefs about its rival’s investment strategy by
observing whether the latter decides to invest when a new (running)
maximum max {X s ; 0 ≤ s ≤ t} is reached.6 Accounting for the risk of
preemption, firm i’s optimal investment threshold is X Pi such that
[VL ( X Pi ) I ] = Π*′, where VL ( X Pi ) = X Pi δ and
β1 + hj ( X Pi )
Π*′ ≡ , (13.6)
β1 − 1 + hj ( X Pi )
where β1 is given in equation (9.12) and hj (·) is the hazard rate
hj ( x) = xFj ′ ( x ) [1 − Fj ( x)]. The authors derive firm i’s myopic threshold
X Li, when firm i ignores its rival’s action, yielding value VL ( X Li ) I = Π*,
with Π * as per equation (13.2). They show that the threshold in case of
information asymmetry is located between the zero-NPV (preemption)
threshold and the monopolist’s myopic threshold.7 Given the optimal
timing decision, firm i’s value is
⎛X ⎞
β1 ⎡ 1 − Fj ( X Pi ) ⎤
( )
Li0 X t , Xˆ t = [VL ( X Pi ) − I i ] ⎜ i0 ⎟ ⎢ ⎥. (13.7)
⎝ XP ⎠ ( )
⎢⎣ 1 − Fj Xˆ t ⎥⎦
If firm i does not exactly know its rival’s investment cost, I , but knows
its distribution, there exists a mapping from the firm’s investment cost
to its optimal investment trigger X Pi .
Murto and Keppo (2002) consider an investment game where the fol-
lower loses any possibility to enter. They characterize the resulting Nash
equilibrium under different assumptions concerning the information
that the firms have about their rivals’ valuation. Thijssen, Huisman, and
6. Rival’s inaction at a new high allows a firm to update its belief about the rival’s invest-
ment trigger and thus about its rival’s investment cost (inaction by the rival is “good” news).
While the updating process raises the value of each firm, it does not alter the firms’ invest-
ment strategies. When finally one of the firms invests, the rival’s value drops to zero.
7. As in the case of preemption with complete information, the rent-equalization principle
suggests that at the preemption point the leader’s value equals the follower’s (here equal
to zero) so that the complete-information preemption trigger corresponds to the zero-NPV
threshold.
414 Chapter 13
Kort (2006) consider a market where two firms compete for investing in
a risky project. They incorporate both a first-mover advantage and a
second-mover advantage in terms of information spillovers resulting
from option exercise. Depending on specific parameter choices, either
the first or the second-mover advantage may dominate, leading to
preemption or a war of attrition game. Interestingly, more competition
does not necessarily lead to higher social welfare. This ultimately relates
to the intensity and informativeness of signals. Duopoly leads to higher
welfare than monopoly if there are few and relatively noninformative
signals, whereas the opposite holds if there are many and relatively
informative signals.
Grenadier (1999) analyzes a general setting where agents formulate
option exercise strategies under imperfect information. Suppose that the
payoff received upon entry is not perfectly known to the firms, each
having received an independent private signal concerning the true
underlying value. A firm has a prior belief about the distribution of its
rivals’ signals. The firm may nevertheless infer its rivals’ private signals
by observing their entry decisions, updating its beliefs when new entry
triggers are attained. This setting provides a general foundation for
solving many problems arising under imperfect information. In such set-
tings investment strategies can generate equilibrium outcomes that differ
significantly from the standard full-information equilibrium outcome.
However, while in many cases observed exercise decisions may convey
valuable private information, there are other instances when no useful
information can be inferred. In such cases an information cascade may
emerge where firms disregard their private information and invest in a
rush following others as in a herd behavior. This may occur when option-
holding firms find their private information overwhelmed by recent
information conveyed by others and adapt their behavior accordingly.
Markets with large information asymmetry may experience smooth
exercise patterns over time, while markets with milder information asym-
metries may sometimes experience a rapid series of investments or infor-
mation cascades.
Martzoukos and Zacharias (2001) study project value enhancement in
the presence of incomplete information and R&D spillover effects.
Duopolists may raise project value by conducting R&D and/or gather-
ing more information about the project. Due to information spillovers,
they act strategically by optimizing their behavior conditional on the
actions of their rival. Maeland (2010) combines real options theory with
auction theory to develop a winner-takes-all investment model for
markets with two or more players with asymmetric information about

the cost of investment. Each investor knows its own costs but ignores its
rival’s cost.
Décamps and Mariotti (2004) consider a duopoly in which firms learn
about the attractiveness of a project by observing some public signal and
their rival’s actions. Firms have symmetric information about the signal
realization but asymmetric information about their rival’s investment
cost. The authors examine the learning externality. By delaying invest-
ment, each firm tries to convince its rival that its own cost is high so that
the rival should invest first. The resulting “war of attrition” results in a
unique symmetric equilibrium.
13.5 Exit Strategies
Exit decisions in declining markets may also involve strategic interac-

tions among incumbent firms. Once again, the decisions made by
duopolists may differ from what a monopolist would do. Firms may
wait for their rival to exit first, hoping to enjoy rents in a monopolistic
industry structure. This may lead to a war of attrition. Fine and Li
(1989) complement deterministic duopoly models of exit, such as
Ghemawat and Nalebuff (1985, 1990) or Fudenberg and Tirole (1986),
by allowing for the stochastic decline of a market. The authors show
that the sequence of exit is not unique due to “jumps” in the demand
process.
Sparla (2004) analyzes closure or exit options for a duopoly where
firms face a stochastically declining market in continuous time. The
optimal timing game is viewed as a war of attrition or chicken game. In
this setting an aggregate shock (modeled as a geometric Brownian
motion) affects the profit value received by the two firms.8 It is seen that
the equilibrium exit policies in a symmetric duopoly differ significantly
from the disinvestment trigger of a monopolist or a firm holding a pro-
prietary option. Duopolists disinvest or exit later than a monopolist.9 The
follower is faced with a decision-theoretic optimal-stopping problem
wherein the timing decision is not affected by the leader’s behavior
because the follower’s value does not depend on the leader’s exit policy.
8. Similar to previous models where investment is considered irreversible, re-entering the
market after having exited is ruled out.
9. A firm’s exit strategy consists of a cumulative distribution G ( X t ) indicating whether the
firm has exited at state X t or not. In cases involving perpetual American call options (e.g.,
option to invest) the threshold is attained from below. Inversely, in the present case where
we deal with a put option the threshold is reached from above.
416 Chapter 13
The follower (firm j) will exit the first time X Fj is attained, where the
threshold X Fj is given by10
X Fj VFj
= Π* (13.8)
S
with VFj = π Fj / δ where the “convenience yield” is δ = k − g = r − ĝ. Π* is
a lower cutoff profitability level to be reached at the time of exit. It is
given by
β2
Π* ≡ , (13.9)
β2 − 1
where β 2 is the negative root of the fundamental quadratic given in equa-
tion (A2.3) in the appendix at the end of the book:
−αˆ − αˆ 2 + 2rσ 2
β2 ≡ (< 0 )
σ2
with αˆ ≡ gˆ − (σ 2 2). In this war of attrition both firms have an incentive
to wait until the rival exits first or until market conditions deteriorate
so badly that both firms are better off leaving the market irrespective
of their rival’s action. For identical firms the unique symmetric strategy
profile in equilibrium is for both firms to exit the first time X F , given by
equation (13.8), is hit. The symmetric equilibrium profile where both
firms exit at TF is the best achievable outcome from the viewpoint of
the industry. In case of asymmetric firms with small cost differential,
the low-cost firm may possibly exit earlier. If the cost differential is
large, however, the high-cost firm exits first and the low-cost firm stays
longer.
Murto (2004) considers a similar problem in which duopoly firms
differ in terms of production scale (with firm i smaller than firm j). Here
firms face a multiplicative aggregate demand shock X t following a geo-
metric Brownian motion. The deterministic component of the market’s
(inverse) demand function is of the constant-elasticity type:
π ( X t , Qt ) = X t Qt−1 η, (13.10)
10. For the sake of comparability between models, Sparla’s (2004) model was simplified
by assuming full closure, that is, exit rather than partial closure (as in the original paper).
We also simplify the expression for the payoff received upon exiting. Sparla (2004)
and Murto (2004) (discussed later) are more explicit, decomposing this value into oper-
ating cost savings made upon exiting the market (positive value) and costs incurred to
make exit effective (e.g., layoff costs). We simplify using a single aggregated salvage
value S.
where η ( > 1) is the elasticity of demand. The resulting exit thresholds, X Li

for the first exiting firm (leader) and X Fj for the last one (follower), are
such that
X Fj VFj
= Π* (13.11)
S
and
X Li VLi
= Π*, (13.12)
S
where the value functions are VFj = π Mj / δ and VLi = π Ci / δ , with
δ = k − g = r − ĝ and Π* as given in equation (13.9). The leader’s willing-
ness to stay in the market increases with volatility because its put option
value is increased. For low levels of volatility, there is a unique exit
sequence where the smaller firm (i) exits first (leads) when threshold X Li
obtained from equation (13.12) is first reached and the largest firm ( j)
follows suit when X Fj from equation (13.11) is reached for the first time.
For high volatility levels, however, this equilibrium is no longer unique
and the reverse ordering with the largest firm exiting first may also obtain
as industry equilibrium.
13.6 Optimal Capacity Utilization
Models dealing with investment in incremental capacity generally assume

that output production is costless and capacity is fully utilized (constant
returns to scale). Aguerrevere (2003) relaxes this assumption and obtains
a mean-reverting price process exhibiting volatility spikes, even when the
(additive) stochastic demand shock or demand intercept X t follows a
geometric Brownian motion.11 He assumes an oligopolistic market with
n identical firms facing a linear (inverse) demand for a perishable good
of the form P( X t , Q) = X t − bQ.12 At each period firms choose their
optimal level of capacity utilization. Firms can incur a cost of I per unit,
expanding capacity incrementally at any point in time. Capacity expan-
sion takes D years to implement (complete). To account for time to build,
a new (Markov) committed capacity state, K t = Qt + Qt ′ = Qt + D, tracks
11. Such price evolutions have traditionally been explained through the dynamics of
storage. Aguerrevere’s (2003) model complements this explanation. In his model the price
behavior arises from the interplay among installed capacity, capacity utilization, and time
to build.
12. Firms operate identical production facilities. The variable cost incurred by a firm is a
function of capacity utilization υ ∈[0; 1]; the cost function is C (υ ) = c1υ + (c2υ 2 2).
418 Chapter 13
the sum of capacity units currently operational Qt and units currently

under construction Qt ′ (“in the pipeline”). If an extra unit of capacity
always at least breaks even (as it can be shut down at no cost), capacity
units under construction can effectively be considered as a set of Euro-
pean call options (with maturities t + D) on the net profit from an extra
unit of capacity. The option to launch the construction of a unit of capac-
ity is thus analogous to an American call on this set of European calls.
The value of each European call option depends only on X t and K t, as
all committed capacity will be operational prior to the earliest maturity
t + D.13 The trigger demand level X M (Kt ) for exercising an expansion
option given the currently committed capacity is obtained. Whenever the
current demand level X t exceeds X M (K ), a monopolist firm will commit
additional capacity. For an n-firm oligopoly, a symmetric equilibrium
results such that the expansion threshold is identical to the monopoly
case. That is, oligopolistic firms will add capacity at the exact same time
as a monopolist would. However, both the committed and operational
oligopoly capacity are strictly greater.14 Surprisingly, utilization of opera-
tional capacity is independent of the number of firms. Without time-to-
build delays, aggregate committed capacity Kt is decreasing in the
underlying volatility. However, with time to build, firms may provide
more capacity if faced with greater uncertainty. This arises from the
trade-off between the increased risk of capacity underutilization and the
higher uncertainty increasing the value of capacity under construction.15
The output price paths exhibit mean reversion and significant spikes in
times of full capacity utilization. Due to time-to-build delays, completion
of capacity expansion is preceded by a phase of high utilization and high
prices. Industry capacity increases with the number of firms, but the
timing of expansion and the utilization rate are independent.
Aguerrevere (2009) relaxes the assumption of time to build and uses
linear operating costs. He examines the firm’s systematic risk (beta) in a
competitive setting. The firm’s beta is determined as the weighted average
of the beta of assets in place and the beta of the firm’s growth options.16
In line with Grenadier (2002), the value of growth options decreases with
the number of firms and approaches zero when n tends to infinity (as in
13. Given this relationship, the partial differential equation describing the value evolution
of the monopolist’s option to invest in an extra unit of capacity can be derived.
14. The oligopoly quantities can be expressed as the corresponding monopoly capacity
times a constant multiplier.
15. Capacity under construction is analogous to a set of European call options whose value
is strictly increasing in volatility.
16. Weights are determined based on the present values of assets in place and of growth
options.
perfect competition). This affects the firm’s beta since the beta of the
assets in place and their weight increases with the number of firms active
in the industry, n. Under intensified competition, the capacity held in the
industry is utilized more in response to demand increases. Regardless of
the number of firms, assets in place are generally less risky when demand
is high as capacity utilization is increased. In case of geometric Brownian
motion, the growth option’s beta is constant, meaning it is independent
of industry capacity, demand level or the number of firms. For high
demand, the firm’s beta decreases with the number of rivals, but for low
demand it increases.
13.7 Lumpy Capacity Expansion (Repeated)
Previous models typically assumed that each firm has only one invest-
ment option. Murto, Näsäkkälä, and Keppo (2004) consider multiple
investment opportunities available to firms. Consider a data bandwidth
market with two incumbent firms. Suppose that the demand function is
of the constant-elasticity type as in equation (13.10).17 Once the infra-
structure (transmission capacity) is installed, providing bandwidth is
effectively costless. Starting with zero initial capacity, firm i (symmetri-
cally firm j) can decide at any time to invest I i (I j) to increase capacity
by a lump sum ΔQi (ΔQj). In each period the firms set their output and
earn the market-clearing price for each unit sold. Investment decisions
are sequential, with the first mover being randomly chosen. In any given
state firms maximize current profits by selling the Cournot–Nash quan-
tity under capacity constraints. While this quantity choice constitutes a
tactical decision, firms also decide on whether to expand capacity. Any
single investment subgame is fully described by current firm capacities,
the level of market demand and the current time, enabling derivation of
the optimal expansion (Markov) strategies via dynamic programming.
Investment-inducing demand thresholds characterize these expansion
strategies. As these thresholds are increasing in a firm’s installed capacity,
the smallest firm is more likely to respond to small demand shocks by
expanding capacity. The authors examine the asymmetric case where
firm j must invest in large lumps compared to its rival, but this disadvan-
tage is compensated by a lower outlay per unit of capacity added. The
outcome in this asymmetric case stands in sharp contrast to the case
17. The GBM is discretized in a CRR binomial lattice. The firms’ continuation values
in the final period are determined as perpetuities assuming steady state for future
capacity.
420 Chapter 13
involving symmetric firms.18 Firm i’s payoff distribution has distinctly

more probability mass at higher payoff levels than firm j’s. Firm i benefits
from the asymmetry although it has higher costs per unit of capacity
because it can react quicker to changes in demand, effectively investing
more often than its rival. This response flexibility advantage exceeds the
cost disadvantage regarding the necessary investment outlay.
Boyer, Lasserre, and Moreaux (2010) refine previous contributions on
strategic investment developed in a deterministic setting, notably Gilbert
and Harris (1984), Fudenberg and Tirole (1985), and Mills (1988). The
authors characterize the development of a stochastically growing duopoly
market and analyze industry dynamics in a setting where firms build
capacities through multiple irreversible lumpy investments. The firm
roles are endogenously determined and commitment to a rigid long-term
development program is not credible.19 Initially, two firms have low
capacities. When firms do not hold any existing capacity, tacit-collusion
equilibria are ruled out because firms are not threatened by the loss of
existing rents. The only possible equilibrium in such burgeoning indus-
tries is the preemptive sequential (closed-loop) equilibrium. This timing
rivalry causes the first industrywide investment to occur earlier than
what would be socially optimal from the viewpoint of industry partici-
pants. This distortion implies riskier entry and lower expected returns.
Rent equalization occurs irrespective of the volatility or the speed of
market development, but higher volatility may cause the first industry
investment to occur earlier. Later if firms hold capacity, two types of
equilibria may arise. The threat of preemption is real and may lead to
the complete dissipation of any first-mover advantage as in a preemptive
sequential equilibrium. Simultaneous investment is also possible and
sustainable as industry equilibrium: such tacit-collusion episodes or
investment waves take the form of postponed simultaneous investments
by both firms. Such equilibria are more likely to exist in highly volatile
or fast-growing markets. When firms are of equal size, this is compatible
with joint-profit maximization. However, when firm asymmetry is large
the joint investment threshold is beyond the level that maximizes value
for the disadvantaged firm. The possibility of collusion or cooperation is
more attractive to symmetric firms than to (sufficiently) asymmetric
18. In the symmetric case the firms’ payoffs are distributed identically. Compared to the
payoffs of a monopolist, the aggregate duopoly payoff in the asymmetric case is lower and
more skewed to the left; both the lower market power in duopoly and the threat of pre-
emption (hastened increased capacity buildup) drive this result.
19. Boyer et al. (2004) assume that reduced-form stage profits are the outcome of Bertrand
price competition, whereas Boyer, Lasserre, and Moreaux (2010) consider Cournot quan-
tity competition.
ones. At later stages of development, when firms hold substantial capac-

ity, competition is weaker and tacit-collusion equilibria may persist. In
such a context, the conventional real options result that higher volatility
leads to later investment is reinforced by the switch from the preemptive
to the tacit-collusion equilibrium at higher volatility levels.
13.8 Other Extensions and Applications
In this section we provide more breadth of application covering other

