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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 or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. For information about special quantity discounts, please email special_sales@mitpress.mit .edu This book was set in Times Roman by Toppan Best-set Premedia Limited. Printed and bound in the United States of America. 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 Preface xxv 1 The Strategy Challenge 1.1 1.2 1.3

xxiii

1

The Changing Corporate Environment 3 What Is Strategy? 10 Two Complementary Perspectives on Strategy 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 2 STRATEGY, GAMES, AND OPTIONS 45

15

Strategic Management and Competitive Advantage 2.1

47

2.2

Strategic Management Paradigms 48 2.1.1 External View of the Firm 48 2.1.2 Internal View of the Firm 50 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

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Contents

2.3

Creating and Sustaining Competitive Advantage 2.3.1 Value Creation 66 2.3.2 Generic Competitive Strategies 70 2.3.3 Sustaining Competitive Advantage 72 Conclusion 73 Selected References 74 3 Market Structure Games: Static Approaches 3.1 3.2 75

66

Monopoly 76 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 Selected References 107 4 Market Structure Games: Dynamic Approaches 4.1 109

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 Selected References 151 5 Uncertainty, Flexibility, and Real Options 5.1 153

5.2

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 Common Real Options 162

Contents

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5.3

Basic Option Valuation 169 5.3.1 Discrete-Time Option Valuation 176 5.3.2 Continuous-Time Options Analysis 184 Conclusion 189 Selected References 189 Appendix 5A Multistep Cox–Ross–Rubinstein (CRR) Option Pricing 190 II 6 OPTION GAMES: DISCRETE-TIME ANALYSIS An Integrative Approach to Strategy: Option Games 6.1 193 195

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 Selected References 217 7 Option to Invest 7.1 7.2 219

Deferral Option of a Monopolist 219 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 Selected References 242 8 Innovation Investment in Two-Stage Games 8.1 8.2 243

Innovation and Spillover Effects 243 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 Selected References 272

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Contents

III 9

OPTION GAMES: CONTINUOUS-TIME MODELS Monopoly: Investment and Expansion Options 9.1 277

275

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 Selected References 307 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 Selected References 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 Selected References 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

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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 Selected References 396 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 Selected References 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 Selected References 458 References 461 Index 473

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Closed-loop strategies In dynamic games.Glossary Accommodated entry Entry is accommodated if structural entry barriers are low and entry-deterring strategies are ineffective or too costly. Competitive markets are characterized by low entry barriers. Structural or administrative barriers are sufﬁcient conditions for blockaded market entry. Closed-loop equilibrium The equilibrium forms a perfect equilibrium in closed-loop strategies. the closed-loop strategies form a Nash . but not the obligation. closed-loop strategies allow players to condition their play on both the previous moves by the players and on calendar time.” Closed-form solution A solution that gives an analytical answer to a mathematical formulation. that is. 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. Blockaded entry A condition where the incumbent need not undertake any entry-deterring strategies to enjoy monopoly rents in the marketplace. All past actions of all players is common knowledge at the beginning of each stage. Chicken game See “war of attrition. 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). to buy or acquire an underlying asset at a predetermined price over a speciﬁed period (maturity). Call option A contract or situation that gives its holder the right. An incumbent attempts to adopt strategies and build competitive advantage early on to cushion the future negative effects of accommodated competitive entry.

Cost advantage One of the main strategies to achieve a competitive advantage is to seek to attain lower costs. 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 . 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. 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. 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.xii Glossary equilibrium in each and every subgame (on and off the equilibrium path). Dominant strategy A strategy that is the best decision for a player regardless of the action or strategy chosen by its opponent. Opportunity costs are subsumed in economic proﬁts. or high customer switching costs. Sources of sustainable earlymover advantages include the learning-curve effect (economies of cumulative production and learning). while maintaining a perceived beneﬁt comparable to that of competitors. The cost of capital reﬂects the systematic (or market) risk of a traded asset perfectly correlated with the investment or asset to be valued. A relative cost advantage inﬂuences the optimal investment timing of competing ﬁrms. An early-mover advantage can stem from the uncontested market presence of a leader that enjoys monopoly rents for some time. Deterred entry A situation occurring when an incumbent can keep an entrant out by employing an entry-deterring strategy.” Commitment value The incremental value (positive or negative) accruing to a ﬁrm from making a strategic commitment. brand-name reputation—especially in situations where buyers are uncertain about product quality (“experience goods”)—. Early-mover advantage An advantage from moving early that enables a ﬁrm to make a higher economic proﬁt than its rivals. Commitment See “strategic commitment.

duopoly. Fixed costs Costs that are independent of the scale of production and are locked in for a given period of time. all other factors remaining constant. Learning-curve effect Learning-based cost advantage that results from accumulating experience and know-how in productive activities over time. or neutralized through the resource-creation activities of competitors. and perfect competition are classic examples of market structure. . Game theory A branch of mathematics and economic sciences concerned with the analysis of optimal decision-making in multiplayer settings. Focal-point argument In the event of multiple equilibria. Monopoly. Some distinguish among ﬁxed and sunk costs though the difference is subtle: “ﬁxed” often refers to short-term commitments. 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.Glossary xiii percent change in the value of the parameter. Information set The information a decision maker has at the moment she makes a decision. the focalpoint argument suggests that an equilibrium that appears “natural” or logically compelling is the one more likely to arise. eroded.. Market structure Characteristic of a market in terms of number and size (power) distribution of ﬁrms. European option An option that can only be exercised at maturity. while “sunk” or nonrecoverable costs generally involve a longer planning horizon. Isolating mechanisms Economic forces put in place by a ﬁrm to limit the extent to which its competitive advantage can be duplicated. Games of incomplete information Games where players do not know some relevant characteristics of their opponents (e. Chess is a well-known example. not earlier. Games of perfect information Games where all players possess all relevant information.g. Extensive-form games of perfect information have the property that there is exactly one node or decision point in each information set. available action sets or their beliefs). their payoffs. Solution concepts meant to provide predictions on the likely outcomes impose certain behavioral restrictions on players.

it is called an American option. Nature Acts of nature are treated as the actions of a quasi-player that makes random choices at speciﬁed points in a game. Myopic strategy A strategy that does not take into account or is independent of the investment decisions of rivals. no player has an incentive to unilaterally deviate. One cannot therefore use past information to predict the future state of the variable. Nash equilibrium A classic equilibrium solution concept used in the analysis of multiplayer games: each player pursues its individual optimizing actions given the best actions of the other players. The net present value of a project is the present value of the expected cash ﬂows minus the (present value of) required investment costs. Maturity The period or last moment at which an option can be exercised. Net present value (NPV) The NPV paradigm is well established in corporate ﬁnance. Such strategies are also called “precommitment strategies. if only at maturity. If the option can be exercised before maturity. Option to invest or option to defer An American-type call option embedded in projects where management has the right (but no obliga- . all the past relevant information is summarized into the latest value of a variable or price. a stand-alone investment is deemed acceptable if its net present value is positive.g. 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 previous play of the opponents and therefore condition their play on calendar time only.. 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). a European option. If the option can be exercised before this date.xiv Glossary Markov property This property asserts that for certain stochastic processes or dynamic problems. Efﬁcient markets and Itô processes have this Markov property. 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. if only at maturity. it is an American option.” 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. a European option. In the absence of managerial ﬂexibility. In equilibrium.

expand. Perfect Nash equilibrium See “subgame perfect Nash equilibrium.Glossary xv tion) to delay the project start for a certain time period.. or abandon a project) at a speciﬁed cost (the exercise price) for a certain period of time. The exercise price is the cost needed to initiate the project. A monopolist ﬁrm has a proprietary investment option. defer. demand) uncertainty. Proprietary option An option held by a ﬁrm that entitles it to the full exclusive beneﬁts resulting from exploiting the option. the value of a plant with the option to expand production). Payoff The utility. Precommitment strategies See “open-loop strategies.” Players The individuals. The valuation approach is meant to capture management’s ﬂexibility to adapt its decisions to the evolving uncertain circumstances.g. or value a player receives when the game is played out. Each player’s goal is to maximize her payoff or value by choosing the best action or sequence of actions (strategy). Real option The ﬂexibility arising when a decision maker has the opportunity to adapt or tailor a future decision to information and developments that will be revealed in the future.. Real options analysis The ﬁeld of application of option-pricing theory to valuing real investment decisions.. enabling discounting of future values at the risk-free interest rate. This contrasts to the standard valuation approach (NPV) consisting . the payoff can be the real option value (e. Risk-neutral valuation A valuation method underlying option pricing analysis that adjusts for risk in the expectation of cash ﬂows (certaintyequivalent). contingent on the resolution of some exogenous (e. ﬁrms. Option valuation Valuation process by which the total value or “expanded net present value” (E-NPV) of an investment opportunity is determined.” 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.g. In the option games context. reward. 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. but not the obligation. to take an action (e. contract. A real option conveys the right. or actors that make decisions in a game situation.g.

Shared options characterize competitive industries where incumbent ﬁrms share the same investment opportunities. you take advantage of me if I am nice to you. Strategic substitutes (or contrarian actions) These characterize actions in situations where ﬁrms react (in equilibrium) in a contrarian or opposite manner (i. reaction functions are downward sloping). In Cournot quantity competition. Such commitments are generally difﬁcult or costly to reverse. reaction functions are upward sloping). Shared options are more involved to analyze as they must account for rival reactions or interactions. Strategic commitment A strategic decision or move intended to alter the competitors’ behavior or beliefs about future market competition. I will be nice to you if you are nice to me.e.e.xvi Glossary in discounting the (actual) expected cash ﬂows at a (higher) risk-adjusted discount rate.. while in Bertrand price competition a soft commitment induces the ﬁrm to maintain a higher price. Open-loop and closed-loop strategies refer to different strategy types: . By extension. In case of quantity competition.. Shared option An option simultaneously held or shared by several ﬁrms in the industry. a soft commitment leads the committing ﬁrm to produce relatively less. Strategy A behavioral rule adopted by a player that prescribes which contingent action(s) to choose at each stage in a game. For example. In case of price competition. Strategic complements (or reciprocating actions) These characterize actions in situations where ﬁrms react (in equilibrium) in a reciprocating or complementary manner (i. Risk neutral Situations where investors are indifferent between a sure payoff (certainty-equivalent) and a risky outcome of equal expected value. A strategy speciﬁes for each decision node or information set which action to pursue. the same description is used for the corresponding valuation method. capacity-setting actions are strategic substitutes. 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) competition stage. For example. 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. price-setting actions are strategic complements.

Once incurred. Sunk costs Investment costs that cannot be recouped. that vary as the output level rises. both ﬁrms have an incentive to be a follower or wait to be the last to move.” . 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”). Tough commitment (or aggressive stance) A strategic commitment intended to hurt the rival. Variable costs Costs. sunk costs are irrelevant for future decision-making. while in Bertrand price competition the ﬁrm will cut its price and enter a price war. leading to a “war of attrition. tough commitment induces the committing ﬁrm to produce more. In Cournot quantity competition. War of attrition (or chicken game) In a duopoly involving a secondmover (follower) advantage. such as direct labor or commissions to sales people.Glossary xvii open-loop strategies make more restrictive assumptions on the information the players possess over the game play.