related literature. Cottrell and Sick (2002) examine competitive value
erosion arising when decision makers anticipate preemptive entry by
rivals. Although market pioneers may gain first-mover advantage, the
authors show that followers may have important advantages as well.
Boyer and Clamens (2001) examine why in the US reengineering proj-
ects often fail due to internal resistance to corporate changes or lack
of commitment from management. Extending a model proposed by
Stenbacka and Tombak (1994), the authors show how efficient imple-
mentation programs affect the adoption-timing decisions in a duopoly.
They also examine the effect of first vs. second-mover advantages and
adoption costs on adoption timing. Kong and Kwok (2007) examine a
duopoly involving asymmetric firms in terms of investment costs and
uncertain revenue flows.
Paxson and Pinto (2003a) consider a duopoly where the leader’s
market share follows a birth and death process, determining the fol-
lower’s and leader’s values. They examine the sensitivity of the firms’
value to changes in market shares, process parameters and volatility.
Paxson and Pinto (2003b) discuss two distinct duopoly models. In the
first, both the unit price and demand (number of units sold) are random.
In the second, returns and investment costs are subject to economic
shocks.
Kulatilaka and Perotti (1998) discuss growth options under uncer-
tainty and imperfect competition. A first-mover advantage may lead to
capture a greater market share, either by deterring entry or by inducing
rivals to leave more room for a stronger competitor. When the strategic
advantage is strong, increased volatility fosters investment in growth
options, while lower volatility might reduce the incentive to do so. This
challenges the common result that higher volatility delays investment.
Nielsen (2002) considers positive externalities and scenarios where a firm
has multiple investment opportunities. With decreasing profit flow, a
monopolist invests later than a leader in a preemption scenario. The
422 Chapter 13
number of available investment projects does not affect the timing of the
first investment. A monopolist will make its second investment earlier
than the follower. Wu (2006) analyzes capacity expansion in an option-
game setting where two symmetric firms choose both investment timing
and capacity levels. Demand grows until an unknown date and declines
thereafter. Firms may enter or exit depending on demand realization.
Williams (1993) considers the option to develop an asset under sto-
chastic demand uncertainty, deriving the optimal investment strategies
and resulting firm values under perfect equilibrium. The author assesses
the impact of development capacity, of the supply of underdeveloped
assets, and the concentration of developers. In Nash equilibrium, sym-
metric developers build at the maximum feasible rate whenever income
rises above a critical value. The optimal building rate depends on a sto-
chastic exogenous factor and affects aggregate demand. Weyant and Yao
(2005) study the sustainability of tacit collusion equilibrium in case of
information time lags. For a longer time lag, preemptive equilibrium is
more likely to arise. Inversely, for a sufficiently short time lag, tacit col-
lusion may sustain whereby firms delay investment more than a monopo-
list. Odening et al. (2007) show that myopic planning may lead to
suboptimal investment strategies. They identify the degree of subopti-
mality and propose measures to reduce the discrepancy.
Botteron, Chesney, and Gibson-Asner (2003) model production and
sales delocalization flexibility for multinational firms under exchange-
rate risk. Depending on industry structure, firms may act strategically
and exercise their delocalization options preemptively at an endoge-
nously set exchange rate. Shackleton, Tsekrekos, and Wojakowski (2004)
analyze the entry decisions of competing firms in a duopoly when rival
firms earn distinct but correlated economic profits. In the presence of
sunk entry costs, firms face hysteresis or delay effects, the range of which
is decreasing in the correlation parameter. They determine the expected
entry time and the probability that both firms enter within a given time
interval. They illustrate their model in the duopoly situation faced by
Boeing and Airbus, focusing on Airbus’s A380 lunch and Boeing’s best
strategic response. Pineau and Murto (2004) apply similar thinking to
the deregulated Finnish electricity market subject to stochastic demand
growth, determining firm strategies in terms of investment and produc-
tion levels for base and peak-load periods. Baba (2001) considers a
duopoly option game to examine a bank’s entry decisions into the Japa-
nese loan market, shedding light on the prolonged slump in this market
over the 1990s.
Conclusion
In this chapter we synthesized and discussed new developments and

applications concerning option games. We have shown how integrating
game theory and real options in a unified framework provides new
insights into competitive strategies and how firms behave in uncertain
markets. These tools are useful for the understanding of real-world
industry phenomena and for predicting how firms (should) behave when
faced with both market and competitive or strategic uncertainty. The
option games approach developed herein considers optimal investment
strategies as part of an industry equilibrium. We considered both sym-
metric and asymmetric firm conditions. Asymmetric models are more
involved but provide a more natural ordering of first and second-investor
timing in sequential decisions. Sequential investment in case of cost
asymmetry involves substantial option value erosion due to competitive
entry.
We also glimpsed at important extensions and applications with
thought-provoking implications for firm competitive strategy and public
policy. These new insights help us understand puzzling phenomena, such
as why there may be strategic delays in patent races while in other situ-
ations (e.g., involving positive externalities) investment might be expe-
dited. They also help us understand industry phenomena like delayed
exit, delayed implementation (sleeping patents) or real-estate market
quirks. Option games are at the forefront of developments in corporate
finance, economics and strategy in both the academic and managerial
realms. Managers willing to consider managerial flexibility and strategic
interactions as a cornerstone of business decisions under uncertainty will
find the option games approach most valuable.
Selected References
Boyer, Gravel, and Lasserre (2004) discuss a set of option games contri-
butions. Huisman et al. (2004) give an overview of continuous-time
models dealing with lumpy investments in a competitive setting.
Chevalier-Roignant et al. (2011) discuss a number of research contribu-
tions and the managerial insights derived. Grenadier (1996) develops
a general approach for dealing with time lags with application to the
real estate market, and Grenadier (1999) discusses informational
asymmetry.
424 Chapter 13
Boyer, Marcel, Eric Gravel, and Pierre Lasserre. 2004. Real options and
strategic competition: A survey. Mimeo. CIRANO, Montreal.
Chevalier-Roignant, Benoît, Christoph M. Flath, Arnd Huchzermeier,
and Lenos Trigeorgis. 2011. Strategic investment under uncertainty: A
synthesis. European Journal of Operational Research 215 (3): 639–50.
Grenadier, Steven R. 1996. The strategic exercise of options: Develop-
ment cascades and overbuilding in real estate markets. Journal of Finance
51 (5): 1653–79.
Grenadier, Steven R. 1999. Information revelation through option exer-
cise. Review of Financial Studies 12 (1): 95–129.
Huisman, Kuno J. M., Peter M. Kort, Gregorcz Pawlina., Jacco J. J.
Thijssen. 2004. Strategic investment under uncertainty: Merging real
options with game theory. Zeitschrift für Betriebswirtschaft 67 (3):
97–123.
Appendix: Basics of Stochastic Processes
The strategy of a firm must generally be adapted to actual, not expected,

market developments.1 As noted, real options analysis allows for the
determination of such optimal strategies. This is enabled by using sto-
chastic calculus and control theory, topics in advanced mathematics that
have many applications in applied sciences, such as physics, finance, and
economics. The underlying theories are often mathematically involved,
so we refer to the dedicated literature.2 Nevertheless, we take care to
interpret the assumptions and provide a compendium of key properties.
The raison d’être of this appendix is to fill prerequisite gaps and help
smooth the exposition in previous chapters. At places we refer to the
following results from this appendix to avoid having lengthy demonstra-
tions in the chapters.
In this appendix we briefly describe in section A.1 the main stochastic
processes that admit “nice” mathematical properties useful for applica-
tions in economics and finance. These stochastic processes are made up
1. There may be a substantial difference between the outcome deduced from a model
taking account of the actual values (with possible deviation from the expected develop-
ment) and an equivalent model based on expected values. This difference can be seen from
Jensen’s inequality applied to convex or concave functions. Since the payoff function f (⋅)
of a call option is convex in the underlying factor X , Jensen’s inequality states that
E [ f ( X )] ≥ f ( E [ X ]).
For a put option whose payoff function is concave in the underlying factor, the opposite
inequality holds. Refer to Savage (2009) for an intuitive treatment of Jensen’s inequality
and how to circumvent the “flaw” arising when using averages for decision-making under
uncertainty.
2. We here concentrate primarily on Itô’s theory of integration. An alternative approach—
sketched in Øksendal (2007)—is based on the Stratonovitch integral rather than the Itô
integral. When Merton identified stochastic calculus as a useful tool for the continuous-time
analysis of capital markets, he considered Itô calculus a more appropriate tool for econom-
ics since it precludes foresight. Merton (1998, pp. 327–28n. 6) argues: “A Stratonovich-type
formulation of the underlying price process implies that traders have a partial knowledge
about future asset prices that the nonanticipating character of the Itô process does not.”
426 Appendix: Basics of Stochastic Processes
of an expected-value term (growth trend or drift) and a “diffusion” term

capturing the stochastic movement of the process around its long-term
expected growth trend. One interpretation is to think of the drift term
as representing a forecast value (mean) for the underlying random factor
and the volatility term as a sort of disturbance, noise or error term that
reflects deviation from the expectation, proxying for uncertainty. In
section A.2 that follows we discuss the notion of “forward net present
value” and provide analytical solutions in a number of interesting situa-
tions. In section A.3 we discuss the concept of first-hitting time, providing
explicit solutions for expected discount factors for certain Itô processes.
Finally, we sketch the mathematical theory of optimal stopping/timing
under uncertainty in section A.4.
A.1 Continuous-Time Stochastic Processes
Stochastic processes represent a mathematical cornerstone of option-

pricing theory and, by extension, of real options analysis. They are also
essential as a building block for the evaluation of real options in a
competitive setting. In such models the underlying asset or factor (e.g.,
stock price or project value) is assumed to follow a specific stochastic
process; that is, the changes in the value of the asset evolve over time
in an uncertain or unpredictable manner. A stochastic process is a col-
lection of random variables such that the value of the process at each
time t is random but determined via a known probability distribution.3
Alternatively, one could think of the changes between the value of
the process at instant t and the value at the next instant t + h as follow-
ing a certain probability law. Stochastic processes are often classified
based on the assumed probabilistic law of motion governing their
increments.4
Stochastic processes can be classified in two categories. They can be
formulated in discrete time if they change only over certain discrete time
intervals (countable time set), or in continuous time if they are subject
to change at any time (continuous time set). Here we primarily focus on
Itô processes, which are continuous-time stochastic processes with
3. In the following discussion we focus on one-dimensional stochastic processes of the Itô
family. The study of multidimensional processes allows the analysis of economic problems
where value functions may depend on several, possibly correlated, stochastic processes.
4. The Brownian motion discussed below, for instance, is characterized by stationary, indi-
vidually independent, normally distributed increments. Any continuous-path process
whose increments share these three properties is a (drifted) Brownian motion (see proof
in Breiman 1968, prop 12.4).
continuous sample paths.5 Itô processes are memoryless or Markov,

meaning that all relevant information governing future increments are
summarized in the latest state of the process. When applied to traded
assets, this property is consistent with the weak form of the efficient-
market hypothesis (EMH).6
Technically we assume the following (filtered) probability space
(Ω, F, P ), where F ≡ {Ft }t ≥ 0 is a filtration, namely a family of tribes (or σ -
algebra) such that Fs ⊆ Ft for all s ≤ t . The tribe Ft corresponds to the
information set on which the decision maker bases her decision at time
t. Our discussion is based on the premise that stochastic processes and
their functions are adapted to the filtration, namely that decision makers
cannot make decisions based on information that is not yet revealed.7
A.1.1 Brownian Motion
A cornerstone stochastic process is the standard Brownian motion or

Wiener process.8 A multitude of continuous-path Markov processes can
be represented in terms of a standard Brownian motion, the most
common being arithmetic and geometric Brownian motions.
Standard Brownian Motion

The term dzt , often entering the description of Itô processes, corresponds
to the increment of a standard Brownian motion.
Definition (adapted from Karatzas and Shreve 1988, p. 47) A standard

one-dimensional Brownian motion is a continuous, adapted process
z = {zt } defined on a given probability space (Ω, F, P ) such that:9
5. Poisson and jump-diffusion processes are not a primary subject of examination here
since they have discontinuous sample paths.
6. The efficient market hypothesis (EMH) asserts that competition among hundreds of
competent, rational investors ensures that the latest information is immediately incorpo-
rated into the current price. If the current price already reflects all the information con-
tained in past prices, prices will change only in response to new, unpredictable
information—which is unrelated to past unexpected information that drove past price
movements. Asset price changes are thus independent over time. The EMH challenges the
foundation of technical analysis.
7. To prevent foresight, expectations formed at time t are conditional on the information
revealed up to now, Ft ; conditional expectations are written E ⎡⎣⋅⏐Ft ⎤⎦ or Et[⋅].
8. This process has been formulated in physics to study the motion of small particles in
liquids or gas. The origin of the concept explains why still today the graph of the values
taken by the process is referred to as a “path.” The physical phenomenon has been discov-
ered by the English botanist Robert Brown in 1827. It has been mathematically formulated
by Louis Bachelier (1901) and Albert Einstein (1905). Bachelier’s (1901) treatise provides
the first known application of the Brownian motion to describe financial or economic
phenomena.
9. The standard Brownian motion and Wiener processes differ in their definitions, but the
mathematical object is essentially the same, owing to Lévy characterization theorem. See
Neftci (2000, pp. 177–78).
• the starting value z0 = 0 almost surely;

• the value increment zt + h − zt is normally distributed with mean zero and
variance h;
• the value increment zt + h − zt is independent of information revealed up
to time t, that is, independent of the information set Ft (and zt a
fortiori).
Selected Properties
The standard Brownian motion is characterized by the following
properties:
• It has continuous sample paths.
• It is a martingale, meaning that the best estimate (expectation) of its
future value is its present value. Formally E [ zt + h | Ft ] = zt for all h > 0.
In the present case the expected value is zero since the starting value of
the process is zero (by definition).
• It is a Markov process, so that10
E ⎡⎣zt + h ⏐Ft ⎤⎦ = E ⎡⎣zt + h ⏐zt ⎤⎦ ∀h > 0 .

•A measure of dispersion or variation over a time interval h is
var(zt + h − zt )2 = h.11 One can also (informally) state that dzt 2 = dt over
any infinitesimal increment (h → dt ) and var (zt ) = t.
• Under certain conditions one can define an integral with respect to a
standard Brownian motion (Itô integral) rather than with respect to time.
The Itô integral captures the noise of the phenomenon around its
expected trend. Such integrals have zero expected value.
A good understanding of the standard Brownian motion is important

because it serves as a building block for a multitude of continuous-path
Markov processes (and all continuous-path martingales).12 Unfortu-
nately, the standard Brownian motion, and all processes based on it, do
not admit a time derivative. This feature is of cardinal significance for
stochastic calculus, as standard differentiation techniques cannot be
readily employed.
10. The equation here relates to the Markov property, not the strong Markov property that
involves stopping times.
11. The mathematical subject underlying this property is more complex than implied here.
It relates to the quadratic variation of the Brownian motion. The quadratic variation drives
much of the differences between deterministic and stochastic processes. We do not intend
to discuss this measure of dispersion in detail, sufficing to use a loose definition of it.
12. Martingales are not discussed at length here but they are regarded essential for a
mathematical understanding of continuous-time finance (e.g., risk-neutral valuation).
Arithmetic Brownian Motion

The drifted or arithmetic Brownian motion x = {xt }t ≥0 , or xt as shorthand,
can be constructed based on the standard Brownian motion described
above. It admits a nonzero starting value and an expected trend. For-
mally this process is of the form
x t = x0 + α t + σ zt , (A.1)
where zt is a standard Brownian motion as defined previously. The

parameter α, called the “drift parameter,” measures the growth
(expected) trend of the process, and σ is its volatility or standard devia-
tion. The arithmetic Brownian motion (ABM) is a continuous-time
Markov process such that, given its initial value x0, the random variable
x t for any future time t ( > 0 ) is normally distributed with mean x0 + α t
and variance σ ²t (or equivalently with standard deviation σ t ).13
One may alternatively think of drifted Brownian motion as the accu-
mulation of independent, stationary, and identical normally distributed
increments dx t over many nonoverlapping small time intervals of length
dt , with each increment having mean α dt and “variance” σ ²dt. This
representation of the arithmetic Brownian motion permits a description
as a stochastic differential equation (SDE) of the form
dx t = α dt + σ dzt . (A.2)
Figure A.1 depicts a sample realization or sample path of an arithmetic

Brownian motion. A linear function with slope α represents the
expected growth trend. The actual sample path moves around the
expected (long-term) trend due to volatility σ . Most economic variables
can be reasonably described by their drift and volatility. For a large
time horizon, the growth trend is the dominant determinant, whereas in
the short term volatility is what really matters.14 When applied to finan-
cial assets, this property is in line with the common saying that in the
long term, stock prices are driven by expected real growth trends, but
in the short run they may fluctuate due to random factors or volatile
capital markets.
13. Since the standard Brownian motion is a martingale with starting value zero, the
third right-hand term disappears in the expectation. The “variance” of the arithmetic
Brownian motion comes from the “variance” of the standardized Brownian motion,
namely var (zt ) = t.
14. Since the mean of the drifted Brownian motion grows with t and the standard deviation
with t , the standard deviation dictates the overall nature of the process in the short run
(as t becomes negligible compared to t ) but the drift dominates in the long run (as t
becomes negligible compared to t).
3 Expected growth trend (linear)
Sample path
1
0
t
Figure A.1
Sample path of an arithmetic Brownian motion
ABM is discretized by x t + h = x t + α h + σ h × ε , where ε is a standard normal random vari-
able generated by a computer program. We assume h = 0.19685, α = 4 percent, σ = 30
percent, x0 = 1 ( t0 = 0 ).
Example A.1 Probability of Option Exercise at Maturity (or of

“Being in the Money”)
Suppose that stock price vt follows an arithmetic Brownian motion as in
equation (A.2) above. A European call option on this stock may be
exercised at maturity (time T ) by paying an exercise price I . What is the
probability that the option will end up “in the money” at maturity T ,
θ t ≡ Pt [ vT ≥ I ]? Here Pt [·] stands for the probability conditional on time-t
information. From equation (A.1) and the definition of the standard
Brownian motion, we have
θ t = Pt ⎡⎣vt + ατ + σ τ ε ≥ I ⎤⎦ ,
where τ ≡ T − t and ε is a random variable with standard normal distribu-
tion. It follows that
θ t = Pt [ ε ≥ −d2 ] (A.3)
with
vt − I + ατ
d2 ≡ . (A.4)
σ τ
Since the cumulative standard normal distribution N (⋅) is symmetric (at

zero),
θ t = Pt [ ε ≥ −d2 ] = Pt [ ε ≤ d2 ] = N(d2 ). (A.5)
The modeling of stock prices as an arithmetic Brownian motion (as in

example A.1) is ill-advised. As pointed out by Samuelson (1965), this
process has a severe flaw for modeling financial assets since prices may
possibly become negative (owing to the normally distributed diffusion
term), a feature hardly descriptive of real price dynamics.15 Stock prices
X t are instead typically assumed to be log-normally distributed to avoid
this flaw exhibited by the arithmetic Brownian motion. That is, the
(natural) logarithm of price is assumed to follow a (drifted or arithmetic)
Brownian motion. The increment of the log of the price can be thought
of as the log-return:
⎛ X ⎞
ln ( X t + h ) − ln ( X t ) = ln ⎜ t + h ⎟ .
⎝ X t ⎠
Log-returns are normally distributed. This different angle calls for the
modeling of prices as a geometric Brownian motion.
Geometric Brownian Motion and Other Exponentials

The geometric Brownian motion (GBM), commonly used for modeling
asset prices, is an exponential form of Brownian motions. Such exponen-
tials are characterized by
X t = f ( x t ) = exp (β x t ) = e β xt , (A.6)
where x t follows the arithmetic Brownian motion of equation (A.1).

β is a constant parameter specifying the shape of the log-return
distribution.16 The starting value of the process is X 0 = e β x0 . One can
15. If prices were negative, investors would purchase the asset and receive funds from the
purchase! In the end the law of demand and supply would force the price to rise to zero
or above.
16. When log-return errors are normally distributed, β = 1. If returns exhibit higher
moments (skewness and leptokurtosis), β may differ from 1. For positively skewed growth
or distress stocks, β may be less than 1 (leading to lower average returns); for negatively
skewed indexes, β may exceed 1. The daily log-returns of most financial assets or indexes
(e.g., stock market indexes, foreign exchange rates, metal and gold prices) exhibit significant
skewness and kurtosis. This evidence is consistent with the premise that log-returns of
financial assets follow a more general distribution than the normal distribution implied by
the geometric Brownian motion. Subbotin (1923) proposed a more general error distribu-
tion than the normal, the power exponential or generalized error distribution (GED).
The symmetric case of the GED includes the double exponential, the normal and the
uniform distributions as special cases. The double exponential underlies Laplace’s (as well
as Poisson’s) first law of random measurement error with the most-likely estimate being
readily associate the exponential X t with its corresponding Brownian

motion by inverting (A.6), obtaining
ln ( X t ).
1
x t = (A.7)
β
Applying Itô’s lemma (see equation A1.2 in box A.1) to the exponential
function and Brownian motion x t yields17
dX t = ( gX t ) dt + (βσ X t ) dzt , (A.8)
where g is given by
1
g ≡ g (β ) = αβ + β 2σ 2. (A.9)
2
The term gX t is the drift of the process X t and βσ X t is its diffusion term.
The drift parameter g of X t is the drift of the corresponding Brownian
motion incremented by β 2σ 2 2, while its volatility term is simply a mul-
tiple (β ) of the volatility of the arithmetic Brownian motion (σ). The drift
parameter g is increasing in the volatility (σ ). The expected value of the
process at future time t follows an exponential growth path given by18
E0 ⎡⎣ X t ⎤⎦ = X 0 e gt . (A.10)
A special case of exponentials of Brownian motion is the geometric

Brownian motion, which assumes that log-return errors are normally
distributed. It is the special case obtained for β = 1. Equation (A.9) with
β = 1 establishes the relationship between the drift of the geometric
Brownian motion and that of ABM or its logarithm, x t = ln ( X t ):
the median of observations. When the arithmetic mean is used instead (as the most prob-
able value for a number of separate and similar observations in a symmetric distribution),
the normal distribution is obtained instead (Gauss’s law and Laplace’s second law). Sub-
botin (1923) showed that Gauss’s law fails to be universal if one relaxes the assumption
that the distribution may be expanded in the power series. Theodossiou and Trigeorgis
(2010) extended this to the “skewed GED.” Two additional parameters control the degree
of skewness and leptokurtosis. Here β > 1 corresponds to skewness and kurtosis being
present in financial asset return errors, which is more accurate for real-world asset prices.
The special case β = 1 corresponds to the theoretical assumption that log-return distribu-
tion errors are normally distributed as per the efficient market hypothesis.
17. f : x exp ( x ) is smooth.
18. The mean and variance (as well as higher moments) can be derived by using the fact
that the diffusion term drops out when taking expectations (the stochastic integral
with respect to the standard Brownian motion is a martingale with starting value
zero). Let h ( s ) ≡ E0 ⎡⎣ X s ⎤⎦ . From (A.8) expressed in the stochastic integral form and Fubini’s
theorem that t allow for permutation of time and state integrals, it obtains
h (t ) = h (0 ) + g ∫ 0 h ( s ) ds . In other words, h (⋅) solves the differential equation h′ (t ) = gh (t )
with initial boundary condition h (0 ) = X 0. Hence, h (t ) = X 0 e gt , as in (A.10).
Box A.1
Itô’s lemma
To describe the dynamics of functions of stochastic processes, one needs

a sort of “differentiation” rule. Since standard differentiation approaches
do not apply for stochastic processes, a common approach is to use Itô’s
lemma. This is analogous to the “chain-rule” of stochastic calculus. We here
state Itô’s lemma in the context of options though it is applicable to a
broader range of problems.a
Suppose an underlying asset (e.g., stock price or project value) modeled
as an Itô process that follows the stochastic differential equation
dX t = gt dt + σ t dzt , (A1.1)
with drift gt = g( X t , t ) and diffusion σ t = σ ( X t , t ). Consider an option on
this asset whose payoff function f (⋅, ⋅) is twice continuously differentiable
in the asset price and continuously differentiable in time.
Itô’s lemma asserts that the option’s price dynamics { f ( X t , t )}t ≥0 also
follows an Itô process and that its value increment is described by the
stochastic differential equation
df ( X t , t ) = ⎡⎢ ft + gt fX + σ t2 fXX ⎤⎥ dt + σ t f X dzt ,
1
(A1.2)
⎣ 2 ⎦
where ft = ft ( X t , t ); fX = fX ( X t , t ) and f XX = f XX ( X t , t ) stand for the first-
order and second-order derivatives of f (⋅, ⋅) with respect to their subscript.
The expected capital gain of the option over an infinitesimal time interval
is given by
Et [ f ( X t + h , t + h)] − f ( X t , t )
Γf ( X t , t ) ≡ lim
h→0 h (A1.3)
1
= ft + gt fX + σ t2 fXX .
2
The operator Γ , called the infinitesimal generator, is given by
∂ ∂ 1 ∂2
Γ≡ + gt + σ t2 . (A1.4)
∂t ∂X 2 ∂X 2
This operator is useful henceforth for the understanding of Bellman or
HJB equations.
a. Doeblin (1940) and Itô (1951) independently discovered this formula. Doeblin’s
variant was lost for almost sixty years until the early 2000s. This formula should
properly be referred to as Itô–Doeblin formula, although the term “Itô’s lemma”
has become standard in financial economics. Karatzas and Shreve (1988, ch. 3)
discuss generalization of Itô–Doeblin formula to multidimensional processes (inte-
grand) and to functions having less restrictive “smoothness” conditions (with con-
tinuous martingales as integrator). Protter (2004, ch. 2) defines stochastic integrals
with respect to (nonnecessarily continuous) semimartingales.
2.5
Expected growth trend

2.0 (exponential)
1.5
1.0
Sample path
0.5
0.0
t
Figure A.2
Sample path of a geometric Brownian motion
In the graph the geometric Brownian motion is approximated in discrete time by
( )
X t + h = X t exp α h + σε t h with α ≡ g − (σ 2 2). h = 0.039526, g = 9 percent, σ = 20 percent,
and X 0 = 1 ( t0 = 0 ). ε t is (standard) normally distributed.
1
g ≡ g (1) = α + σ 2 . (A.11)
2
The volatilities are the same, σ . The stochastic differential equation

for the geometric Brownian motion can be written (from equation A.8
with β = 1) as
dX t = ( g X t ) dt + (σ X t ) dzt, (A.12)
where zt is a standard Brownian motion. The geometric Brownian motion

is also referred to as a proportional Brownian motion since the expected
change per time interval h, Et ⎡⎣ X t + h − X t ⎤⎦ X t , equal to gh , is propor-
tional to the time interval considered.19 Figure A.2 depicts a realized
sample path for the geometric Brownian motion.
In contrast to the arithmetic Brownian motion where the growth trend
is linear, we here have an exponential growth trend due to the continu-
ously compounded nature of growth. The actual sample path moves
19. Dixit (1993) employs the term “proportional Brownian motion.”
around this exponential expected growth trend. The expected future

value of X t , obtained by substituting equation (A.11) in equation
(A.10), is
E0 ⎡⎣ X t ⎤⎦ = X 0 exp ⎡⎢⎛⎜ α + σ 2 ⎞⎟ ⎥ t .
1 ⎤
(A.13)
⎣⎝ 2 ⎠⎦
X 0 ≡ e x0 is the initial (time-0) value of the geometric Brownian motion.

The expected future value depends on the initial value X 0 increasing
exponentially (geometrically) at a constant growth rate g = α + (σ 2 2).
Growth is compounded since future value is driven by both growth on
the initial value X 0 and growth on recent growth. The expected value for
powers of the geometric Brownian motion is derived in a similar manner:
E0 ⎡⎣ X t n ⎤⎦ = X 0 n eγ t, (A.14)
with γ ≡ ng + [ n (n − 1) σ 2 2 ] and n a positive integer.20

The variance of the geometric Brownian motion is given by21
( )
var0 ⎡⎣ X t ⎤⎦ = X 0 2 e 2 gt eσ t − 1 .
2
(A.15)
Uncertainty affects the dispersion around the growth trend, with the
variance of X t increasing with instantaneous volatility σ . The actual real-
ized value of the process at time t, X t , might differ from the expected
value E0 ⎣⎡ X t ⎦⎤ since the actual value depends on noise or randomness as
well. In the deterministic case (σ → 0), i.e., when volatility is zero, only
the expected value matters (as var0 ⎡⎣ X t ⎤⎦ → 0).
Example A.2 Black–Scholes European Call Option Pricing
Suppose that stock price Vt follows a geometric Brownian motion as in
equation (A.12). Consider a European call option with maturity T (> t )
and exercise price I . Example A.1 derived the probability of being in the
money for a European call option on a stock that follows an arithmetic
Brownian motion. Replace vt by ln (Vt ) and the exercise price I by ln ( I )
in equation (A.4), so the probability of the option being exercised at
20. The function f : x x n is twice continuously differentiable with f x ( x ) = nx n−1 and
f xx ( x ) = n (n − 1) x n−2. Apply Itô’s lemma from box A.1 equation (A1.2) to f (⋅) and
employ the infinitesimal generator notation in (A1.4); then the instantaneous expected
value change is Γf ( X t ) = γ f ( X t ) . Set h ( s ) = E0 ⎡⎣ X s n ⎤⎦. From Dynkin’s formula and
t
Fubini’s theorem, h (t ) = X 0 n + γ ∫ 0 h ( s) ds. h (⋅) thus solves the ordinary differential
equation h ′ (t ) = γ h (t ) with initial condition h (t ) = X 0 n . Equation (A.14) follows.
21. As var0 ⎣⎡ X t ⎦⎤ = E0 ⎣⎡ X t 2 ⎦⎤ − E0 ⎣⎡ X t ⎦⎤ , the result follows from equations (A.14) (with
2
n = 2 ) and (A.13) [first moment] by factorization.

maturity (ending up in the money) in the case of the geometric Brownian

motion obtains as
θ t = Pt [VT ≥ I ] = N(d2 ) (A.16)
with
ln (Vt I ) + ατ
d2 ≡ , (A.17)
σ τ
where α = g − (σ 2 2) and τ = T − t. The expected value of the underlying
asset conditional on being “in the money” at maturity is
ξt ≡ Et ⎡⎣VT ⏐VT ≥ I ⎤⎦
−∞ ⎝
1
{
2 ⎠ }
= ∫ Vt exp ⎛⎜ g − σ 2 ⎞⎟ τ + σ τ ε χ {VT ≥ I } dN(ε ) ,
∞
where χ {}⋅ is the indicator function— χ {VT ≥ I } is 1 if VT ≥ I (i.e., if ε ≥ −d2)

and zero otherwise—and the random variable ε is standard normally
distributed. dN(⋅) is the probability density of the standard normal
distribution
1 ⎧ ε 2 ⎫
dN (ε ) ≡ exp ⎨− ⎬ dε .
2π ⎩ 2⎭
It follows that
ξt =
Vt e gτ
2π
∫
∞
− d2 {
exp −
1
2
(ε 2
)}
− 2σ τ ε + σ 2 τ dε .
Let ε ′ ≡ ε − σ τ , with ε ′ 2 = ε 2 − 2σ τ ε + σ 2 τ . Since ε ≥ −d2 implies

ε ′ ≥ −d1 with
d1 ≡ d2 + σ τ , (A.18)
then
Vt e gτ ∞ ⎧ ε ′ 2 ⎫
ξt =
2π
∫− d1
exp ⎨−
⎩ 2
⎬dε ′ = Vt e N (d1 )
⎭
gτ
(A.19)
by symmetry (at zero) of the standard normal distribution (ε ′ ).

In complete capital markets that preclude arbitrage opportunities, we
can use the insights from risk-neutral pricing (e.g., see Cox and Ross 1976
or Harrison and Kreps 1979), whereby we replace the growth rate g in
equation (A.19) by (a certainty equivalent growth ĝ analogous to) the
risk-free rate r. At maturity T the payoff of the European call option on
a (non–dividend-paying) asset is CT = max {VT − I ; 0}. Therefore the

(time-t) value of a European call option, obtained as the discounted
expected future value under risk-neutral expectation, is
Ct = e − rτ Eˆ t [CT ] = e − rτ Eˆ t [VT − I | VT ≥ I ]
= e − rτ Eˆ t [VT | VT ≥ I ] − e − rτ IPt [VT − I ]
= e − rτ ξt − e − rτ Iθ t .
From equations (A.16) and (A.19) with discount rate r, this readily
results in the Black–Scholes formula given in equation (5.7):
Ct = Vt N (d1 ) − Ie − rτ N (d2 )
with d1 and d2 given in equations (A.18) and (A.17), with α = r − (σ 2 2).
The geometric Brownian motion is probably the most widely used

price process in finance and economics because it provides a good start-
ing proxy for the dynamics of stock prices, exchange rates, prices of
natural resources, and other financial time series, while it remains trac-
table mathematically. Consider a traded asset whose price dynamics can
be modeled via geometric Brownian motion. The future value X t + h of
the asset price (considered from time-t perspective) is a log-normally
distributed random variable with mean X t e gh and volatility σ h increas-
ing in the time horizon (h). Given the relationship between the geometric
Brownian motion and the arithmetic Brownian motion, the logarithm of
the asset price, ln ( X t + h ) ≡ x t + h, is a normally distributed random variable
with mean xt + α h (with xt ≡ ln ( X t ) and α = g − (σ 2 2)) and variance
σ 2 h. Alternatively, log-returns ( x t + h − xt = ln ( X t + h X t )) are normally dis-
tributed with mean α h and variance σ 2 h.
Although market participants may observe the past values of X t as it
evolves over time (investors may possess a long time series of past
prices), the actual future value of the process always remains uncertain
to them. Market participants naturally form expectations about future
developments.22 The drift of the geometric Brownian motion (used to
model the expected asset price) can be seen in perspective vis-à-vis the
total return of the asset and the dividend payout. In capital markets the
appropriate risk-adjusted discount rate k —which equals the total return
on the asset in equilibrium—is typically higher than the expected price
growth rate g (k ≥ g). The total return k consists of the asset price
increase or capital gain, g, plus any benefit or “dividend yield,” δ , the
22. Henceforth to avoid any confusion, the value of the process at time t (once realized
and observed) is denoted by X t , whereas X t refers to the unknown random variable.
asset holder receives over time. To ensure that there is no arbitrage

opportunity, k = g + δ must hold.23
Consider a time series of the asset price, X t = exp ( x t ), modeled as
geometric Brownian motion. Even though at first sight the drift and
volatility parameters of the geometric Brownian motion may appear
difficult to estimate given the exponential nature of the process, they can
be readily determined when one considers the logarithm of the price
( x t = ln( X t )) or the evolution of the log-return (ln ( X t + h X t ) for h small).
It is generally easier to estimate the drift parameter α by taking
the average value of the log-returns Δx t ≡ x t + h − x t = ln ( X t + h X t ) over
small, equally sized time intervals of length h. The volatility of asset
price changes equals the volatility of Δx t or x t . The latter can be readily
assessed as the standard deviation of the asset’s log-returns. The growth
trend g of X t is readily established in equation (A.11) from past data
concerning the asset’s log-return.24
A.1.2 Mean-Reversion Process
Arithmetic or geometric Brownian motions characterize asset prices

whose future value may potentially attain values far away from the start-
ing one and may increase or decline dramatically for long time horizons.
Although such processes may serve as useful approximations in many
circumstances, they may not represent adequately equilibrium dynamics
in many situations where capacity adjusts to meet demand. Certain asset
prices, such as commodity prices or interest rates, tend to move toward
a natural long-run equilibrium with actual values evolving randomly up
and down around the long-term mean. An example of a commodity
whose price follows a mean-reverting process is copper. Although the
actual price is stochastic, in the long term it tends to revert to a historical
mean observable in long-term time series. For such processes a mean-
reverting process may be more suitable as a modeling device.
Arithmetic Ornstein–Uhlenbeck Process

The simplest and best known mean-reverting process is the simple or
arithmetic Ornstein–Uhlenbeck process represented by the following sto-
chastic differential equation:
23. For American call options, Merton (1973) shows that the option will not be exercised
prior to maturity unless the dividend yield is positive (δ > 0).
24. A better estimate of the drift parameter is obtained by considering a long-time average
since the trend is the determinant factor in the long run. For the volatility parameter, it is
possible to use a series over a number of days if the number of estimates is high enough.
The volatility of the geometric Brownian motion is constant whatever the time horizon
considered.
dX t = η ( X − X t ) dt + σ dzt. (A.20)
Here η describes the speed or strength of reversion toward the “natural

level” X of the process (the long-term mean). In case of commodities, X
might represent the long-run marginal production cost. When there is no
force toward the long-term mean (η → 0), the process X t becomes a
Brownian motion without drift (α = 0), with the future value having vari-
ance σ 2 t . Given the initial value of the process at time 0, X 0 , the expected
value for X t at future time t is given by
E0 ⎡⎣ X t ⎤⎦ = wη (t ) X 0 + (1 − wη (t )) X , (A.21)
with wη (t ) ≡ exp (−ηt ). Since wη (t ) ∈ (0, 1), the expectation in equation

(A.21) can be interpreted as a weighted average of the initial value X 0
and the long-term equilibrium mean value X . As t goes to infinity, the
expected value in equation (A.21) converges to the long-term average
X (since wη (t ) → 0). The variance of the mean-reversion process above
is given by25
σ2
var ( X t − X ) =
2η
(1 − wη(t )2 ). (A.22)
If the speed of mean-reversion gets large (η → ∞), the process tends

rapidly to its natural mean level X (since wη (t ) → 0) and the variance
around the mean becomes negligible.
Geometric Ornstein–Uhlenbeck Process