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

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

variable or parameter Euro M Bn ≡ Million Billion Means “is deﬁned to be” X* M S L F * ^ . or the preset investment trigger—not necessarily the optimal one—in continuous-time option games Optimal investment trigger (*) Monopolist ﬁrm’s total value (with investment timing or expansion option) Total ﬁrm value (with investment timing or expansion option) in an oligopoly characterized by simultaneous investment Leader’s value (with investment timing or expansion option) in sequential investment option games 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.Symbols xxi ˆ β 2 (β 2 ) Negative root of the fundamental quadratic function (elasticity of the option to exit) x0 xt X0 Xt XT Time-0 value of the stochastic process in the case of arithmetic Brownian motion Stochastic process value at time t in the case of arithmetic Brownian motion ( xt ≡ ln ( X t )) Time-0 value of the stochastic process in the case of geometric Brownian motion Time-t value of the process in the case of geometric Brownian motion Value of the stochastic process at maturity T in discrete-time option games.

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’” Economists do indeed recognize that there are multiple forces at work in most situations. Benoît Chevalier-Roignant and Lenos Trigeorgis synthesize and consolidate much of this literature and skillfully extend it. 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. I will endeavor a personal remark. This book is an admirable effort at such an economic analysis. So what does one do when facing an uncertain future in the company of rivals? This is a difﬁcult problem. The last two decades have brought a trickle of research contributions that address some aspect of this dilemma. conceptually as well as mathematically.Foreword President Truman once said: “Give me a one-handed economist. For students in any of these areas. They begin with very simple and clear overviews of the issues. They focus on applications to industrial organization and business. concepts and models from the separate areas of real options and game theory. When facing an uncertain future. on the other hand that. But in game theory. Generations of students and researchers over the next decade or two will ﬁnd the book an invaluable starting point for their own work. and it takes quite subtle analysis to understand their interaction and balance. remaining ﬂexible until more information arrives has value. this book can serve as a hypermarket for one-stop intellectual shopping. This is the starting intuition of real option theory. All of my economic advisers say ‘On the one hand this. The authors also deserve congratulations for their excellent exposition. I also contributed to popularizing game theory. But I seem to suffer from a kind of attention-deﬁcit disorder in . I was involved in some of the early research on real option theory. because one can cherry-pick to make investments only when the prospects are relatively favorable. In this book.

and diverted to. amazed at how much has changed in the intervening years. Although I have enjoyed my excursions into other ﬁelds. I am happy that my contributions to real option theory are still remembered. other ﬁelds like political economy and governance institutions. But. returning to the real options literature after many years to read this book.xxiv Foreword research. Avinash Dixit Princeton. therefore I got interested in. perhaps I should have stayed and contributed to these equally exciting developments that have combined options and games to produce better twohanded economists. I also feel like Rip Van Winkle. NJ June 2010 . and feel honored to be asked to write a preface to this book.

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

The trade-off between these two forces calls for a careful balancing act. we discuss prerequisite concepts and tools concerning basic game theory. First. and ideas found in diverse books and research works on game theory (e. We aim to ﬁll this gap here by synthesizing the existing literatures to provide a consistent and accessible account of options and games. From a modeling perspective. In the ﬁrst part of the book.xxvi Preface business environment. industrial organization (Tirole 1988). The current book brings important materials and ideas together in a uniﬁed framework. industrial organization. and real options analysis (Dixit and Pindyck 1994. sometimes conﬂicting. there is a value of waiting or ﬂexibility related to the real option that the ﬁrm holds to make future better-informed decisions. Such situations lead to two. Second. Option games help model situations where a ﬁrm that has a real option to (dis)invest in speciﬁc projects faces competition. tools. This makes the task at hand very ambitious because these ﬁelds of research normally require different tool kits and needed results are scattered around in disparate parts of the literature. main sources of value for the ﬁrm. We combine some of the best materials.g. Osborne 2004). Fudenberg and Tirole 1991. while the last part on continuous-time option games is not covered in any systematic way anywhere and is an important addition. the examination of such a trade-off calls for a combination of the real options and game theory approaches to decision-making. which makes it much easier for managers and academics to enter and understand this new ﬁeld. For pedagogical convenience and for the sake of simpler and clearer exposition and buildup of the basic ideas. This book aims to make accessible to a wide audience recent results on how to achieve and quantify balance between ﬂexibility and commitment through the new approach of “option games. We are then in a position to amalgamate these diverse ﬁelds into a uniﬁed framework for option games. The second part of the book presents the new approach in discrete time.” We believe that this approach can play an important role in managing modern business in a changing global marketplace. with the richer theory coming later . and real options analysis. Trigeorgis 1996) and go beyond current knowledge to chart new territory. we ﬁrst present each of the building blocks step by step to form the supporting foundation and columns of the structure. 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.. there is a value of commitment in light of the strategic interaction with competitors.

and Jean Tirole for enhancing the relevance of this book with their valuable interviews and comments. Marco Días. criticism. We thank Avinash Dixit for his feedback. closed-loop equilibrium) in a step-bystep fashion to facilitate and smooth out the exposition. The book provides a very pragmatic and intuitive. 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. and Jacco Thijssen made invaluable detailed comments and provided suggestions for improvement on the entire manuscript. open-loop vs. 1. Eric Lamarre. . Robert C. Bart Lambrecht. We also thank Stefan Hirth. Helena Pinto. Several other colleagues offered valuable comments on select parts of the book or on speciﬁc chapters: Christoph Flath.g. we would like to thank our families. Aumann. We attempted to strike a balance between making the book accessible to a wider audience while simultaneously making it challenging and rigorous. The book should also be of interest to (academically trained) practicing managers who are interested in applying these ideas. Rainer Brosch. Artur Rodrigues. investment trigger.Preface xxvii (culminating toward chapter 12) as the keystone that will complete the arch. Merton. 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. Marcel Boyer. and supportive. Scott Mathews. but we need to introduce various key notions (e. Avinash Dixit. John Khawam. and encouragement. and Bruno Versaevel. Marco Días. ideas. for their love and support. subjecting the art of strategy to a scientiﬁc inquiry. Several of the issues left unresolved in the earlier parts of the book are addressed in chapter 12. Grzegorz Pawlina. It provides many strategic insights and a ready-to-use tool kit offering quantitative guidance for important competitive trade-offs faced by the modern ﬁrm. yet rigorous approach to strategy formulation. alive or departed. Kuno Huisman. Reinhard Selten. Last but not least. and suggestions. The authors would like to thank Arnd Huchzermeier for his support.1 The book should be especially appealing to the academic community. Jane MacDonald from the MIT Press has been most enthusiastic. particularly in the areas of strategy. prologue. and Han Smit for useful comments.. Sigbjørn Sødal. Richard Ruble. and ﬁnance. Peter Damisch. We thank Robert J. efﬁcient. Chapter 12 can be thought of as the climax of the book. economics.

1

The Strategy Challenge

At a time when national monopolies have been losing their secular wellprotected 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 corporations. 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 industry when it faces uncertainty and signiﬁcant entry and exit costs? Recent developments in economics, ﬁnance, and strategy equip management 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 complementary 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 disciplines, 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 integrative approach to corporate strategy in section 1.4. We provide an overview of the book organization in section 1.5.

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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 similarity: 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, negotiating rent, or deciding to go on strike are all situations that economists try to understand using game theory. So, too, are corporate takeovers, auctions, 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

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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 conﬁdence 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 partners. 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 tremendous 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 carefully commit to speciﬁc strategies while developing adaptive capabilities

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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 environment 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, resulting 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 Mitsubishi 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 dramatic 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 environment 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

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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 competitive 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 rational 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 corporations for guiding real-world strategic investment decisions.

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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 interactions and challenges traditional thinking that presumes that ﬁrms pursue strategies in isolation. Game theory is for the most part deterministic. Option games help management better intuit how uncertainty can be modeled in a strategic setting. This approach helps improve prediction and understanding of industry dynamics in highly uncertain industries. It enhances previous industrial organization literature on strategic investment in a deterministic setting to better explain the strategic investment behavior of ﬁrms under changing conditions. Box 1.2 provides 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 dominance 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 appealing 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

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Box 1.2 (continued)

year fell short of Airbus’s 1,055. But Boeing’s orders included more widebody 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 analysts 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 carbonﬁber composite material in place of aluminum for about half of each plane. If it works, Boeing could vault back in front of Airbus, perhaps decisively. 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 different 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 Boeing’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 investment 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

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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.”

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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 industry’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.

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. This is the reason why a large literature in strategic management relies on economic theory as it provides a reliable.3 The pursuit of one-size-ﬁts-all 2.2 What Is Strategy? Corporate strategy is high on the agenda of every major corporation. Although it is commonly agreed that strategy is critical in today’s changing corporate environment. We formulate a conceptual framework for strategic management and assess if it provides prescriptive insights into real-world managerial problems. 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. There are no easy “recipes for success” applicable to each ﬁrm in every industry. . A manager from Boeing discusses in box 1. focusing on the changes in corporate strategy of Boeing compared with Airbus.” 3. (3) objective appraisal of the ﬁrm’s internal resources and capabilities. agreed-upon. longterm objectives. (2002). an analysis of the strategic interplay vis-à-vis Airbus is highlighted. there is no universally agreed-upon deﬁnition of business strategy. Formulating the right strategy in the right place at the right time is not an easy task. Herein we take a different approach. rational discipline relying on rigorous market and competitive analysis. This is the “best-practices” approach. Good ﬁrm performance is considered the result of soundly formulated and well-implemented strategies. One can understand why ﬁrms succeed or fail by analyzing their decision processes in terms of consistent principles of market economics and rational strategic actions. (2) deep understanding of the competitive landscape. According to Chandler (1962).3 the use of real options to capture and assess the diverse sources of uncertainty in his business. adaptable solution programs. rigorous foundation to understanding speciﬁc developments and reactions taking place in the market place. There are two main approaches to strategy formulation. Our approach to strategy is based on the premise that strategic management is a structured.10 Chapter 1 have faced over the recent years. Grant (2005) identiﬁes the following elements as key to a successful strategy: (1) simple. It requires deep analysis and ready-to-implement. strategy is “the pattern or plan that integrates an organization’s goals. policies and action sequences into a cohesive whole. 1. strategy is “the determination of the basic long-term goals and objectives of an enterprise and the adoption of courses of action and the allocation of resources necessary for carrying out these goals. and (4) effective implementation.” According to Mintzberg et al.

physical or contractual? Boeing projects have many sources of uncertainty. including possible actions of our competitors. Since the uncertainty landscape is in constant evolution. What are the sources of uncertainty you face at Boeing. Of special signiﬁcance are the scenarios that we build around the real options analyses that help us understand both the risks and the opportunities of any venture. of variables modeled using various Monte Carlo and discrete event simulation capabilities. even hundreds. real options analysis has been used mostly on large-scale projects.3 Interview with Scott Matthews. these large projects pose particular risks that require more careful analyses including the use of real options techniques. We build models that attempt to integrate technology development. We then apply a series of targeted investments to investigate and better understand the true scale of these uncertainties. Boeing 1. due to both our risk mitigation efforts as well as exogenous events. Usually there are just a handful of principal uncertainty drivers which are determined using sensitivity analysis. Because of the higher investment amounts. and how do you manage them with options. manufacture. These are . 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. These models have dozens. design. we continue to update the model and modify our investments as appropriate. and market forces. 2. To date.The Strategy Challenge 11 Box 1. supply chain.