An extension of the preceding mean-reverting process is the geometric
Ornstein–Uhlenbeck process solving the stochastic differential equation
dX t = η ( X − X t ) X t dt + σ X t dzt . (A.23)
The key differentiating feature between the geometric Ornstein–Uhlen-

beck process and the geometric Brownian motion discussed previously
lies in the drift parameter. In mean-reversion the difference X t − X
between the current level at time t ( X t ) and the “natural level” X influ-
ences the drift η ( X − X t ) X t , being positive if the current value is below
its long-term average and negative otherwise. There is no expected change
in the process if the present value exactly equals the long-term mean
X . For geometric Brownian motion, however, the drift gX t is propor-
tional to the latest value of the process at time t . Its sign is always either
positive or negative. The diffusion term (σ > 0) here suggests that even
25. See Dixit and Pindyck (1994, ch. 3, app. A) for a derivation of equations (A.21) and
(A.22) above.
if the process has reached its long-term average, it may still deviate from
it. The higher the volatility, the higher is the probability of a deviation
from the average.
A.1.3 General Itô Processes
Broader families of processes may sometimes be more appropriate to

describe certain price dynamics. Such processes are also used to derive
useful properties and insights applicable to the whole family. So far we
have discussed specific cases of memoryless or Markov processes, namely
arithmetic and geometric Brownian motion and the mean-reverting pro-
cesses. All these belong to a broader class of processes, called Itô pro-
cesses. These processes are such that decision makers cannot rely on
information not yet revealed (are “adapted to the filtration”) and can be
expressed as the sum of a drift (an integral with respect to time) and an
Itô integral involving the standard Brownian motion. For such processes,
the drift and the diffusion term, gt ≡ g ( X t , t ) and σ t ≡ σ ( X t , t ), are
allowed to depend on the latest value of the asset price X t and the time
period (t). An Itô process is a stochastic process of the (integral) form
X t = X 0 + ∫ g s ds + ∫ σ s dzs .
t t
(A.24)
0 0
It is common to write the Itô process (A.24) in its differential form
dX t = gt dt + σ t dzt , (A.25)
where zt is a standard Brownian motion.26 An Itô process whose drift

and volatility do not depend on time but only on the latest asset price is
called a time-homogeneous Itô process or a diffusion process. It can be
expressed (in its differential form) as
dX t = g ( X t ) dt + σ ( X t ) dzt . (A.26)
The general Itô process covers a fairly broad family of stochastic pro-
cesses used in economic analysis and enables the modeling of Markov
processes with continuous sample paths.27 All processes considered
26. For technical reasons (existence) it is further assumed that the drift and the volatility
terms are adapted to the filtration, have finite variations and that they comply with the
linear growth and Lipschitz conditions (see Karatzas and Shreve 1988).
27. Itô processes belong to a larger family of processes. They are subsumed into Lévy
processes and càdlàg processes. Càdlàg processes share the property of being right-
continuous and admitting left-limits along all sample paths. Lévy processes are càdlàg
processes with the additional property of having independent, identically distributed incre-
ments. The Itô, Poisson, and mixed jump-diffusion processes are all Lévy processes. Lévy
and càdlàg processes are beyond our scope of analysis here.
previously belong to this general class. The arithmetic Brownian motion

described in equation (A.2) is obtained for gt = α and σ t = σ (α and σ
being constant). For the geometric Brownian motion of equation (A.12),
the drift is gt = gX t = [α + (σ 2 2)] X t and the diffusion term σ t = σ X t
(α and σ being constant). Mean-reverting processes are also Itô pro-
cesses. For the simple Ornstein–Uhlenbeck process given in equation
(A.20), gt = η ( X − X t ) and σ t = σ , where X is the long-term average,
η the speed of mean reversion and σ a constant volatility. The geometric
Ornstein–Uhlenbeck process in equation (A.23) is characterized by
gt = η ( X t − X ) X t and σ t = σ X t. Itô’s lemma, given in box A.1 equation
(A1.2), applies to this general class of processes.
It is often desirable to develop models that admit closed-form solu-
tions to help deduce clear-cut investment rules to be followed by analysts
or decision makers. Unfortunately, it is not always easy or possible to
obtain analytical solutions for an Itô process. This is the case, for example,
when the underlying factor is mean reverting. In such settings one must
resort to numerical methods instead. Trigeorgis (1996, ch. 10) summarizes
some of them. These methods take advantage of the Markov property
of the Itô process. Simple models involving the arithmetic Brownian
motion generally admit analytical solutions. Nonetheless, as noted,
the arithmetic Brownian motion is ill-suited to describe such phenomena
as equilibrium asset price dynamics. The geometric Brownian motion
corrects some of these flaws while maintaining some of the “nice”
mathematical properties of the simple Brownian motion. This is the
reason why this process is generally preferred in much of real options
analysis.
A.2 Forward Net Present Value
In valuing investment timing options, one can follow a backward valua-

tion process, first determining the forward expected net value of the
project (“reward function”) at maturity and then discounting this using
an appropriate expected discount factor. In assessing the current value
of the option, we first need to determine the forward value of the under-
lying project received upon exercise in the future.28
28. Deriving this value rests on a number of equilibrium conditions applied to dynamic
problems. The underlying notion is Bellman’s (1957) principle of optimality. It asserts that:
“An optimal policy has the property that, whatever the initial action, the remaining choices
constitute an optimal policy with respect to the subproblem starting at the state that results
from the initial actions.” This principle is at the core of dynamic programming and is used
to derive optimal behavior when faced with dynamic problems.
Consider the deferral or investment option in discrete time, where VTs

denotes the value of the underlying asset (project) in state s at future
time T . The exercise price of the investment option is the investment cost
I . The decision whether to invest at time T depends on the value of
VTs − I in state s. This value represents the forward net present value
obtained upon exercise at time T . In the simplest setting, the payoff at
time of exercise T is determined given the assumed irreversible nature
of investment. This value is the stream of all expected profits to be
received onward, net of costs, with no possibility to take corrective action.
This process for assessing the forward net present value is analogous to
discounted cash flow.
Suppose that the underlying stochastic factor X t follows the diffusion
or time-homogeneous Itô process of equation (A.26). Owing to the
Markov property, the time-T perpetuity value of a cash-flow stream start-
ing in a given state equals the time-0 perpetuity value of an identical flow
stream starting in the same state. For simplicity, consider the time-0 per-
petuity value. Suppose that upon exercising the investment option at time
0, the decision maker receives onward an instantaneous profit flow π ( X t )
in state X t in perpetuity.29 Suppose the appropriate risk-adjusted discount
rate is k . What is the perpetuity value V [π ( X 0 )] received upon exercising
the investment option at time 0 when the firm will receive profit flow π (⋅)
in perpetuity? This time-0 state-contingent project value is given by
V0 [π ( X 0 )] ≡ E0 ⎡ ∫ π ( X t ) e − kt dt ⎤ .
∞
(A.27)
⎣ 0 ⎦
Over an infinitesimal time interval dt, an operating firm can expect to
receive the instantaneous profit or dividend flow π = π ( X t ) plus addi-
tional capital gain. The expected (instantaneous) capital gain is E (dV ) dt .
This expected capital gain corresponds to the drift term in the stochastic
differential equation descriptive of the value increment. It is given by
the infinitesimal operator Γ in box A.1 equation (A1.4):
1
ΓV = gt VX + σ t2 VXX ,
2
where VX , VXX refer to the first and second-order derivatives of the value
function with respect to the shock X t .30 In the case of a time-homoge-
neous Itô process, gt ≡ g ( X t ) and σ t ≡ σ ( X t ). If there are no arbitrage
opportunities, the firm should receive during this time length the same
total return it would have obtained from holding an asset in the capital
29. The profit function π (⋅) is twice continuously differentiable in the shock.
30. The value function does not depend on time, so that Vt ≡ ∂V ∂t = 0 .
markets with the same risk profile; that is, it should receive the (instan-
taneous) total return k . Thus in equilibrium it must hold that
kV = π + ΓV , (A.28)
where for notational simplicity we drop the dependence on the underly-

ing process X t . This equation is known in stochastic (Itô) calculus as the
Hamilton–Jacobi–Bellman (HJB) equation.31 In general, there is no ana-
lytical closed-form solution to this partial differential equation (PDE) since
the solution depends on the functional form of gt and σ t . In specific cases,
however, analytical solutions can be obtained.32 We discuss such cases next.
Example A.3 Forward NPV for Arithmetic Brownian Motion

From equation (A.1), E0 [ x t ] = x0 + α t . Applying Fubini’s theorem to
(A.27) in the case of the arithmetic Brownian motion of equation (A.1)
yields33
∞
V0 ≡ V [ x0 ] = ∫ e − kt E0[ x t ] dt
0
∞ ∞
= x0 ∫ e − kt dt + α ∫ te − kt dt.
0 0
∞ ∞
Since ∫ e − kt dt = 1 k and ∫ te − kt dt = 1 k 2 , it follows that34
0 0
x0 α
V0 = + . (A.29)
k k2
31. We derive here the HJB equation more formally. For notational simplicity, we
denote Vt = V [π ( X t )]. Equation (A.27) above can be approximated for a small time inter-
val h by
∞ 1
V0 ≈ π ( X 0 ) h + E0 ⎡⎢ e − kh ∫ π ( X t ) e − k(t −h)dt ⎤⎥ ≈ π ( X 0 ) h + E0 [Vh ] .
⎣ h ⎦ 1 + kh
By multiplying the expression above by 1 + kh and substracting V0 from both sides, we
obtain
khV0 ≈ (1 + kh) π ( X 0 ) h + E0 [Vh ] − V0, or

1
kV0 ≈ (1 + kh) π ( X 0 ) + {E0 [Vh ] − V0 }.
h
Using the infinitesimal generator notation in (A1.4) of box A.1, equation (A.28) obtains
by taking the limit h → 0 . The HJB equation above does not allow corrective action/control
over time interval h.
32. The examples below are solved from an alternative probabilistic perspective, not from
a functional-analysis approach involving the ordinary differential equation (A.28). For
other settings the functional approach might be more useful.
33. In the context of stochastic integrals, Fubini’s theorem states that it is permissible to
interchange the time (Lebesgue)
∞
and the∞ Itô integrals. In this case we apply this to the
expectation operator: E0 ⎡⎣ ∫ 0 x t e − kt dt ⎤⎦ = ∫ 0 e − kt E0[ x t ] dt . See Karatzas and Shreve (1988,
p. 209).
34. Based on a different approach, Dixit (1993, pp. 11–12) examines power functions of
the arithmetic Brownian motion.
Example A.4 Forward NPV for Geometric Brownian Motion and

Other Exponentials
Consider the exponentials X t = e β xt of the arithmetic Brownian motion
in (A.1). From Fubini’s theorem
∞ ∞
V0 ≡ V [ X 0 ] = E0 ⎡ ∫ e − kt X t dt ⎤ = ∫ e − kt E0 ⎡⎣ X t ⎤⎦ dt .
⎣ 0 ⎦ 0
It follows from equation (A.10) that

∞
V0 = X 0 ∫ e − {k − g (β )}t dt .
0
For δ (β ) ≡ k − g (β ) > 0, this converges to

X0
V0 = , (A.30)
δ (β )
where δ (·) is the fundamental quadratic function defined in equation
(A2.1) of box A.2. The terminal value V [ X 0 ] exists if and only if the
dividend yield δ (β ) is strictly positive, namely if β ∈ (β1 , β 2 ), where β1 and
β 2 are the positive and negative roots of the fundamental quadratic func-
tion. Note that 1 is always contained inside the two roots of the funda-
mental quadratic (since β 2 < 0 < 1 < β1). The choice of the appropriate
type of fundamental quadratic function is discussed in box A.2.
In the special case where β = 1, δ (1) = δ = k − g , and X t = exp ( x t ) so
that X t follows a geometric Brownian motion with drift parameter
g = α + (σ 2 2) and volatility σ; the terminal value expression in equation
(A.30) then becomes analogous to the Gordon perpetuity formula,
giving the forward present value of a cash flow stream starting at time
T + 1 (with value at time T being XT ), growing exponentially at expected
constant rate g in perpetuity. This formula—usually thought of in dis-
crete time—reads
∞
1+ g⎞
t
VT ≡ V [ XT ] = ∑ ⎛⎜
XT + 1 XT + 1
⎝ ⎟⎠ XT = = ,
t =1 1 + k k−g δ
where XT + 1 = (1 + g ) XT . The (improper) integral underlying the equa-
tion above converges if and only if there is a positive dividend yield δ ,
namely for δ ≡ k − g > 0 (or k > g).
Example A.5 Forward NPV for Powers of Geometric Brownian

Motion
The expected present value for powers of geometric Brownian motion
can be derived in a similar manner. From equation (A.14) and Fubini’s
theorem,
Box A.2
The fundamental quadratic
We consider two versions of the “fundamental quadratic” for Brownian

motion, the choice of which depends on model assumptions. The first
“general” expression applies when one uses the actual drift g, actual prob-
abilities and the risk-adjusted discount rate k. The second version, using
risk-neutral drift ĝ, martingale or risk-neutral probability measures and
the risk-free rate r , is anchored in option-pricing theory and risk-neutral
valuation.a
The first, more general expression for the fundamental quadratic of
Brownian motion is
1
δ (β ) ≡ k − g (β ) = k − αβ − β 2σ 2 , (A2.1)
2
where α is the drift parameter of the arithmetic Brownian motion x t cor-
responding to exponentials of Brownian motion X t ( x t = ln ( X t ) β ) with
drift g = αβ + (β 2σ 2 2). The fundamental quadratic expression can be
thought of as describing some sort of dividend yield, namely the
difference between the total equilibrium return k and capital gains
g ( = αβ + (β 2σ 2 2)). The roots of this quadratic function (setting δ (⋅) = 0)
in the general case are
α α 2
+ ⎛⎜ 2 ⎞⎟ + 2 2
k
β1 = −
⎝σ ⎠
(> 1) ,
σ 2
σ
(A2.2)
α ⎛ α ⎞2 k
β2 = − 2 − ⎜ 2 ⎟ + 2 2
⎝σ ⎠
(< 0 ) .
σ σ
β1 and β 2 above are the positive and negative roots of the fundamental
quadratic. The fundamental quadratic is strictly concave in β and strictly
positive in the interval (β 2 , β1 ). Since 1 ∈ (β 2 , β 1 ), the expected present
value exists for the geometric Brownian motion. An example of the fun-
damental quadratic function is shown in figure A.3.
When risk-neutral valuation holds (in complete markets with no arbi-
trage opportunities), the total return k is replaced by the risk-free rate r
and the risk-neutral drift α̂ is used (instead of α ).b The risk-neutral version
of the fundamental quadratic above becomes
()
δ βˆ = r − αβ
1
ˆ ˆ − βˆ 2σ 2 ,
2
(A2.3)
a. The dynamic programming approach is “general” as long as one can identify the
correct discount rate—which may not be an exogenous constant as Dixit and
Pindyck (2004) assume. It applies to both incomplete markets (where there is a
range of solutions) and complete markets (where risk-free arbitrage ensures a single
unique solution, the risk-neutral version).
b. Trigeorgis (1996, pp. 101–106) discusses how to obtain the risk-neutral drift.
Box A.2
(continued)
Fundamental quadratic
d (b) = k − ab − 1 b 2s 2
2
d (0) = k ∂d
Slope (0) = −a
∂b
b2 0 b1 b
Figure A.3
Fundamental quadratic of Brownian motion
ˆ ˆ + (βˆ 2σ 2 2)). The roots of the

where α̂ is the risk-neutral drift (with gˆ = αβ
risk-neutral quadratic are
αˆ ⎛ αˆ ⎞
2
r
βˆ 1 = − 2 + ⎜ 2 ⎟ + 2 2 (> 1),
σ ⎝σ ⎠ σ
(A2.4)
αˆ ⎛ αˆ ⎞
2
r
βˆ 2 = − 2 − ⎜ 2 ⎟ + 2 2 (< 0 ) .
σ ⎝ σ ⎠ σ
Both variants of the fundamental quadratic have been used in the litera-
ture. McKean (1965), Karlin and Taylor (1975), and McDonald and Siegel
(1986) discuss the problem of early exercise of the perpetual American
call option. The former authors use the general expression of the funda-
mental quadratic, whereas McDonald and Siegel use the risk-neutral
version. We generally prefer the risk-neutral version since it is in line with
modern financial theory (option valuation). Using the first expression is
justified, in general, if the assumptions underlying risk-neutral valuation
do not hold.
∞ ∞
V [ X 0n ] = ∫ e − kt E0 ⎡⎣ X t n ⎤⎦ dt = X 0 n ∫ e − (k −γ )t dt ,
0 0
with γ ≡ ng + [ n ( n − 1) σ 2 ] 2. For k > γ , the expression above converges to

X0n
V [ X 0n ] = . (A.31)
k −γ
A.3 First-Hitting Time and Expected Discount Factor
In part III we viewed deferral option valuation as an optimal invest-

ment-timing problem involving the forward perpetuity value received
upon exercise and an expected discount factor associated with the
timing decision. In the previous section we discussed how to obtain
the forward expected present value of a perpetuity flow. We next con-
sider the second component of this call option value. Section A3.1
deals with the notion of first-hitting time, and section A3.2 is con-
cerned with the discounting of a flow received at such a random first-
hitting time.
A.3.1 Exercise Timing and First-Hitting Time
First-hitting time refers to the first time a stochastic process reaches

a given or specified (here an absorbing) barrier.35 Once the process
reaches this critical threshold (from above or below), the decision
maker takes action. An important issue for practical application thus
concerns when the process reaches the critical threshold. The random
time the stochastic process X t first reaches the critical threshold XT
{
(from below) is T ≡ inf t ≥ t0 ⏐ X t ≥ XT . }
The first-hitting time is an important factor in deciding when one
should actually invest. Unfortunately, the first-hitting time is a random
variable per se, so a clear-cut prescription cannot be given. An expected
value for the first time when the underlying asset price reaches the criti-
cal threshold, however, can be determined and may admit a closed-form
solution in certain settings. Uncertainty or randomness may of course
lead to an actual first-passage time deviating from the expected one. If
the expected first-hitting time is, say, ten years, it does not mean that
management should launch the project exactly in ten years. This just
gives an early warning proxy.
35. The first-hitting time is a stopping time adapted to the filtration F , meaning that
at each time the decision maker knows whether the “passage” though the barrier has
occurred.
Example A.6 Expected First-Hitting Time for Arithmetic Brownian

Motion
For the arithmetic Brownian motion given in equation (A.1) with
drift α (> 0), the expected time for the Brownian motion first reaching
(absorbing) barrier xT ( xT > x0) is given by
x − x0
E0 ⎡⎣T ⎤⎦ = T . (A.32)
α
The expected time equals the “gap” between the time-0 value of the
process ( x0) and the terminal value to be reached ( xT ), divided by the
expected (arithmetic) growth α per unit of time. The variance of the first-
passage time is given by
σ 2 ( xT − x0 )
var0 ⎡⎣T ⎤⎦ = . (A.33)
2α 3
The likelihood of actual investment occurring before or after the expected

time is increasing in the underlying volatility.36
Example A.7 Expected First-Hitting Time for Geometric Brownian

Motion
The expectation of the first-hitting time for the geometric Brownian
motion can be readily obtained from equation (A.32) above by trans-
forming the geometric into an arithmetic Brownian motion. Suppose
that X t follows geometric Brownian motion with drift parameter g and
volatility σ . The first time that the threshold XT is reached by the geo-
metric process X t (starting at X 0) corresponds to the first time that
the corresponding arithmetic Brownian motion x t = ln ( X t ), starting at
x0 = ln( X 0 ), reaches the threshold xT = ln( XT ). The arithmetic Brownian
motion has drift α ≡ g − (σ 2 2) and volatility σ . The expected first-hitting
time (upper barrier) is finite if g > σ 2 2. Substituting these parameters
in equation (A.32) gives the expected first-passage time to hit an upper
barrier ( XT > X 0) for geometric Brownian motion as
1 ⎛ XT ⎞
E0 ⎡⎣T ⎤⎦ = ln ⎜ ⎟. (A.34)
α ⎝ X0 ⎠
A.3.2 Expected Discount Factor
The second step in the valuation process involves determining the present
(time-0) value of receiving at a future random time (T ) a given forward
36. Cox and Miller (1965, pp. 221–22) derive formulas for the expected value and the vari-
ance of the first hitting time.
net present (time-T ) value VT − I. This requires a formula for the expected
discount factor that allows transforming tomorrow’s uncertain (time-
wise) payoff into present (time-0) value. Since the investment time T is
a random variable, classical discounting tools relying on deterministic
timing cannot be utilized.
We next describe the (stochastic) expected discount factor, a notion
used extensively in the latter chapters of the book. We express the dis-
count factor using risk-neutral or risk-adjusted expectations Êt [⋅] while
discounting at the risk-free rate (r). We define the expected discount
factor as follows:
Bt (T ) ≡ Eˆ t ⎡⎣e− r (T − t ) ⎤⎦