for example. 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. 569). As suggested by Dixit and Pindyck (1994). Ghemawat (1991) criticizes the success factors approach and identiﬁes commitment as a main driver of corporate success or failure. When we are successful. the origin of which could be traced back to strategic gaming scenarios and market timing.” The increasing cone of market and strategic (competitive) uncertainty makes the dynamic formulation of strategy key to survival and success in a changing marketplace. A successful strategy should exhibit consistent but adaptive behavior over time and involve certain strategic commitments that might sometimes hinder managerial ﬂexibility. A ﬁrm should not always invest or commit immediately.3 (continued) often modeled as real option investments with a type of varying volatility. At a certain point market considerations dominate and provide a better approach to modeling the scenarios. we ﬁnd our competitive response limited by timing or technology and product availability considerations. resolving the investment or commitment timing issue is critical to a ﬁrm’s success. Box 1. However. and therefore take on the characteristics of well-placed option investments.12 Chapter 1 Box 1. in an uncertain environment. investment situations where decisions are costly or impossible to reverse compel corporate managers to be cautious and careful to make decisions at the right time. Following Rumelt (1984. We have managed to execute a few plays against our competitors. p. as we are attempting to both reduce uncertainty while at the same time increase the value of the subsequent project stage.4 . Strategy should also be dynamic in that it should be adaptable to changing market circumstances or competitive dynamics. Do you see a usefulness for game theory and option games in Boeing’s strategic thinking. 3. 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. He sees commitment as a well-thought-out plan of action affecting the ﬁrm in the long term. but should be prepared to decide at the right moment to reap the beneﬁts of a developing opportunity. This feature of strategy implies that. these plays are often highly leveraged. success factors has failed to provide a coherent direction to guide the actions and decisions of ﬁrms. like other companies in dynamic markets.

companies need to position themselves to capitalize on opportunities as they emerge. if the market for the products the plant produces should decline. Instead of making a decision based on a rigid ﬁnancial analysis of a given project as a whole. but not the obligation. managers can analyze. At that point managers have the option to scale down or abandon operations. Wall Street Journal In turbulent times adaptability is critical. the ﬁnancial implications of each step along the way and every potential variation—without committing to anything . for instance. But many widely applied tools of strategy development were designed for relatively stable environments.4 Flexible strategy and real options Stay Loose: By Breaking Decisions into Stages. Markets. As a mind-set this approach encourages managers to be ﬂexible in their planning. to buy or sell shares at a given price at some time in the future. Start Small Instead of making rock-hard plans and irreversible long-term commitments. Just as stock options. In more concrete terms it allows them to value investment decisions and business initiatives in a new way. from the start. On the other hand. When building a new plant. it may be tempting to realize the full economies of scale by building the biggest facility the company can manage. for example. 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. That way. To succeed in this environment. while limiting the damage if adversity hits. Executives Can Build Flexibility into Their Plans Lenos Trigeorgis. and competition are becoming more dynamic by the day. This requires a whole new level of ﬂexibility. That is the essence of what is known as “real options” analysis. 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. Rainer Brosch. technologies. and Han Smit. if things turn out well. they have the option to expand the plant. the idea is to create ﬂexibility by breaking decisions down into stages. to pursue certain business initiatives. an approach that borrows from the workings of the ﬁnancial markets. real options give executives the right. Good managers have always been able to think on their feet. a smaller investment has been put at risk. but not the obligation.The Strategy Challenge 13 Box 1. That’s why today ﬂexibility is more valuable than ever in business strategy. But it may be wiser to ﬁrst build a smaller plant that can be easily expanded later on. give the holder the right.

with its promise of cost savings and increased proﬁts. production would be based entirely in one country. Publication date: September 15. including the value of the options that would be lost or gained depending on what competitive course is chosen. Reprinted with permission of The Wall Street Journal. Under the other. for example. the company would set up plants around the world. . What does this look like in practice? A leading European automaker was considering two investment alternatives for the production of a new vehicle. Many managers already incorporate game theory into their planning to help predict how competition will play out. Those who manage that portfolio most effectively will be in the best position to realize their company’s growth potential. But with competition emerging and evolving more rapidly than ever.14 Chapter 1 Box 1. Copyright © 2007 Dow Jones & Company. hold back. Consider. Competitive Edge Real options analysis can also be useful in helping strategic planners address the challenges of competition. Inc. Once the project is under way. 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. exceeded the difference in cost between the two alternatives. they also can account for the changing value of each option as events unfold. or retreat at each stage. The cost of the ﬂexible system would be higher. Under one alternative. supplementing game theory with real options analysis can help companies be more ﬂexible in how they react. What this all adds up to is a portfolio of corporate real options. All that information gives them a clearer framework for decisions on whether to launch a project and whether to proceed. This is a question of growing relevance as sometimes competing technologies are at the heart of more products. allowing it to switch production from site to site to take advantage of ﬂuctuations in exchange rates or labor costs. So it chose the multinational plan. each with a value that will change along with the company’s developing markets. 2007. In deciding whether to ﬁght or cooperate. companies can use real options analysis to better quantify the value of each contingency. But the company decided that the value of that ﬂexibility.4 (continued) before they must.

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discusses the need for strategic plans to be ﬂexible and adaptable in a changing environment. Since strategic decisions have long-term consequences, 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 generally 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 allocate 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 management. 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

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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 cashﬂow (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 estimates 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 economic 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 inferior 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 corporate 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 investments 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 t t E [Ct ]. Let V ≡ ∑T=0 E [Rt ] (1 + k ) and I ≡ ∑T=0 E [Ct ] (1 + k ) denote the present value t t of the stream of cash inﬂows and outﬂows, respectively. k denotes the appropriate riskadjusted 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.

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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 decisions 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 enhancing 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 prevailing 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 deviations 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 estimation of a risk-adjusted discount rate, a forecast of expected cash ﬂows, and an assessment of potential side effects (e.g., erosion or synergies 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.

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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 position themselves to capitalize on opportunities as they emerge while limiting the damage arising from adverse circumstances. If market developments deviate signiﬁcantly from the expected future scenario, managers 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 prescriptions 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 approximation 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 consideration 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 Appropriate Valuation of bonds, preferred stocks, and ﬁxed-income securities Valuation of relatively safe stocks paying regular dividends Valuation of companies with signiﬁcant growth opportunities Valuation of call and put options Source: Myers (1984, p. 135). Corporate real assets Valuation of ﬂows from ﬁnancial leases Valuation of “cash cows” Valuation of projects with substantial growth opportunities Valuation of R&D projects

Inappropriate

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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 agreedupon course of action. In real life this hardly holds. Managers have valuable ﬂexibility and can adapt to the actual market developments once uncertainty gets resolved. They may, for example, abandon a onceundertaken 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 constant 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 determination 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 riskadjusted, which allows the use of the risk-free discount rate. Real options

11. Several corporate-ﬁnance textbooks subsume DTA into real options analysis. We disagree. 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.

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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 capitalinvestment decisions—whether it’s launching a new automobile, or building a chip-fabrication plant, or installing an ERP system, or making any number of other very pricey investments—hurl companies toward uncertain 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

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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 opportunity 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 investment’s prospects. When the outcome of an investment is least certain, real options analysis has the highest value. As time goes by and prospects 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 numerical 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,

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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 favorable 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 consultancy 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

The Strategy Challenge

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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 decisions 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.

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Chapter 1

Over the last half century game theory has developed into a rigorous framework for assessing strategic alternatives.13 It helps managers formulate the right strategies and make the right decisions under competition. 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 (monopoly), 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.

are ranked and different scenarios developed. that could lead to a million outcomes. Yahoo’s trepidation became clear from the outset.” comments Tom Mitchell.) For its Yahoo bid. CEO of Open Options.6 (continued) dilemma. a Chevron decision analyst. a consultancy. began to catch on. “If you have four or ﬁve players. product and marketing director of Microsoft’s Canadian online division. Open Options uses algorithms to model what action a company should take—considering the likely actions of others—to attain its goals. Koch has publicly discussed Chevron’s use of game theory to predict how foreign governments and competitors will react when the company embarks on international projects. “It reveals the win-win and gives you the ability to more easily play out where things might lead. Many companies are reluctant to talk about the speciﬁcs of how they use game theory. MSN. with four actions each might or might not take. (Consultants note that companies often bone up on game theory when they ﬁnd out that competitors are already using it. “And that’s a simple situation. But oil giant Chevron makes no bones about it. Open Options wouldn’t disclose speciﬁcs of its work for Microsoft.” where the fate of two detainees depends on whether each snitches or stays silent about an alleged crime. And indeed they weren’t. or even to admit whether they use it at all. to model the merger and plot a possible course for the transaction. the open-source computer operating system. The exercise is intended to show that there are more outcomes to a situation than most minds can comprehend.” says Ken Headrick. “We knew that they would not be particularly interested in the acquisition. The result replicates the so-called Nash . but in client workshops it asks attendees to answer detailed questions about their goals for a project—for example. and to get managers thinking about competition and customers differently. “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.” says Frank Koch. The goals of all players are given numerical values and charted on a matrix. 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 competitors—including Microsoft—when Linux.” To simplify complex playing ﬁelds.The Strategy Challenge 25 Box 1.” he says. such as competitors and government regulators. the bid ultimately failed and a subsequent partial acquisition offer was abandoned in June. Microsoft hired Open Options. “Game theory is our secret strategic weapon.

But as research in behavioral ﬁnance and economics has shown. In effect this boils game theory down to the schoolyard lesson that perfection comes through repetition. common psychological biases can easily produce irrational decisions. And when they learn of new threats. Practice in fact may be key. In this optimal state.” says Mitchell. Game theory is one way that companies can assess their options with more discipline. and its ultimate usefulness may depend on how quickly it moves from novelty to accepted practice. relying passively on sources such as the news and annual reports. .” as basketball coach Pat Riley once said. 2008. the theory goes. particularly when decisions require both economic and strategic considerations.cfo. they tend to react in the most obvious way.26 Chapter 1 Box 1. “CFOs welcome this because it takes into account ﬁnancial inputs and blends them with nonﬁnancial inputs. As a tool. Moreover ﬁnance executives have their own sets of metrics. “Discipline is not a dirty word.6 (continued) equilibrium. a consultant at McKinsey. game theory can be useful in many areas of ﬁnance. They say the theory is at odds with human nature because it assumes that all participants in a game will behave rationally. Publication date: July 15. a player no longer has an incentive to change his position. “Game theory assumes rationally maximizing competitors who understand everything that you’re doing and what they can do. the Nobel Prize winning mathematician portrayed in the movie A Beautiful Mind. choices become more complicated. Reprinted with permission from CFO Magazine. however. and when favored indicators such as net present value clash with game theory models. Rational to a Fault? Some experts. focusing on near-term metrics such as earnings and market share. McKinsey takes that to heart with its “war game” scenarios. Similarly John Horn. “Sometimes [game theory] tells you things you don’t like.” says Horn. website www.” says Koch. argues that game theory gives people too much credit. question game theory’s usefulness in the real world. “That’s not how people actually behave.) McKinsey’s latest survey on competitive behavior found that companies tend to neglect upcoming moves by competitors. ﬁrst proposed by John Forbes Nash. Game theory is still ﬁnding its place as a tool for companies. in which a company’s top managers play the roles of different parties in a simulation.” (Activist investor Carl Icahn said Yahoo’s board “acted irrationally” in rejecting Microsoft’s bid.com © CFO Publishing LLC.