∀t ≥ 0 . (A.35)
This expected discount factor can be used to convert tomorrow’s value

(received at unknown time T ) into today’s terms (at known time t).
Equivalently, consider a bond with a nomination of /1 paid at a future
random time T . The expected discount factor Bt (T ) refers to the
expected present value (as of current time t) of /1 to be paid or
received at an uncertain time T in the future. Bt (T ) is jointly a function
of the future value to be reached at time T, XT , and the value of the
process at current time t, X t . It may be understood as a discount
factor over states X t and XT . Therefore, for some applications, we
express it as B ( X t ; XT ) .
In the case of a time-homogeneous Itô process or diffusion as
per equation (A.26) with drift gt ≡ g ( X t ) and volatility σ t ≡ σ ( X t ), the
expected discount factor has the following properties:37
B ( X 0 ; XT ) = B ( X 0 ; X t ) × B ( X t ; XT ) or B0 (T ) = B0 (t ) × Bt (T ), (A.36)
B0 (T ) =
1 1
B ( X 0 ; XT ) = or . (A.37)
B ( XT ; X 0 ) BT (0 )
We now sketch the necessary steps that enable the derivation of the
expected discount factor. As long as X t < XT, for a very small time
interval h the event ( X t + h = XT ) is highly unlikely, resulting in the follow-
ing recursion expression
× Et ⎡⎣ B ( X t + h ; XT )⎤⎦ .
1
B ( X t ; XT ) ≈
1 + rh
37. Given the strong Markov property of Itô processes, the increments X t − X 0
and X T − X t are independent for T ∉[0; t ]. Hence B ( X 0 ; XT ) = B ( X 0 ; X t ) × B ( X t ; XT ),
confirming equation (A.36). For XT = X 0 , it follows from (A.36) that
B ( X 0 ; X t ) × B ( X t ; X 0 ) = B ( X 0 ; X 0 ) = 1, obtaining (A.37).
Multiplying by 1 + rh and substracting B ( X t ; XT ) from both sides, this

yields
rhB ( X t ; XT ) ≈ Et ⎡⎣ B ( X t + h ; XT )⎤⎦ − B ( X t ; XT ).
From box A.1 equation (A1.3), it obtains that
1
rB − gt BX − σ t2 BXX = 0 , (A.38)
2
where BX and BXX denote the first- and second-order derivatives of the
expected discounted factor with respect to X t (Bt = 0). This equation can
be solved subject to certain boundary conditions. The first boundary
condition is that when the threshold is reached, the stochastic bond pays
/1 so the discount factor equals 1:
B ( XT , XT ) = 1. (A.39)
The second condition is that the higher the distance from the preselected
investment target XT , the lower the likelihood the cutoff value XT will
be reached. That is, when the value process approaches zero, the discount
factor tends to zero as well:
lim B ( X t ; XT ) = 0 . (A.40)
X t → 0
The partial differential equation in (A.38) and the boundary conditions

in (A.39) and (A.40) help obtain the expected discount factor in a
general setting. In the following, we consider some particular cases of
interest.
Example A.8 Expected Discount Factor for Arithmetic Brownian

Motion
Following Dixit (1993, pp. 16–17), the general solution of equation (A.38)
for the arithmetic Brownian motion is
B ( xt ; xT ) = Aeβ1 xt + Beβ2 xt ,
where β1 and β 2 are the positive and negative roots of the fundamental
quadratic given in box A.2 equation (A.2.2). Boundary conditions (A.39)
and (A.40) help identify the constants A and B. Since β 2 < 0, we have
B = 0 from condition (A.40). From condition (A.39), A = e − β1xT. The
expected discount factor, giving the value at time t of receiving 1 euro at
random time T (for an upper threshold xT > xt) is thus
Bt (T ) = e β1 ( xt − xT ). (A.41)
Example A.9 Expected Discount Factor for Geometric Brownian

Motion and Other Exponentials
Suppose that the underlying asset now follows an exponential of the
Brownian motion X t = exp (β x t ), where the process x t satisfies the sto-
chastic differential equation (A.2). Given that x t = ln ( X t ) β , equation
(A.41) results in the following expected discount factor (used to discount
to present time t a flow received at random future time T ):38
b
⎛X ⎞
Bt (T ) = ⎜ t ⎟ , (A.42)
⎝ XT ⎠
where b ≡ β1 β . For the special case of a geometric Brownian motion

(β = 1), the expected discount factor becomes39
β
⎛X ⎞
1
Bt (T ) = ⎜ t ⎟ . (A.43)
⎝ XT ⎠
Example A.10 Expected Discount Factor for Mean-Reverting

Process
In case the stochastic process follows mean-reversion (geometric
Ornstein–Uhlenbeck) as in equation (A.23), Dixit, Pindyck, and Sødal
(1999) show that the discount factor is given by40
θ1
⎛X ⎞ H (ζ X t )
Bt (T ) = ⎜ t ⎟ , (A.44a)
⎝ XT ⎠ H (ζ XT )
where ζ = 2η σ 2 , δ = k − g = r − ĝ, and
2
1 δ + ηX ⎛ 1 δ + ηX ⎞ r
θ1 = − + ⎜ − +2 2 . (A.44b)
2 σ2 ⎝2 σ 2 ⎟⎠ σ
The function H (⋅) is defined by
θ1 θ (θ + 1) y2 θ 1 (θ 1 + 1) (θ 1 + 2 ) y3 . . .
H ( y) = 1 + y+ 1 1 + + , (A.44c)
b1 b1 (b1 + 1) 2 ! b1 (b1 + 1) (b1 + 2 ) 3!
where
⎛ δ + ηX ⎞
b1 = 2 ⎜ θ 1 + . (A.44d)
⎝ σ 2 ⎟⎠
38. This is subject to β > 0 , otherwise growth g (β ) is negative and the expected discount
factor is not well defined.
39. The results here are based on a functional approach. Harrison (1985) employs a mar-
tingale approach to derive the expected discount factor, whereas Karlin and Taylor (1975,
p. 364) derive it based on the density function of the first-hitting time of the arithmetic
Brownian motion and its Laplace transform.
40. See page 10 of the 1997 working paper version of Dixit, Pindyck, and Sødal (1999).
A.3.3 Profit-Flow Stream with Stochastic Termination
The discussion above on expected discount factors enables us to derive

useful properties concerning the (expected) forward present value. Let
⎡∞ ⎤ ⎡∞ ⎤
V [ XT ] ≡ ET ⎢ ∫ X t exp ( −k (t − T )) dt ⎥ = ET ⎢ ∫ X t BT (t ) dt ⎥
⎣T ⎦ ⎣T ⎦
be the terminal (forward) value once the process first reaches trigger
level XT . For simplicity, we denote VT = V [ XT ]. Whether closed-
form solutions for terminal values exist or not depends on the sto-
chastic process followed by the underlying factor. Exponentials (and
polynomial functions) of the Brownian motion do admit analytical
solutions.
Consider the present value of a continuous profit flow, π (⋅), starting
now (t = 0) and continuing until termination at time T . This value is
important when we deal with the option to expand capacity (by lump
sums) and for option games in which profit flows are earned in the con-
tinuation region (or terminated when a competitor enters at random
time). The present value of profit flows earned in the continuation region
is given by

E0 ⎡ ∫ π ( X t ) e− kt dt ⎤ = E0 ⎡ ∫ π ( X t ) e− kt dt ⎤ − E0 ⎡ ∫ π ( X t ) e− kt dt ⎤ .
T ∞ ∞
⎣⎢ 0 ⎦⎥ ⎣ 0 ⎦ ⎣T ⎦
Given the (strong) Markov property for the Itô process, it follows
that41

E0 ⎡ ∫ π ( X t ) e− kt dt ⎤ = E0 ⎡ ∫ π ( X t ) e − kt dt ⎤ − B0 (T ) ET ⎡ ∫ π ( X t ) e − ( − ) dt ⎤
T ∞ ∞ k t T
⎢⎣ 0 ⎥⎦ ⎣ 0 ⎦ ⎣ T ⎦
= V0 − B0 (T ) VT .
Alternatively,

V0 = E0 ⎡ ∫ π( X t ) e − kt dt ⎤ + B0 (T ) VT .
T
(A.45)
⎣⎢ 0 ⎦⎥
Example A.11 Present Value with Stochastic Expiration for
Geometric Brownian Motion
Consider the special case of geometric Brownian motion. For this diffu-
sion process, from (A.30) V0 = X 0 δ , VT = XT δ , and from (A.43)
B0 (T ) = ( X 0 XT ) 1, where δ ≡ k − g = r − ĝ with ĝ being the constant (risk-
β
neutral) drift parameter of the process and β1 as given in equation (A2.2)

of box A.2. From equation (A.45), in case of the geometric Brownian
41. For a formal derivation of this property, the reader may refer to Harrison (1985, pp.
44–46).
motion the present value of a profit flow stream with stochastic expira-
tion T becomes42
β −1
T X ⎛ ⎛X ⎞ 1 ⎞
E0 ⎡ ∫ X t e− kt dt ⎤ = 0 ⎜ 1 − ⎜ 0 ⎟ ⎟⎠ . (A.46)
⎣⎢ 0 ⎦⎥ δ ⎝ ⎝ XT ⎠
The expression above is illustrated for a sample path example in figure

A.4.43
A.4 Optimal Stopping
Obtaining formulas for forward values is generally useful in valuing real

options problems. In the case of the investment timing option, the option
holder has the opportunity to delay investment (the investment cost I ,
once incurred, is sunk). Upon investing at stochastic time T , the firm will
receive the forward value of the project (VT ) by paying investment
cost I . Assuming the project’s profit flow stream is stochastic (e.g., the
profit is a derivative on a stochastically evolving underlying factor),
forward value formulas enable us to determine the value of the commit-
ted investment (the forward NPV) at the future random time T the
investment decision will take place.
The problem for the investor consists in determining the optimal
investment timing, given that the project value evolves stochastically.
This type of problem is called optimal stopping as it involves deciding
when to optimally stop waiting and start investing. Before making
the stop/invest decision, the process “continues” until it reaches a
critical barrier or trigger value. The range of state values for which
the stopping decision is not (yet) made is the continuation or inaction
region.
Suppose that before the investment is undertaken (e.g., a lumpy
expansion investment is made), the firm receives initial stochastic profit
flow π 0 ( X t ) . This profit flow continues until the firm decides to make a
new investment (expand). The first region before the new investment
occurs during which the firm receives a base profit flow, π 0 ( X t ), is the
continuation or inaction region; in this region the firm still waits. The
second region in which the firm invests (in added capacity) is the stop-
ping or action region. Once the new investment threshold has been
42. This is identical to the result in Dixit and Pindyck (1994, p. 316). Symbols are changed
for notational consistency.
43. Rigorously speaking, (expected) present values V0 and VT are not depicted in the graph;
here only a sample path is considered.
Stochastic profit flow (in millions of euros) Present value V0 (in millions of euros)
2.5 p 0 exp (gt) 2.5

454
2.0 2.0
pt
1.5 1.5
1.0 1.0
p t × exp(−kt)
0.5 exp(− kt) 0.5
V0
0.0 0.0
–6 Time t Time t
Stochastic profit flow (in millions of euros) Profit value in the continuation region (in millions of euros)
2.5 2.5
2.0
pt
2.0
1.5 1.5
~
1.0 p (X *) ~ 1.0 VT p t × exp(−k(t−T ))
p t × exp(−k(t−T ))
VT Time t p t × exp(−kt)
0.5 0.5 V0 − B0 T VT
( ~) B0 T VT
( ~)
0.0 0.0 ~
~
–6 T Time t T Time t
Figure A.4
Value in the continuation region for a specific sample path of geometric Brownian motion
We consider the geometric Brownian motion of equation (A.12) with g = 9 percent and σ = 20 percent. The (risk-adjusted) discount rate is k = 15
percent. In the discretized version of the GBM, time increments are h = 0.04 . For illustrative simplicity, we consider a ten-year time period.
reached, the firm stops waiting and invests immediately. Once the
firm undertakes the added investment, it receives a larger profit flow
π 1 ( X t ).
Let VT denote the value of the project at time T in state XT . Let F ( X t )
be the time-t value of a perpetual American call option on this project.
Depending on the region in which the process is found, the project
value equals either the present value of receiving the new stochastic
profit flow π 1 ( X t ) in perpetuity from time T onward, resulting in gross
project value VT minus the necessary investment outlay I , or the value
of waiting and deferring the investment (expansion) decision for a time
period of length h.
There is actually an investment threshold X* that divides the state
space into two regions, the inaction and action regions.44 This critical
cutoff level X* provides guidance in deciding whether and when to
invest in the project. If the current state is in the region ( −∞, X*), it is
optimal not to act (i.e., wait to invest). In the region ( X*, ∞ ), it is strictly
dominant to act (invest). At the cutoff point, X*, the firm is just indif-
ferent between action (investing) and inaction (waiting). This threshold
is unique.45 The two regions and the optimal investment timing T* are
illustrated in figure A.5 for a sample realization of a stochastic process
with positive drift.
In the period prior to investment (at stochastic time T* ), the continu-
ation value is characterized as follows. Over a small time interval, h, the
profit flow π 0 ( X t ) h received by the firm plus the instantaneous capital
{ }
gain Êt ⎡⎣ F ( X t + h )⎤⎦ − F ( X t ) h must equal the total equilibrium return,
rF ( X t ) h. For h → 0, this leads to the HJB equation
rF = π 0 + ΓF . (A.47)
There are various approaches used to derive the unique optimal critical
level X* that divides the two regions. A common approach (see Dixit
and Pindyck 1994) involves deriving two related “boundary
conditions”:
1. Value-matching At the optimal threshold, X*, the option holder is

just indifferent between still waiting and holding the option, F ( X*),
44. This threshold level is an “absorbing barrier.”
45. For the uniqueness of the threshold, see Dixit and Pindyck (1994, pp. 128–30). Dixit
and Pindyck’s (1994) model is more general as it addresses concurrently the stopping
problem for investment and exit. Huisman (2001, pp. 34–35) is more in line with our present
setup as only the option to defer is considered.
Action
region
(invest)
X*
Inaction
region Sample path of the
(wait) stochastic process
~ t
T*
Figure A.5
Optimal stopping and first-hitting time
or investing immediately and receiving the forward value VT ( X*) − I.

That is,
F ( X*) = VT ( X*) − I . (A.48)
2. Smooth-pasting (optimality)46 This condition ensures that the option

to wait approaches smoothly the committed project value when the
process X t approaches the optimal cutoff value X*. At the point of
optimal investment, X*, the project value function (V − I or project
NPV) is tangent to the option value function, that is,
FX ( X*) = VX ( X*). (A.49)
The investment-timing problem is crucial to analyzing a number of real

options in continuous time. The investor needs to deduce (1) the value
of the investment opportunity given a specified investment rule and (2)
the optimal investment threshold level, X*, at which the investor should
take action. By following this optimal investment rule, the firm receives
46. This condition, also called high-contact or smooth-fit condition, was first applied by
McKean (1965) and Merton (1973) in option-pricing models. Dixit and Pindyck (1994, pp.
130–32) discuss it informally, whereas Øksendal (2007, ch. 10) provides a more advanced
treatment. Peskir and Shiryaev (2006) provide an advanced mathematical treatise on
optimal stopping. Dumas (1991) discusses the appropriate optimality conditions in stochas-
tic control models: the smooth-pasting condition applies to stopping and impulse control
models (e.g., lumpy investment decisions), while the supercontact condition (a higher
order condition) to instantaneous control models (e.g., incremental capacity investment
problems).
Table A.1
Characteristics of basic stochastic processes
Terminal Expected Expected first-

Stochastic process Description value VT discount factor B0 (T ) hitting time E0(T )
Arithmetic Brownian motion (ABM) dx t = α dt + σ dzt α xT e β1( X0 − XT ) xT − x0

+
k2 k α
β1
Geometric Brownian motion (GBM) dX t = gX t dt + σ X t dzt XT ⎛ X0 ⎞ 1 ⎛X ⎞
⎜⎝ ⎟ ln ⎜ T ⎟
k−g XT ⎠ g − (σ 2 2) ⎝ X 0 ⎠
b
Exponentials of Brownian motion (EBM) X t = exp (β x t ) with x t ABM XT ⎛ X0 ⎞ 1 ⎛X ⎞
ln ⎜ T ⎟
δ (β ) ⎝⎜ XT ⎟⎠ αβ ⎝ X 0 ⎠
θ1
Geometric Ornstein–Uhlenbeck (GOU) dX t = η ( X − X t ) dt + σ X t dzt NA ⎛ X 0 ⎞ H(ζ X 0 ) NA
⎜⎝ ⎟
XT ⎠ H(ζ XT )
Note: β1 , θ 1, and b1 are given in (A.2.2), (A.44b), and (A.44d) respectively; ζ = 2η σ 2 ; b = β1 β ; H (⋅) is defined in (A.44c); NA: Not available. We use
the risk-neutral version throughout chapters 9 to 12.

457
the highest option value (optimal investment policy). Finally, the investor
can ascertain when the optimal decision is expected to take place. Once
the investment trigger is found, actual investment may possibly occur far
in the future if the current state does not evolve to offer sufficient profit-
ability for the project.
Conclusion
In this appendix we described several important stochastic processes and

reviewed the basics of stochastic calculus. We discussed useful properties
for the most widely used diffusion processes, namely arithmetic Brown-
ian motion, geometric Brownian motion, and mean-reversion. We also
reviewed important notions concerning forward net present value, first-
hitting time, and expected discount factor. The developed concepts and
derived formulas serve as useful building blocks for various chapters in
part III of the book. In chapter 9, for example, we recast the investment
option in view of the trade-off between obtaining a larger forward net
present value (discussed in section A.2) versus a lower expected discount
factor (discussed in section A.3.2). Table A.1 offers a compendium of
useful formulas for easy reference.
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Index
Abandon or contract option, 153, 163, 165, Bargaining, 135–38

167 Bargaining power, of suppliers and
Accommodated entry, xi, 65, 119, 120, customers, 65–66
122–23, 132 Barriers to entry, xi, 51, 63, 72
Action region, 312–313, 453, 455 strategic (endogenous), 64, 65
Advertising strategies, 264–70 structural (exogenous), 64–65
soft investment in, 129, 266–67, 269 Basic option valuation, 169, 174
Aguerrevere, Felipe, 418 Bayesian Nash equilibrium, 116
Airbus, 6, 7, 8, 12, 63, 99, 353, 422 BCG matrix, 71, 71n
Akerlof, George, 31, 40, 41n Bellman equation, 327, 433
Altruism, reciprocal, 143, 144 Bellman’s principle of optimality, 441
American call option, xiv-xv, 294n, 307, Benefit parity/proximity, 71
308, 326 Bertola, Giuseppe, 305n
perpetual (early exercise of), 446 Bertrand, Joseph, 84
American investment option, 285 Bertrand paradox, 84, 87, 90, 266, 267, 270
Antitrust regulation Bertrand price competition, 33n, 84, 86–92,
and German chocolate, 140–41 97, 126–28
and joint research ventures, 409 with cost symmetry, 106
and sleeping patents, 410 differentiated, 87–88, 90–92
Arithmetic Brownian motion, 297–98, equilibrium profits in, 270
429–31, 457 and investment options, 238–40, 241, 242
expected discount factor for, 450 tough vs. soft commitment in, 127
expected first-hitting time for, 448 “Best-practices” approach, 10
forward NPV for, 443 Binomial tree/lattice, 177, 183, 220n
Arithmetic Ornstein–Uhlenbeck process, on evolution of demand, 210, 211
438–39 on evolution of market prices, 210, 212
Asymmetric Cournot duopoly/oligopoly, on evolution of market uncertainty, 201
106, 235–38, 381, 382 for patent fighting strategies, 206
Asymmetric or incomplete information, Black, Fischer, 40, 175. See also Black–
30–31, 424 Scholes model
games of, xiii, 83n Black–Scholes (BS) model, 174, 176,
investment with, 411–15 185–187, 189, 404–405, 435–38, 458–59
market structure under, 102–105, 107 Blockaded entry, xi, 65, 119, 410
and R&D spillover, 414 Boeing
Atoms function, 362n, 398 in duopoly, 63, 99, 422
Auction, 367, 414–15 interview with Scott Matthews, 11–12
Aumann, Robert, 24, 40, 40–41 787 Dreamliner, 6–9, 353
interview with, 145, 146–47 Boston Consulting Group (BCG), 198–99
BCG matrix, 71, 71n
Backward induction, 109, 112, 131, 135 interview with Rainer Brosch and Peter
Baldursson, Fridrik, 325 Damisch, 198–99
474 Index
Boundary conditions Certainty equivalent, 19n, 174, 178, 436.

smooth-pasting, 293n, 328–29, 329n, 456, See also Risk-neutral valuation
458 Cheap talk, 112, 134
value-matching, 293n, 328, 374, 455–56 Chicken game. See War of attrition
Bounded rationality, 86 Closed-form solution, xi
Boyer, Marcel, 389n, 420, 421, 423, 424 Closed-loop equilibrium, xi-xii, 361n, 366,
Brand-name reputation 389, 394, 398, 399, 400
and early-mover advantage, xii Closed-loop strategies, xi, xvi, 83n, 121n,
as soft commitment, 269 325n, 398, 399
Brazil, real options applications, 172–73 Coca-Cola, 53, 266
Brennan, Michael, 358 Co-opetition, 147–50
Brosch, Rainer, 13, 198–99 Collaboration. See also Cooperation
interview with, 198–99 in investment, 392, 394
Brownian motion, 427, 458–59 on patent, 395
arithmetic (ABM), 297–98, 429–31, 443, Collaborative (tacit-collusion) equilibrium,
448, 450, 457 393
fundamental quadratic for, 416, 445–46 symmetric, 401–402
geometric (GBM), 298, 431–38, 457 (see Collusion
also Geometric Brownian motion) and oligopolists’ expansion, 312–17
standard, 287, 312, 327, 344, 427–28 tacit, 145, 147, 107–108, 151–52
by Cournot duopolists, 95–96
Calculus, stochastic, 42, 227, 294n, 425, 426, in existing market, 371–72, 389n
428, 433, 458–59 in real-estate development, 406
Call option, xi perfect equilibria of, 372, 400
American, xiv-xv, 294n, 307, 308, 326 sustainability of, 422
perpetual, 446 symmetric, 401
European, 193, 227, 189, 190 Commitment (strategic), xvi, 12, 30,
Black–Scholes pricing of, 185, 187, 107–108, 110–12, 117–18, 151–52
435–38 credibility of, 117, 118
capacity units under construction as, 418 and reaction functions, 97
and oil reserve development, 280 and sequential Stackelberg game, 131,
Capabilities, 3, 10, 11, 47, 50, 73, 331. See 133–34
also Dynamic capabilities strategic effect of, 271n
Capacity expansion (investment), 422 taxonomy of strategies for, 118–119,
in duopoly, 332–33, 352, 354–55 123–25, 126
in existing market, 389–95 and Bertrand competition, 126–28 (see
lumpy (repeated), 419–21 also Bertrand price competition)
lumpy vs. incremental, 299, 299n, 353 (see and Cournot quantity competition, 128,
also Incremental capacity investment; 130–31 (see also Cournot quantity
Lumpy capacity investment) competition)
as monopolist’s option, 278, 298–306 entry strategies, 119–23
for oligopoly tough vs. soft, 121, 131, 194 (see also
and incremental investment, 317–22, Soft commitment; Tough
323 commitment)
and lumpy investment, 312–317 in differentiated Bertrand competition,
options approach to 127
and oil reserves, 279–80 Commitment or flexibility. See Flexibility
and utilities, 280–81 or commitment trade-off
in perfect competition, 322, 324–25 Commitment value, xii
and social optimality, 324–25 Competition
Capacity utilization, optimal, 417–19 and co-opetition, 147–50
Capital, cost of, xii exogenous, 404–405
Cartel, 59n imperfect, 24n, 421
and Cournot duopoly, 95 perfect, 23, 24n, 63, 322, 324–25 (see also
Case applications, 209–16, 247–70 Perfect competition)
Cash flow, expected, 174. See also in R&D, 409–10
Discounted cash-flow (DCF) method and real options analysis, 14
Index 475
reciprocating vs. contrarian, 271, 272 (see between Cournot duopolists in repeated
also Soft commitment; Tough games, 138–39, 141–42, 145, 147
commitment) in existing market, 370–72
Competitive advantage, 17, 74, 471 and prisoner’s dilemma, 29
creating and sustaining of, 66, 72–73 and symmetric vs. asymmetric firms in
and generic competitive strategies, capacity expansion, 420–21
70–72 Co-opetition, 147–49
through innovation, 54 Coordination failure, 235, 369, 370, 378,
and isolating mechanisms, xiii, 73 384, 392. See also Coordination
through value creation, 66–70 problem
external vs. internal perspectives on, Coordination problem, 226n, 359, 384, 386,
48–50 387
and patent strategy, 395 in deterministic case, 362
static vs. dynamic, 109, 112, 151, 195 and focal-point argument, 234, 235,
Competitive analysis, 50, 56 379–380
“five-forces” analysis, 59–66 and mixed-strategy approach, 235
macroeconomic, 57–58 and precommitment, 361
microeconomic (industry level), 58–59 and preemption, 366
Competitive erosion, 35, 343, 350, 351, 375, and war of attrition, 363
389, 404, 405, 421, 423 Corporate environment, 3–10
Competitive landscape, change in, 52 Corporate finance. See Finance, corporate
Competitive strategy. See Strategy Corporate strategy. See Strategy
Competitive value erosion, 35, 421 Cost(s)
Complements. See Strategic complements of capital, xii
Complementors, 148 fixed, xiii
Complete information, 115, 403 opportunity, xii, 277, 284
Compound option(s), 163, 167–68 sunk, xvii, 117, 117n, 271n, 275
in R&D setting, 163, 408, 410–11, 412 variable, xvii, 162
Concentration (industry) Cost advantage, xii
in “five-forces” analysis, 61 large, 382–84, 385, 388–89
Herfindhal–Hirschman index of, 62–64 small, 384–89
Consolidation, in corporate environment, Cost asymmetry
4 in Cournot duopoly, 96–97, 106, 229–35
Constant-elasticity demand function, in Cournot oligopoly, 99, 100–101, 106,
78–79 235–38
Consumer surplus, 66–67 Cost leadership, 70–71
Contestable market, 119 and Cournot duopoly models, 92, 96
Contingent-claims analysis, 307n, 308–309, Costly reversibility, 117
326 Cost parity/proximity, 72
Continuation or inaction region, 312–13, Cost symmetry
316, 453, 455 in Cournot duopoly, 92–96, 106, 227–29
Continuation strategy, 397–98 in Cournot oligopoly, 101, 106
Continuous-time option analysis, 275, 277, Counterthreats, and game theory, 2
278, 184–89, 380n Cournot, Antoine Augustin, 113
Continuous-time stochastic processes, Cournot quantity competition, 84, 91–92,
426–427, 458 128, 130–31
Brownian motion, 427–438 (see also duopoly, 33n, 92–99, 102–105, 107
Brownian motion) cooperation in repeated games and folk
general Itô or diffusion process, 440–441 theorem, 138–39, 141–42, 145, 147
mean-reversion process, 438–440 with cost asymmetry, 106, 381, 382
Contract or abandon option, 163, 165, with cost symmetry, 106
167 with information asymmetry, 102–105,
Contrarian actions. See Strategic 107
substitutes and investment options, 224–35
Cooperation, 135, 143 in new markets, 375–76
Aumann on, 146–147 probability of simultaneous investment
and co-opetition, 147–50 in, 364
476 Index
Cournot quantity competition (cont.) Differentiation strategy, 71, 129, 265–66

and R&D investment, 247 horizontal, 71–72
in Stackelberg game, 134 vertical, 72
oligopoly, 99, 100–102 Diffusion (sequential ordering), 338
with cost asymmetry, 106, 235–38 Diffusion (stochastic process), 425–26, 440,
with cost symmetry, 106 449
and incremental investment, 318 Discounted cash-flow (DCF) method, 16,
and investment timing, 315–17 22, 169. See also Net present value
and option games, 240 (NPV) method
and Stackelberg game, 131 Discount factor, 282. See also Expected
Cox, John, 190, 243, 436, 448n. See also discount factor
Cox–Ross–Rubinstein (CRR) binomial and Brownian motion
model arithmetic, 298
Cox–Ross–Rubinstein (CRR) binomial geometric, 287, 313
model, 174, 184, 185, 190–91 elasticity of, 292, 293, 298, 300, 302, 350
Credibility of strategic moves, 117, 118 and monopolist’s option to defer, 282,
CRR. See Cox–Ross–Rubinstein (CRR) 283, 286
binomial model and Wicksell model, 283
Customer Discount rate, 174, 177, 178n, 277n, 279,
market power, 65–66 282, 286n, 287n, 294n, 298, 307n, 437,
segment, 70 442, 445
switching costs, and early-mover Discrete-time option games. See Option
advantage, xii games (discrete-time)
value, factors in, 68 Discrete-time option valuation, 174,
176–84, 185
Damisch, Peter, 13, 198–99 Diversification, 17, 168, 279
interview with, 198–99 Dividend yield or opportunity cost, 16,
DFC. See Discounted cash-flow (DCF) 282, 289, 297, 308, 313, 335, 346, 375,
method 404, 435n, 437, 438n, 444, 445
Decision theory, static and dynamic, 39 Dixit, Avinash, 12, 13, 32, 33, 49, 109, 111,
Decision time, 224–25 117, 118, 188, 189, 242, 278n, 279–81,
Decision-tree analysis (DTA), 19 285n, 291, 292n, 293, 294, 298n, 301n,
and real options analysis, 19–20 (see also 305n, 307, 312n, 318n, 325, 333, 373,
Real options analysis) 378n, 379n, 396, 397, 439n, 451, 445,
Defensive patent wall, 207 453, 455, 456n
Deferral or waiting (timing) option, xiv-xv, interview with, 32–33
163, 163–64 on game theory basics, 28–32
examples of, 179–180, 182–84 Dixit–Pindyck model (investment timing),
of follower in duopoly, 341 333, 373
of monopolist, 219–24, 278, 347, 351 Dominant firm, 63
in deterministic case, 281–84 Dominant strategy, xii, 28–29, 111, 207–208
in stochastic case, 284–98 and cost asymmetry, 230
and NPV rule, 275 for investment options, 239
for patent, 395 “Doomsday Machine,” 110, 117, 118, 121n
Demand, isoelastic, 321–22, 323 Drift (diffusion), 425–426
Demand functions (inverse), 78 Dr. Strangelove . . . (movie), 110, 117, 121n
Demographic trends, 55 Duopoly, 81–82, 84
Deterministic profit, 301 adoption-timing decisions in, 421
Deterred entry, xii, 65, 119–20, 120–21 and Bertrand price competition, 33n, 84,
Deterrence, 110 86–88, 90–92, 97, 106
Deutsche Bank, 196 Boeing and Airbus as, 63, 99, 422 (see
Días, Marco A. G., 13, 172 also Boeing)
interview with, 172–73 and cooperation in existing market,
Differentiated Bertrand model, 63, 87–88, 370–72
90–92 and Cournot quantity competition, 33n,
equilibrium profits in, 270 84, 91–99, 102–105, 106, 107, 134 (see
and investment options, 238–40, 241, 242 also under Cournot quantity
tough vs. soft commitment in, 127 competition)
Index 477
exit policies in, 415 Entry

and folk theorem, 145 accommodated, xi, 65, 119, 120, 122–23,
and expansion of existing market, 389–95 132
and investment in new market, 372–89 barriers to, xi, 51, 63, 64–65, 72 (see also
and investment in new technologies, 411 Barriers to entry)
and lumpy capacity expansion, 419–21 blockaded, xi, 65, 119, 410
and preemption, 360, 363, 365–70 deterred, xii, 65, 119–20, 120–21
sequential investment in, 331–39 threat of, 64–65
and capacity expansion, 352, 354–55 Entry strategies, 119–23
under uncertainty, 339–48, 351–52, Equilibrium concepts
356–57 Bayesian Nash, 116
and signals, 414, 415 closed-loop, xi-xii
Dynamic capabilities, 50 path dependence, xv, 73, 285n
Dynamic decision theory, 39 Markov perfect, xv, 325n, 427, 452
Dynamic (sequential) game, 83 Nash, xiv, 25–26, 28, 89, 103, 109, 113–14,
Dynamic game theory, 39 116, 239, 398
Dynamic models, 151 open-loop, xiv, xvi, 360–61, 393–94, 396
Dynamic programming, 39n, 298n, 308, rationalizability, 89n
326–29 solution concept, 27n, 38n, 39n, 85, 89,
Dynamic strategic interactions, 39 92n, 112, 113, 116, 119, 135
subgame perfect Nash, xvii, 109, 114–15,
Early-mover advantage. See First-mover 116
advantage “trembling hand,” 115
Economic profit, xii, 16, 17, 67 Erosion. See Competitive erosion
Economics. See also Economic sciences EU Emission Trading Scheme (EU ETS),
experimental, 85 159
heuristics in, 85 European call options, 189, 190, 193, 227
macroeconomic analysis, 57 Black–Scholes pricing of, 187, 435–38
Economic sciences capacity units under construction as, 418
areas of research in, 32–33 pricing of, 185
Nobel Prizes awarded in, 40 European electricity industry, 155
rationality assumed in, 146 additional generation capacity required
Economies of scale, xii, 70, 76, 280–81 in, 156
Economies of scope, xii, 70–71, 76 business risk exposure of generation
Efficient-market hypothesis (EMH), 427 technologies in, 160–62
Elasticity, xii-xiii Emission Trading Scheme (ETS) for,
of discount factor, 292, 293, 298, 300, 302, 159
350 idiosyncratic business risks for, 158
price elasticity of demand, 78, 321–22, Italian electricity authority (Enel), 4–5,
323 131, 132, 166
and Lerner index (markup rule), 80–81 in examples, 181, 182–83, 184, 188,
Elasticity markup rule, 80–81 202–206, 222, 343–44
Electricity market, 132 liberalization in, 132
European, 154, 155 (see also European and real options, 163–64, 166–67, 168–69,
electricity industry) 170
Finnish, 422 European energy sector, 154
Italian (Enel), 131, 132 European liberalization, 129, 132
and real options, 162–69 European option, xiii, 220n. See also
reserve margins, 154–56 European call options
scale vs. flexibility in, 280, 281 Evolutionary games, 114
uncertainties for, 156–57 Exercise price or investment cost, 164, 165,
firm-specific risks, 156 167, 188, 190, 198, 267, 280, 289n, 299,
idiosyncratic business risks, 156, 157–58 308, 327, 346, 348, 430, 435, 442
generation technologies and business Exercise timing, and first-hitting time, 447
risk exposure, 159–62 Existing market model
technology-related business risks, 158 cooperation in, 370–72
Energy sector, European, 154. See also and oligopolists’ lumpy expansion,
European electricity industry 312–17
478 Index
Existing market model (cont.) Financial options, 5n, 153, 174

and option to expand, 389 Firm (company)
for asymmetric case, 393–95 external view of, 48, 50
for symmetric case, 389–92 internal view of, 50
Exit strategies, 415–17 knowledge-based view of, 47
Exogenous competition, 404–405 as portfolio of businesses, 198–99
Expanded or extended net present value resource-based view of, 73
(E-NPV), xiii, xv, 208, 288, 343, 351–52, Firm profitability, drivers of, 56
352, 384, 385 Firm roles, 359, 361 (see also Coordination
Expand or extend option, 163, 164–65 problem; Industry structure;
business applications of, 279–81 Leadership)
and capacity utilization, 418 endogenous, 374–75
in duopoly, 352, 354–55, 389–95 probabilities of, 364
example of, 180–81 Firm-specific risks, 156
in existing market, 389 First-hitting time, 447–48
for asymmetric case, 393–95 and investment trigger, 285
for symmetric case, 389–92 First-(early-)mover advantage, xii, 34,
and investment timing, 311 335n, 338–39, 342, 343, 345, 357. See
Expansion of capacity. See Capacity also Leadership
expansion in auction, 367
Expected discount factor, 448–51. See also and asymmetric case, 393
Discount factor and capacity expansion, 354
for arithmetic Brownian motion, 297, and Nash equilibria, 360
450 and precommitment, 361
elasticity of, 351 and preemption, xv, 362–63, 391–92
for geometric Brownian motion, 287, 293, in Reinganum model, 360
451 Fisher separation theorem, 15
and other exponentials, 451 “Five-forces” analysis, 51, 59–66, 147
for mean-reverting process, 451 Fixed costs, xiii
and Wicksell model, 283 Flex-fuel technology, 172, 173
Expected profit function, 102 Flexibility
Expected-value term, 425–26 in managerial decision-making, 19, 284
Experience effects. See Learning curve for multinational firms (exchange rate
effects risk), 422
Experimental economics, 85 and optionality, 198
Exponential demand function, 78, 79 and real options analysis, 13–14, 21–22
Exponentials of Brownian motion, 431–38, and uncertainty, 271, 271n
444, 445, 451, 452, 457 in utility planning, 280–81
Extended (expanded) net present value, Flexibility or commitment trade-off,
xiii, xv, 208, 288, 343, 351–52, 352 xxv-xxvi, 5, 12, 47, 118, 195, 195n, 197,
“Extended-rivalry” interactions, 59 272–73
in “five-forces” analysis, 60 Dixit on, 32
Extensive form, of bargaining game under and integrative approach, 15
complete information, 136 in option games, 217
Externalities quantification of, 243
negative, 35, 64, 320, 333n, 334, 355, 408, Focal-point argument, xiii, 231n, 234, 235,
409 339, 345, 361, 380
positive, 35, 408, 409, 421, 423 Focal-point equilibrium, 360, 383
External view of firm, 48, 50 Focus strategy, 70, 72
Folk theorem, 145, 145n
Fairness, as source of cooperation, 29 Follower or second mover, 34, 99, 106, 131,
Fat cat strategy, 124–25, 267, 269 133–137, 272, 334, 342, 344, 345–47, 350,
Fight mode, in patenting, 395 351–352, 357, 359, 360, 361–93, 406, 407,
Finance, corporate 408, 409, 411, 413, 415–17, 421, 422
and industrial organization, 37 Forward net present value, 441–47, 453
and strategy, 15–20 for arithmetic Brownian motion, 443
Financial economics and strategic for geometric Brownian motion and
management, 49 other exponentials, 444
Index 479
for powers of geometric Brownian options analysis with, 39–40