and biology. so excessive mathematical rigor may limit the 14. One of the underlying premises of standard game theory is the presumed rationality of economic agents. including political science. 15. 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.8. To perform strategic analysis. Nash’s work.” namely (1) identifying the players. 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. provided a broad mathematical basis for the study of equilibria in strategic conﬂict situations (Nash 1950a.15 From a speciﬁed game structure. conducting such an analysis involves a clear depiction of the “rules of the game. etc. More critical advancements were made in the early 1950s when John F. suppliers. . but the metaphorical interpretation is generally accepted as more appropriate. 16. Nash Jr. the focus of game theory was mostly on zero-sum games. one may derive useful predictions on how rivals are likely to react (equilibrium strategies) in a given environment. 1951). Game theory has revolutionized microeconomics and given a strong analytical basis for studying real market structures. Box 1.). and (5) specifying the order or sequence of the play. Deﬁning rationality and optimality in a given strategic setting is one of the core objectives of game theory. (3) specifying the information structure of the game.The Strategy Challenge 27 strategies in a multiple-player setup came with The Theory of Games and Economic Behavior by John von Neumann and Oskar Morgenstern (1944). b. it also brought appealing insights into strategic management. Nash equilibrium makes behavioral assumptions beyond common knowledge of rationality.7 provides an overview of the basics of game theory by Avinash Dixit. As discussed later. As ﬁrm competitiveness involves interactions among many players (ﬁrms. one needs to reduce a complex multiplayer problem into a simpler analytical structure that captures the essence of the conﬂict situation. buyers. (4) determining the payoff values attached to each possible strategy choice. military strategy. sociology. law. Nash’s (1950b) equilibrium concept applies to a large set of problems beyond zero-sum games.14 More recently game theory has been applied in many ﬁelds. psychology. Before John F. An interview with Professor Dixit concerning the interconnection between real options and game theory and his pedagogical approach is given in box 1. This has an impact on the choice of the game-theoretic solution concept. (2) describing their available alternative choices. international relations. Myerson (1999) provides a comprehensive analysis of how the Nash equilibrium concept shaped economic theory.16 This assumption is not always consistent with real-world behavioral phenomena.

wouldn’t I?” Every general reader has heard of the prisoner’s dilemma. allied victory in World War II is a forgone conclusion. “Then I’d certainly be a dammed fool to feel any other way. and suggest to each that he or she should ﬁnk on the other and turn state’s evidence. Dixit. The Nash Equilibrium The theory constructs a notion of “equilibrium” to which the complex chain of thinking about thinking could converge. where the outcome for each participant or “player” depends on the actions of all. Sherrerd ’52 University Professor of Economics. If you are a player in such a game. His commanding ofﬁcer points out. Princeton University Game theory studies interactive decision-making.7 Overview of game theory basics Avinash K. The police interrogate two suspects separately. and in turn trying to take into account your thinking about their thinking. It would seem that such thinking about thinking must be so complex and subtle that its successful practice must remain an arcane art. The Prisoner’s Dilemma In Joseph Heller’s novel Catch-22. Here are a few examples to convey some ideas of game theory and the breadth of its scope. John J. as in some . For such a theory to be useful. when choosing your course of action or “strategy” you must take into account the choices of others. the court will treat you especially harshly. it is better for you to ﬁnk than not to ﬁnk—ﬁnking is your uniformly best or ‘dominant’ strategy. This paved the way for applications. 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. and so on. Biologists have even used the notion of Nash equilibrium to formulate the idea of evolutionary stability. you must recognize that they are thinking about yours. Indeed some aspects such as ﬁguring out the true motives of rivals and recognizing complex patterns do often resist logical analysis.” This is the case whether the two are actually guilty. “But suppose everyone on our side felt that way?” Yossarian replies. But many aspects of strategy can be studied and systematized into a science—game theory. But in thinking about their choices. “If the other does not ﬁnk. Nash used novel mathematical techniques to prove the existence of equilibrium in a very general class of games. the equilibrium it posits should exist. and Yossarian does not want to be among the last ones to die. K. Thus no matter what the other does. then you can cut a good deal for yourself by giving evidence against the other: if the other ﬁnks and you hold out.28 Chapter 1 Box 1.

then the prospect of future cooperation may keep them from ﬁnking. In such situations it is essential to mix one’s moves randomly so that on any one occasion the action is unpredictable. which was conducted at the Rand Corporation in 1950. though jointly desirable for them.The Strategy Challenge 29 Box 1. John Nash played an important role in interpreting the ﬁrst experimental study of the prisoner’s dilemma. So avoiding death is his dominant strategy. (But in this instance consumers beneﬁt from the lower prices when sellers ﬁnk on each other. and he is personally better off alive than dead. this is the well-known tit-for-tat strategy. But an occasional long pass in such a situation is important to keep the defense honest. His death is not going to make any signiﬁcant difference to the prospects of victory.A. How might such dilemmas be resolved? If the relationship of the player is repeated over a long time horizon. or a server in tennis who goes exclusively to the receiver’s forehand. Of course. will fare poorly because the opponent will anticipate and counter the action. Finally. A “large” player who suffers disproportionately more from complete ﬁnking may act cooperatively even when the small is ﬁnking. 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.7 (continued) episodes of NYPD Blue. and the United States bears a disproportionate share of the costs of its military alliances. as in the ﬁrm L. Conﬁdential. Real-World Dilemmas Once you recognize the general idea. when an offense faces a third down with a yard to go. when both ﬁnk. . if the group as a whole will do better in its external relations if it enjoys internal cooperation. collapses in the face of their separate temptations to ﬁnk. Mixing Moves In football. they both fare worse than they would have if both had held out. or innocent. 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. but that outcome. Thus Saudi Arabia acts as a swing producer in OPEC. or to get people to volunteer enough time for worthwhile public causes.) The same concept explains why it is difﬁcult to raise voluntary contributions. a run up the middle is the usual or “percentage” play. Similarly a penalty kicker in soccer who kicks exclusively to the goalie’s right. Yossarian’s dilemma is just a multi-person version of this. cutting its output to keep prices high when others produce more. you will see such dilemmas everywhere. then the process of biological or social selection may generate instincts or social norms that support cooperation and punish cheating.