motion, 444, 447 origins of, 24
France Selten on, 85–86
EDF electric utility in, 202–206 static and dynamic, 39
GDF gas utility in, 166–67 Gardening metaphor, for managing
Friedman, James, 139, 145, 151 options portfolio, 170
Fudenberg–Tirole model of investment General Itô or diffusion processes, 440
timing, 332, 359, 360, 361, 362, 372, 396, Generation technologies, and business risk
397 exposure, 159–62
Fudenberg, Drew, 39n, 81n, 107, 108, Generic competitive strategies, 70–72
118–21, 124, 129, 132, 139n, 145, 152, Geometric Brownian motion (GBM), 298,
194, 243, 246n, 249, 286n, 324n, 332, 431–38, 457
333, 359, 360, 361, 362, 365, 366, 371, and closed-form solutions, 329
372, 373, 390, 396, 397, 406n, 415, 420 and continuous-time option analysis, 184,
Fundamental quadratic, 416, 445–46, 450 186
in example of Black–Scholes formula,
Games 187
of complete information, 115, 403 expected discount factor for, 313, 451
of imperfect information, 83n, 115, 414 expected first-hitting time for, 448
of incomplete information, xiii, 83n, forward NPV for, 444, 447
102–105, 107, 115, 414 powers of, 435
multistage, 139n present value with stochastic expiration
of perfect information, xiii, 83n for, 452–53, 454
repeated (supergames), 135n, 139, 147 Geometric Ornstein–Uhlenbeck (GOU)
cooperation between Cournot process, 439–40, 457
duopolists in, 138–39, 141–42, 145, 147 Germany
infinitely, 139n antitrust actions in, 140–41
and prisoner’s dilemma, 144 Deutsche Bank in, 196, 196n
and tacit collusion, 145, 147 telecom market of, 129
and “rules of the game,” 27, 82–83 Globalization, 53
sequential or dynamic, 83 Goodwill strategies, 264–70
simultaneous, 83, 139n, 224, 229 Gordon perpetuity formula, 444
of timing, 332, 396, 397 Grenadier, Steven, 49, 317, 320, 322, 325,
for duopoly, 332–39 326, 373n, 403n, 405, 406, 407, 414, 418,
in Fudenberg–Tirole model, 362, 396 423, 424
two-stage, 271–72 Growth options, 47, 163, 167, 168, 284, 311,
in goodwill and advertising, 264–70 318n, 418, 419, 421
innovative (R&D), 243, 246–50 Growth trend, 425–26
in patent licensing, 262
Game theory, xiii, 1–3, 6, 12, 14, 20–34, 49, Hamilton–Jacobi–Bellman (HJB)
50, 81, 84, 107–108, 143, 151–52, 153, equation, 433, 443
195, 209, 254 Harrison, Michael, 39n, 436, 451n, 452n,
advantages and drawbacks in 458
(comparison), 38 Harsanyi, John C., 40, 40–41, 115
applications of, 2–3, 36–37 Hedging, 156, 175
in business decision-making, 24–26 Herfindhal–Hirschman index (HHI),
basics of (Dixit), 28–32 62–64
in Boeing’s strategic thinking, 12 Heuristics,in economic analysis, 85
in continuous time, 332 (see also Horizontal differentiation, 71–72
Investment timing) Huisman, Kuno J. M., 49, 317n, 332n, 362n,
development of, 113–15 367n, 373n, 392n, 396, 397, 406n, 408,
fields of application of, 27 414, 423, 424, 455n
integrated with real options analysis Hysteresis, 307n, 422
(option games), 6, 32, 173, 195, 199, 423
and irreversible commitments, xxiii Idiosyncratic business risks, for electricity
metaphorical vs. literal interpretation of, industry, 156, 157–58
27, 33 Imperfect competition, games of, 24n,
mixing moves in, 29–30 421
480 Index
Imperfect information, 83n, 115, 414. See Internal view of the firm, 50
also Information International Energy Agency, suggestions
Inaction region, 312–13, 316, 453, 455 of risk from, 189
Incomplete or asymmetric information, Investment. See also Commitment;
30–31, 424 Strategic investment
games of, xiii, 83n, 115 collaborative, 392
investment with, 411–15 and commitment, 360
market structure under, 102–105, 107 decision-theoretic models of, 408
and R&D spillover, 414 game-theoretic models of, 408
Incremental capacity investment, 303–306 with information asymmetry, 411–15
Induction, backward, 109, 112, 131, 135 joint, 371–72, 384, 394
Industrial organization, 34, 37, 75, 107–108, Pareto-superior equilibrium of, 391
151–52 Jorgensonian rule of, 284, 336
dynamic, 39 modified, 295–97, 324, 356, 374, 381
and finance, 37 modified (risk-neutral), 345
and game theory, 40 in new technologies, 411
static, 39 in oil reserves, 279–80
Industry analysis and preemption, 366
“five-forces” analysis, 51–52, 59–66, 147 Tobin’s q theory of, 284
structure–conduct–performance (SCP), sequential, 331, 357 (see also Sequential
58–59 investment)
Industry structure(s) simultaneous, 311, 331, 364 (see also
assumptions, 78 Simultaneous investment)
evolution of, 378 tough vs. soft, 266 (see also Soft
probability of occurrence of, 364, 369, commitment; Tough commitment)
386 two-stage (R&D), 410
Infinitesimal generator, 133 under uncertainty, 5
Information in utilities, 280–81
complete, 115, 403 Investment, R&D, 243–53
imperfect, 83n, 115, 414 Investment option(s), xiv-xv
incomplete or asymmetric, 30–31, 424 American, 285
(see also Uncertainty) call option, xiv-xv, 294n, 307, 308, 326,
games of, xiii, 83n, 115 446
investment with, 411–15 for Cournot duopoly, 224–27
market structure under, 102–105, 107 under cost asymmetry, 229–35
and R&D spillover, 414 under cost symmetry, 227–29
perfect, xiii, 83n for Cournot oligopoly (asymmetric),
in Stackelberg model, 134 235–38
Information cascade, 414 for differentiated Bertrand price
Information economics, 31 competition, 238–40, 242
Information set, xiii, 83 in duopoly under uncertainty, 339
Innovation. See also R&D example, 186, 332
competitive advantage through, 54 monopolist’s deferral option, 219–24
and patents, 59 multiple, 419, 421–22
Innovative investment strategies, and in new market, 357, 372–73
time-to-build delays, 410 in asymmetric case, 379–89
Integrative approach to strategy, 35–41 in symmetric case, 373–79
Intellectual property (IP) rights. See also shared, xvi, 35, 35n, 344, 356
Patent valuation of, 284–85
licensing of, 254 Investment option value, for oligopoly,
and option games, 408 316
Interest rate, 176, 180, 183, 186, 187, 201, Investment staging, 164
208, 211, 271n, 295, 305, 313, 333, 336, Investment strategy, 285–88
348, 356, 374, 410, 438. See also optimal, 285n, 288–98, 334, 341, 372
Risk-free rate and time-to-build delays, 410
Internal rivalry, in “five forces” analysis, Investment threshold. See Investment
61 triggers
Index 481
Investment timing, 195, 195n, 275, 277, Itô process, 175, 288, 292, 293n, 326, 427,
307–308, 325–26, 332, 333, 357, 360, 361, 440, 458–59
382, 456. general Itô process, 440
for capacity expansion, 278, 298–306 Markov property for, 452
for duopolist, 332–39 and standard Brownian motion, 427
for monopolist, 219–24, 278, 308–309, 347 time-homogeneous, 440, 449
in deterministic case, 281–84 Itô’s lemma, 432, 433
in stochastic case, 284–98
for oligopoly, 311 Joaquin, Domingo C., 331n, 339, 344, 346,
for incremental capacity investment, 356, 358
317 Joint investment, 371–72, 384, 394
with lump-sum capacity expansion, Pareto-superior equilibrium of, 391
312–17 Joint venture, 315
for perfect competition, 322, 324–25 Jorgensonian rule of investment, 284, 336
under uncertainty, 196–97, 307 modified, 295–97, 324, 345, 356, 374, 381
Investment timing game, 362–63
Investment triggers, 227, 240, 455 Kamien, Morton I., 254n, 255n, 261n
and capacity expansion(optimal), 327, Karatzas, Ioannis, 325, 458, 459
352, 354 Kester, W. Carl, 35
for Cournot duopolist, 226, 237–38 Knowledge-based view of firm, 47
under cost asymmetry, 229, 231, 232, Kort, Peter M., 317n, 373n, 380n, 392n, 393,
233–35, 237–38, 262, 420 396, 397, 406n, 408, 414, 424
under cost symmetry, 227–28 Kulatilaka, Nalin, 21
under differentiated Bertrand price
competition, 241 Lamarre, Eric, xxvii
and first-hitting time, 285 interview with, 199–200
for follower in new-market investment Lambrecht, Bart M., 379n, 410, 412
(optimal), 341, 373–74, 380, 381 Large cost advantage, in preemption
in goodwill/advertising case, 267–70 games, 382–84, 385, 388–89
joint, 371 Late-mover advantage, 363, 366, 386, 414,
for leader in asymmetric new-market 421. See also Second-mover advantage
investment (optimal), 384 Leader or leadership, 361
for monopolist, 221–23, 237, 288–91, in duopoly, 334–39
305–306, 321 capacity expansion, 354–55
incremental capacity investment, 306 new market, 374–75, 376, 377, 378
for oligopoly, 311, 313, 316, 349, 350 under uncertainty, 339–43, 345–48
incremental expansion, 320–21, 322 in Stackelberg duopoly, 99, 106, 131,
lump-sum expansion, 315, 316 133–34
perfect competition, and social optimality, Leahy, John V., 324–26
324 Lean and hungry look strategy, 124
and R&D investment, 246–47, 248–49, Learning-curve effect, xiii, 71
250 and early-mover advantage, xii
in duopoly with high spillover, 251–53 Lerner index (markup rule), 80–81
in duopoly with low spillover, 251, 252 Licensing, Patent. See Patent licensing
Irrationality, 89n Linear demand function, 78, 79
Aumann on, 146 Luehrman, Timothy, 170–71
Selton on, 85–87 Lumpy capacity investment, 299–303
Irreversible investment, 32, 280, 285n, 297, repeated capacity expansion, 419–21,
325, 356, 373, 381, 389, 410, 415n, 420, 423
442
Isoelastic demand, 321–22, 323 Macroeconomic analysis, 57–58
Isolating mechanisms, xiii, 73 Managerial flexibility, 5, 12–16, 19, 38, 51,
Italy 55, 169, 198, 247, 271n, 288, 423
Enel electricity authority in, 4–5, 131, 132, Market, and threat of substitute products,
166 64
in examples, 181, 182–83, 184, 188, Market equilibrium, in monopoly, 81
202–206, 222, 343–44 Market share, bargaining over, 135–37
482 Index
Market structure and investment timing, 275, 277, 278

at beginning of investment game, 379 option to expand capacity, 298–306
probabilities of, 370 option to invest, 219–24, 278, 281–98,
Market structure games, xiii, 58–59, 217–18 308–309, 347
dynamic approach to, 109 natural, xxv, 76, 129
bargaining and cooperation, 135–145, Morgenstern, Oskar, 2, 24, 27, 40, 113
147–50 Multinational corporations, 57, 301, 302,
commitment in, 110–112, 117–28, 130–34 320–22
(see also Commitment) Multiplicative stochastic demand shock,
static approach to, 107 381, 416
duopoly, 81–82, 84, 86–99, 102–105, 107 Multistage games, 139n
monopoly, 76–81, 106 Myers, Stewart C., 43, 167n
oligopoly, 99–102 Myopic firm and strategy, xiv, 324
Market uncertainty, xxv, 5, 372, 373 (see
also Uncertainty) Nalebuff, Barry J., 33n, 49, 109, 117, 118,
Markov process, xiv, 325n, 427 148, 149
arithmetic Brownian motion, 429 Nash, John, 26, 27, 40, 113–14. See also
geometric Brownian motion, 431–38 Nash equilibrium
and Itô process, 440, 452 Nash equilibrium, xiv, 25–26, 28, 103, 109,
mean-reversion process, 438–40, 451 113–14, 116, 239, 398
standard Brownian motion, 427, 428 and Bertrand price competition, 88, 89,
Markup rule (Lerner index), 80–81 90
Matthews, Scott (Boeing), xxvii and Cournot quantity competition, 84, 93,
interview with, 11–12 95, 100
Maturity, xiv, 23, 164, 165, 183, 185, 187, and duopoly investment, 337, 337–38
188, 190, 191, 193, 201, 202–203, 206, and focal point argument, 231n
208, 251n, 256, 262–63, 265–68, 271n, mixed-strategy profile, 368
289n, 418, 430, 435–36, 441 in multistage setting, 112
McDonald Robert L., 165n, 188n, 29, 275, refinements of, 114, 115, 116
278n, 288, 294, 296n, 301n, 307, 333, subgame perfect, xvii, 398
347, 446. See also McDonald–Siegel Natural monopolies, xxv, 76, 129
timing option value Nature (as player), xiv, 82
McDonald–Siegel timing option value, Net present value (NPV) method, xiv, 16,
275, 288, 294n, 301n, 333, 347 174, 177. See also Discounted cash-flow
McKinsey & Company (DCF) method
interview with Eric Lemarre, 199–200 advantages of, 38
Mean-reversion process, 438–40 drawbacks of, 18–19, 21, 22, 22–23, 38
expected discount factor for, 451 expanded (extended) E-NPV, xiii, xv, 208,
Merton, Robert C., xxvii, 40, 174, 174n, 189 288, 343, 351–352, 352, 384, 385
interview with, 175–76 and finance-strategy gap, 17–18
Microeconomic theory, 58–59 forward, 441–47, 453
and strategic management, 49 for arithmetic Brownian motion, 443
Microsoft, 24, 25 for geometric Brownian motion and
Minimax solution, 113 other exponentials, 444
Mining/chemicals industry, option-games for powers of geometric Brownian
application in, 209–17 motion, 444, 447
Mixed strategy(ies), 113, 367–70 NPV rule, 16, 221, 227, 281, 284, 292
and coordination problem, 235, 359, 360, revision of, 275
362 under timing flexibility, 279
Monopolistic differentiated competition, proper use of, 18
63 vs. real options analysis, 196
Monopoly, 23, 24n, 58, 62–63, 76–81, 106, Network effects, 55–56
231, 235, 321 Neumann, John von, 2, 24, 27, 40, 113
vs. Cournot duopoly, 226 New market, 314–17, 340, 357
and differentiated Bertrand price option to invest in, 372–73
competition, 240 for asymmetric case, 379–89
and innovation, 59 for symmetric case, 373–379
Index 483
Niche, in focus strategy, 70, 72 issues arising in, 395

NPV. See Net present value method Lamarre (McKinsey) on, 200
NPV rule, 16, 221, 277, 281, 284, 292. See Option games (continuous-time), 275, 277,
also Discounted cash-flow (DCF) 278, 184–89, 380n
method Option games (discrete-time), 1, 6, 35, 41,
revision under timing flexibility, 275 184, 185, 193, 206–208, 210, 217–18, 253,
272, 273, 275, 333, 423
Observability, of strategic move, 117 applied to mining/chemicals industry,
Oil reserves, investment in (options 209–17
approach), 279–80 illustration of, 197, 201–206
Oligopoly, 63, 81, 99–102 Option markup formula, 290–91, 293
Cournot, 99, 100–102 Option-pricing formula, 179
under cost asymmetry, 106, 235–38 for multistep CRR, 190–91
under cost symmetry, 106 Option-pricing theory, 153, 175, 178
and incremental investment, 318 Option valuation, xv, 169, 174, 189
and investment timing, 315–17 discrete-time, 176–84, 185
dynamic models of, 39n Option value erosion, 423
expansion threshold for, 418 Ornstein–Uhlenbeck process
and investment timing, 311 arithmetic, 438–39
for incremental capacity investment, geometric (GOU), 439–40, 457
317–22, 323 Outsourcing
with lump-sum capacity expansion, of Boeing 787 Dreamliner, 7, 8–9
312–17 and value chain redesign, 148
Open-loop equilibrium, xiv, 360–61, Overinvestment, 250
393–94
Open-loop (precommitment) strategies, Pareto optimality, and sequential
xiv, xvi, 83n, 121n, 325n investment, 339n, 345
Opportunity cost, xii Pareto-superior joint-investment
and investment timing, 284 (see also equilibrium, 390–91
Investment timing) Passive management, 18
and NPV rule, 277 Patent(s), 253–54
Optimal investment timing, 195, 195n and innovation, 59
Optimal stopping, 453, 455–56, 458 in investment-timing example, 278
under uncertainty, 196–97 sleeping, 207, 410
Option(s) xiv, 153. See also Call option; Patent bracketing, 150
Real options Patent leveraging strategies, 395
American, xiv-xv, 294n, 307, 308, 326 Patent licensing, 253–56, 263–64, 272–73,
perpetual (early exercise of), 446 410
compound, 410 and drastic innovation, 254, 256–57,
European, xiii, xiv, 193, 220n (see also 260, 262, 263–64
European call options) fixed-fee, 254, 257–58, 259, 261
proprietary, xv, 35, 35n and nondrastic innovation, 260, 262
R&D, 245–46 royalty rate, 254, 258–59, 261
real, xv, 153–54, 162–63 (see also Real under small vs. larger cost savings,
options) 261
shared, xvi, 35, 35n, 344, 356 and spillover effects, 249, 253
Option analysis or approach under uncertainty, 261–64
to capital investment, 279 Patent race, 408–11
in oil reserves, 279–80 Patent strategy, 149–50, 206–208
in utilities, 280–81 Patent wall, 150
continuous-time, 184–89 Path dependence, xv, 73, 285n
with game theory, 39–40 Patience
Option games, xxvi, 1, 6, 41, 195, 217, 242, in bargaining, 135, 136, 138
403, 423 in cooperative behavior, 142
in Boeing’s strategic thinking, 12 Payoff, xv, 27, 38, 83, 244
Brosch and Damisch (BCG) on, 199 Paxson, Dean A., 411, 421
Días (Petrobras) on, 173 Payoff matrix, 209
484 Index
Perfect Bayesian equilibrium, 116 Profit-flow stream, with stochastic

Perfect competition, 23, 24n, 63, 325–26 termination, 452–58
and investment timing, 322, 324–25 Profit values, stochastically evolving, 339
quantity produced, 99–105, 107 Proprietary option, xv, 35, 35n
Perfect information, xiii, 83n Puppy dog ploy (strategy), 124, 126, 267
Perfect Nash equilibrium. See Subgame Pure strategy, 89, 113, 307, 338, 339, 345,
perfect Nash equilibrium 347n, 357, 359, 360, 368, 379, 383
Pindyck, Robert S., 12, 49, 111, 189, 190, Put option, 18, 153, 165, 167, 172, 181,
242, 278n, 279–81, 285n, 289n, 291, 415n, 417, 425n
292n, 293, 294, 298n, 301n, 305n, 307,
312n, 318n, 321n, 325, 326, 333, 373, q investment index (Tobin’s q), 284,
378n, 379n, 396, 397, 439n, 445, 451, 292–93
453n, 455, 456n. See also Dixit–Pindyck Quantity competition. See Cournot
model (investment timing) quantity competition
Porter, Michael, 59, 66, 70, 147
Portfolio Matrix (BCG), 199 Random rival entry, 404–405
Portfolio(s) of real options, 14, 168, 169, Rationality, 86, 146
170–71, 175, 176, 177–78, 185, 198–99, and game theory, 26, 84, 85–86, 89, 89n,
285n 113–14, 145
Potential entrants, 64–65 R&D (innovation) investment, 272–273,
Prahalad, Coimbatore K., 49, 51 407–11, 423
Precommitment strategies, 360–61. See and drastic vs. nondrastic innovation,
also Open-loop strategies 262
Preemption, xv, 99, 317n, 325n, 360, 363, options created by, 244–46
365–70, 375–79, 391–92, 396, 397, 409 and patent licensing, 253–64
asymmetric, 381–82 proprietary vs. shared investment in, 248
with large cost advantage, 382–84, 385, and spillover effects, 243, 246–53, 414
388–89 Reaction function, 88, 90, 91, 93, 94, 96, 97,
with small cost advantage, 384–89 97–98, 99, 102–103, 128, 337
fear of, 393 Real estate development, 405–407, 424
and first-mover advantage, 362–63 waves in, 403
Preemption timing, 366 Real options, xv, 153–54, 162–63, 189–90,
Present value. See also Net present value 307, 332
(NPV) method investmentexample of, 186
with stochastic expiration (for geometric and opportunity cost, 277
Brownian motion), 452–53, 454 portfolios of, 168–69, 170
Price competition. See Bertrand price and R&D, 244
competition strategy as portfolio of, 170–71
Pricing problem types of
in Cournot duopoly, 93, 94–95, 105 abandonment for salvage value, 153,
in Cournot oligopoly, 101 167
factors determining, 65–66 compound growth option, 163, 167–68
in monopoly, 76, 77, 79, 291–92 contract (scale down) or abandon, 163,
Pricing, risk-neutral, 436 165
Prisoner’s dilemma, 24–25, 28–29, 139, expand or extend, 163, 164–65, 279–81
143–44 (see also Expand or extend option)
repeated, 144, 147 growth option, 421
Producer surplus, 67 investment timing, xiv-xv, 163, 163–64,
Production costs, drivers of, 69 224–40, 242, 372–89, 453 (see also
Product redesign, 71, 72 Deferral or waiting option; Investment
Profit options)
deterministic, 102, 301 shut down (and re-start), 165, 188
economic, xii, 16, 17, 50, 63n, 64n, 67, 76n, staging or time-to-build, 163, 164
86–87, 99, 102, 119, 148, 162 switch use, 163, 165–67
stochastic, 301 Real options analysis (ROA), xv, xxiii, 5–6,
Profitability index, 284, 294, 298, 319, 324, 19–20, 23, 40, 153–54, 189, 195, 425
336, 343, 376, 406 advantages and drawbacks in, 38
gross, 292–93 and basic option valuation, 169, 174
Index 485
at Boeing, 11 Schwartz, Eduardo S., 273, 409

in Brazil, 172 Scope, economies of, xii, 70–71, 76
and continuous-time option analysis, Second-mover advantage, 34, 99, 363, 366,
184–89 386, 414, 421
discrete-time vs. continuous-time Selten, Reinhard, xxvii, 30, 40–41, 114–15
approach in, 197n (see also Option interview with, 85–86
games (continuous time); Option Sensitivity analysis, 19
games (discrete time)) Sequence of the play, 27
and discrete-time option valuation, Sequential equilibrium, 115
176–84, 185 Sequential game, 83
and dynamic programming, 39n Sequential investment, 357. See also
and game theory, 32, 173 Investment timing
and mining-industry application, 216 and asymmetric information, 412
and optimal investment timing, 196 and asymmetric positions, 393, 393–94
and proprietary vs. shared options, 35 and cost asymmetry, 423
and R&D investment, 243 in duopoly, 331–39
and stochastic investment timing, 285n and capacity expansion, 352, 354–55
Reciprocal altruism, 143, 144 under uncertainty, 339–48, 351–52,
Reciprocating actions. See Strategic 356–57
complement in investment timing games, 363
Reinganum, Jennifer F., 286n, 331, 332, in oligopoly
333, 335n, 338, 339, 357, 358, 360, 361, and capacity expansion, 355–56
366, 396, 397 under uncertainty, 348–52
Reinganum model of investment timing, preemptive, 409
331n, 332, 338, 339, 360 Sequential investment equilibrium, for
Rent dissipation, 388 real estate, 406–407
Rent equalization, 366, 367, 376, 382, 406, Sequential Stackelberg game, 131,
413n, 420 133–34
Repeated games, 135n, 139, 147 787 Dreamliner (Boeing), 6–9, 353
cooperation between Cournot duopolists Shared option, xvi, 35, 344, 356
in, 138–39, 141–42, 145, 147 Shareholder value, maximizing of, 83
infinitely, 139n Shock(s), 38n, 157
of prisoner’s dilemma, 144, 147 stochastic, 284, 301, 302
and tacit collusion, 145 additive, 302
Reputation, 34, 65, 73, 89, 118, 147 multiplicative, 301, 302, 320–22
Research and development. See R&D Shutdown (and re-start) option, 165, 188
Resource-based view of the firm, 73 Signaling, 34
Return on investment, and investment Simultaneous game, 83, 139n, 224, 229
timing, 283–84 Simultaneous investment, 311, 331
Risk-free interest rate, 180, 183, 185, 186, and asymmetric information, 412
201, 208, 211, 313, 348, 374 Cournot, 378
Risk management in dynamic setting, 317n
beta as risk measure, 418 and identical firms, 338
and real options analysis (Lamarre), in investment timing game, 363
200 joint or collaborative, 393
Risk neutral probability of, 364
expected discount factor, 449 in R&D, 409
probability, 178–79 vs. sequential investment, 347
valuation, xv-xvi, 436 Sleeping patent, 395, 410, 423
“Rules of the game,” 27, 82–83, 111, 112 Small-cost advantage, in asymmetric
preemption, 384–89
Salvage value, 117n, 153, 167, 295n, 416n. Smit, Han, 13
See also Abandon or contract system Smit–Trigeorgis model, 193, 197n, 217, 242,
Samuelson, Paul, 40, 175–76 344, 357–58, 411–12
Scale, economies of, xii, 70, 76, 280–81 Smooth-pasting condition, 293n, 328–29,
Schelling, Thomas, 24, 30, 40, 40–41 329n, 456, 458
Scholes, Myron, 40, 175. See also Black– Social-cultural factors, in macroeconomic
Scholes model analysis, 57
486 Index
Social optimality Strategic complements (reciprocating

and capacity expansion in perfect actions), xvi
competition, 324–25 vs. substitutes, 97–99, 194, 271, 272
of research, 408–409 Strategic conflict. See Game theory
and sequential investment, 345 Strategic effects, of commitment, 118,
Sødal, Sigbjørn, 278n, 289n, 291, 292n, 307, 120–21, 122
451 Strategic entry barriers, 65
Soft commitment (accommodating stance), Strategic form, of investment timing
xvi, 121, 123 games, 363
in advertising, 129, 266–67, 269 Strategic investment, 246–53, 271, 285–88,
in Cournot quantity competition, 130 423
in differentiated Bertrand competition, direct effect of, 120, 122
127 strategic effect of, 120, 122, 123–25, 126,
Solution concepts, 89, 116 128, 131, 132
Bayesian equilibrium, 116 under uncertainty, 243, 396
Nash equilibrium, 25–26, 28, 109, 113–14, Strategic management, 47, 73, 74
116 integrative approach to, 35–41, 195, 217
perfect Bayesian equilibrium, 116 (see also Option games)
rationalizability, 89n paradigms of, 48–50
refinements, 113–15 Strategic move, 11, 117
subgame perfect equilibrium, 398 Strategic substitutes (contrarian actions),
“trembling-hand” equilibrium, 115 xvi
Spence, Michael, 31, 40, 41n vs. complements, 97–99, 194, 271, 272
Spillover effects, and R&D investment, Strategic uncertainty, xxv, 5
243, 246–53, 272 Strategy (competitive), xvi-xvii, 10, 12–15,
Stackelberg, Heinrich von, 131 43, 82–83
Stackelberg game, sequential, 131, 133–34 in changing competitive environment,
Stackelberg model of duopoly, 131, 335n 51–56
follower, 99, 106, 131, 133–34 closed-loop, xvi, 83n, 121n, 325n, 398,
leader, 99, 106, 131, 133–34 (see also 399
Leadership) dominant, xii, 28–29, 207–208
Staging or time-to-build option, 163, 164 and cost asymmetry, 230
Static decision theory or game theory, 39 example, 203–204
Stiglitz, Joseph, 31, 40, 41n in investment options, 239
Stochastic Itô calculus, references on, weak, 230
458–59 exit, 415–17
Stochastic processes, xvi, 425–26, 458–59 generic, 70–72
continuous-time, 426–27 open-loop, xvi, 83n, 121n, 325n
Brownian motion, 437–38 perspectives on, 15
geometric Brownian motion, 275, 298 and corporate finance, 15–20
(see also Geometric Brownian motion), game theory, 20–34
298 as portfolio of real options, 170–71
general Itô process, 440–41 and real options thinking, 198
mean-reversion process, 438–40 success factors in, 10
discrete-time, 426 Strategy profile, 83
expected discount factor, 448–51 Strategy space, 397–98
first-hitting time, 447–48 Strengths, weaknesses, opportunities, and
forward net present value, 441–47 threats (SWOT) analysis, 51
optimal stopping, 453, 455–56, 458 Structural entry barriers, 64–65
properties of (basic processes), 457 Structure–conduct–performance (SCP)
Stochastic profit, 301–303, 304, paradigm, 58–59
Stochastic shock, 284, 301, 302 Subgame perfect Nash equilibrium, xvii,
additive, 302 109, 114–15, 116
multiplicative, 301, 302, 320–22 Submissive underdog strategy, 125
Stopping, optimal, 453, 455–56, 458 and underinvestment, 250n
Stopping or action region, 312–13, 453, 455 Substitutes, threat of, 64
Strategic commitment. See Commitment Substitutors, 148
Index 487
Suicidal Siberian strategy, and Uncertainty

overinvestment, 125, 250n at Boeing, 11–12
Sunk costs, xvii, 117, 117n, 271n, 275 and capacity expansion, 418
Supergames, 139. See also Repeated and competition vs. cooperation, 150
games Cournot quantity competition under,
Suppliers, market power of, 65–66 225
Sustainable competitive advantage, 17, 41, duopoly with sequential investment
335n, 342n under, 339–48, 351–52, 356–57
Switching costs, 64, 66, 129, 165, 166n, 167n and electric utilities, 156–57
Switching option(s), 163, 165–67 firm-specific risks, 156
Symbols used in this book, xix-xxi generation technologies and business
risk exposure, 159–62
Technological changes, in macroeconomic idiosyncratic business risks, 156, 157–58
analysis, 57–58 technology-related business risks,
Technologies, for electric industry (and 158–59
business risk exposure), 159–62 and flexibility–commitment trade-off,
Technology portfolios, 168–169, 170 197
Technology-related business risks, for and game theory, 38, 38n
electricity industry, 156, 158–59 growth options under, 421
Temporary shutdown option, 188 and investment in existing market, 392
Threats investment opportunities under (dynamic
empty, 112 programming), 326–29
of entry, 64–65 and investment timing, 196–97, 307
in “five-forces” analysis, 60–61 and Jorgensonian rule, 295–96
and game theory, 2 market, xxv, 5
counterthreats, 2 and new market investment, 372, 373
of retaliation, 145 and oil reserve as option, 280
of substitutes, 64 in oligopoly with sequential investment,
Time, decision vs. real, 224–25 348–52
Timing of investment. See Investment option games under, 6, 195, 217, 240
timing option models of investment under, 333
Tirole, Jean, xxvi, xxvii, 39n, 81n, 107, 108, and patent leveraging strategies, 395
118–21, 124, 129, 132, 139n, 152, 194, patent licensing under, 261–64
243, 246n, 249, 286n, 324n, 332, 333, and patent races, 408
359, 361, 365, 366, 371, 372, 373, 390, quantity competition under, 224–38
396, 397, 406n, 415, 420 and R&D, 243
interview with, 36–37 and real options, 20–23
Tit-for-tat strategy, 29, 142, 143–44 strategic, xxv, 5
Tobin, James, 40, 284, 292 and strategic investment, 243, 396
Tobin’s q, 284, 292 technological, and sleeping patents, 410
Top dog strategy, 123–124, 128, 134 and technology adoption, 408
Tough commitment or investment in utility planning, 280–81
(aggressive stance), xvii, 121, 123, 266 Underinvestment, 16n, 122, 250, 250n
in advertising, 267, 269 Utility planning. See also Electric utilities
in Cournot quantity competition, 130 scale vs. flexibility in, 280–81
“Trembling-hand” equilibrium, 115 Utilization of capacity, optimal, 417–19
Trigeorgis, Lenos, 13, 19, 35n, 41, 49, 119n,
149, 153n, 189, 190, 193, 197n, 206, 209, Valuation, risk-neutral, xv-xvi
217, 218, 219, 242, 243, 249, 272, 273, Value chain, 51, 60, 69–70
301n, 344, 357, 358, 360, 395, 411, 412, relationships along, 147, 148
423n, 424, 432n, 441, 445 Value creation, 66–70
Trigger strategy, 142, 240, 277. See also external vs. internal perspectives on,
Investment triggers 48–50
Two-stage games, 271–72 Value erosion, competitive, 35, 421
in goodwill and advertising, 264–70 Value-matching condition, 293n, 328, 374,
innovative (R&D), 243, 246–50 455–56
in patent licensing, 262 Value net, 148–49
488 Index
Value redistribution, 148–49

Variable costs, xvii
for fuels in electric utility, 162
Vertical differentiation, 72
Volatility, 426
Waiting option. See Deferral or waiting

option
Waiting region, 314
War of attrition, xvii, 99, 196, 363, 414, 415
and exit strategy, 416
Weeds, Helen, 408, 409, 410
Wernerfelt, Birger, 49, 50
Wicksell model, 283
Wiener process, 427. See also Brownian
motion
Yahoo, Microsoft bid for, 24, 25
Zero-sum games, 27n

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Competitive Strategy

Options and Games

The MIT Press

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Library of Congress Cataloging-in-Publication Data

Chevalier-Roignant, Benoit, 1983–

1 The Strategy Challenge 1

I STRATEGY, GAMES, AND OPTIONS 45

2 Strategic Management and Competitive Advantage 47

2.3 Creating and Sustaining Competitive Advantage 66

5.3 Basic Option Valuation 169

II OPTION GAMES: DISCRETE-TIME ANALYSIS 193

6 An Integrative Approach to Strategy: Option Games 195

III OPTION GAMES: CONTINUOUS-TIME MODELS 275

9 Monopoly: Investment and Expansion Options 277

12.2.1 Symmetric Case 373

Accommodated entry Entry is accommodated if structural entry bar-

in discounting the (actual) expected cash flows at a (higher) risk-adjusted

open-loop strategies make more restrictive assumptions on the informa-

i, j Competing firms (in a duopoly)

α Actual growth rate for arithmetic Brownian motion

β 2 (β̂ 2 ) Negative root of the fundamental quadratic function (elasticity

President Truman once said: “Give me a one-handed economist. All of

In real life most situations corporate managers face are characterized by

business environment. Whether to invest in a new product or enter a new

All Is Fair in Love, War, and Poker

What Do Love, War, and Poker Have in Common?

Threats and Counterthreats

Understand the World

Modern lovers might think the idea of engagement ring as guarantee is a

Reprinted with permission of BBC News, bbc.co.uk/news. Publication

1.1 The Changing Corporate Environment

The competitive environment around the globe is becoming increasingly

in an ever-changing marketplace. Globalization, deregulation, and the

and uncertainty for Enel. With further deregulation other European

the strategic interactions among option holders, analyzing investment

Boeing Bets the House on Its 787 Dreamliner

Never before has Boeing farmed out so much work to so many

Publication date: May 7, 2006.

1.2 What Is Strategy?

Corporate strategy is high on the agenda of every major corporation.2

Boeing projects have many sources of uncertainty. We build models that

often modeled as real option investments with a type of varying volatility,

We find that game-theoretical approaches provide additional insight to a

success factors has failed to provide a coherent direction to guide the

Stay Loose: By Breaking Decisions into Stages, Executives Can Build

In turbulent times adaptability is critical. That’s why today flexibility is

Instead of making rock-hard plans and irreversible long-term commit-

Real options analysis can also be useful in helping strategic planners

Reprinted with permission of The Wall Street Journal, Copyright © 2007

discusses the need for strategic plans to be flexible and adaptable in a

1.3 Two Complementary Perspectives on Strategy

Two approaches to strategy are of particular interest as they provide

1.3.1 Corporate Finance and Strategy

projects.4 A key issue is how to address the intertemporal trade-off faced

Alternatively, the present value represents the discounted sum of eco-

today’s investment decisions may constrain or open up new future

Financial assets Corporate real assets

Appropriate Valuation of bonds, preferred Valuation of flows from

Source: Myers (1984, p. 135).

simulation, and decision-tree analysis. Each has had, however, known

analysis is an innovative capital-budgeting tool suitable for the analysis

1.3.2 Game Theory and Strategy