which. Committing yourself to a ﬁrm ﬁnal offer leaves the other party the last chance to avoid a mutually disastrous breakdown. and TV sets to create a new medium. Indeed recent empirical studies of serving in tennis grand slam ﬁnals. call phones. that is a credible signal of your own true valuation of your idea. as military strategist Karl von Clausewitz told us long ago. And a child is more likely to get the sweet or toy it wants if it is crying too loudly to hear your reasoned explanations of why it should not have it.30 Chapter 1 Box 1. are two sides of the same strategic coin. This is a game where the players have different information. Members of a labor union send their leaders into wagebargaining with ﬁrm instructions or mandates that tie their hands. 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. if you are willing to put enough of your money where your mouth is. You have no track record. Commitments Greater freedom of action seems obviously desirable. you know the true potential of your idea much better than does your prospective . and you might be a complete charlatan who will use the money to live high for a few years and then disappear. Devising actions to make one’s commitment credible is one of the ﬁner acts in the realm of strategic games. 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. thereby making it credible that they will not accept a lower offer. The proﬁt potential is immense. and this can get you a better deal. 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. have found the behavior consistent with the theory. Thomas Schelling pioneered the study of credible commitments. and other more complex “strategic moves” like threats and promises. 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. Anyone can talk a good game. You go to venture capitalists for ﬁnance to develop and market your idea. But a mere verbal declaration of ﬁrmness may not be credible.7 (continued) Mixing is most important in games where the players’ interests are strictly opposed. This has found many applications in diplomacy and war. 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. and penalty kicks in European soccer leagues. and this happens most frequently in sports.

studies of contract and tort law. we are just discovering how top management can manipulate and distort the performance measures to increase their own compensation while hurting shareholders and workers alike. for example. It is no bad thing if an idea seems obvious when it is properly formulated and explained. What game theory does is to unify and systemize such intuitions. And there remains the problem of who will watch over the upper-level management. In such games. actions that reveal or conceal information play crucial roles. Game theory and information economics have given us valuable insights into these issues. But all such monitoring is imperfect: the time on the job is easily monitored. and has proved equally useful in political science. 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. we do not have perfect solutions. . testiﬁes to its importance. The award of the Nobel Memorial Prize in 2001 to its pioneers. and even biology. and the calculation of good strategies for new games is simpliﬁed. From Intuition to Prediction While reading these examples. If you have had some experience of playing similar games. on the contrary. Avoiding Enrons A related application in business economics is the design of incentive schemes. Of course.The Strategy Challenge 31 Box 1. This is a game where shareholders and the government need to ﬁnd and use better counterstrategies. Then the general principles extend the intuitions across many related situations. Modern corporations are owned by numerous shareholders who do not personally supervise the operations of the companies. but the quality of effort is very difﬁcult to observe and judge. Hence the importance of compensation schemes that align the interests of the workers and managers with those of the shareholders. and managers to watch over supervisors. Aligning Interests. The ﬁeld of “information economics” has clariﬁed many previously puzzling features of corporate governance and industrial organization. you have probably intuited good strategies for them.7 (continued) ﬁnancier. What has enabled information economics to burgeon in the last twenty years is the parallel development of concepts and techniques in game theory. you probably thought that many of the lessons of game theory are obvious. and Joseph Stiglitz. George Akerlof. Michael Spence. a science or theory that takes simple ideas and brings out their full power and scope is all the more valuable for that.

In your teaching of game theory at Princeton you rely a lot on stories. Undergraduates have richer and more varied lives. 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. games. 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. sports. or more generally. 3. literature. 2. Economists are becoming aware of aspects of human behavior . games. You have helped establish and popularize both real options and game theory as separate disciplines.8 Interview with Avinash K. literature. whereas an irreversible commitment has value in many situations of strategic competition. Analyzing the two together enables us to understand when one prevails over the other. therefore examples from sports.32 Chapter 1 Box 1. movies. Can you elaborate on your view or approach? Undergraduate students are rightly skeptical of abstract theory. and other engaging tools to motivate your students. But MBA students are narrowly focused on business and moneymaking. This is clearly an important research program. and movies appeal to them. Dixit 1. Using examples to bring out theoretical concepts is similar to the case method used in most business schools. the trade-off between the two. How do you see the interconnection or interplay among the two? The real options concept emphasizes the value of ﬂexibility.

Cournot and Bertrand duopoly models discussed in chapter 3 form the basis for many industrial organization setups which are often much more complex. sociologists. Useful insights into an issue or behavior of practical relevance can be then deduced. the beneﬁts of specialization remain. This discussion follows Saloner (1991. when game theory is applied in more complex situations. Second.8 (continued) that differ from selﬁsh rationality assumed in most traditional economic theory. See Grant (2005. 120–25. 127). 19. 111).17 One objective of microeconomic modeling is to simulate qualitatively the type of environment being studied. Game theory can generally be used to deduce principles and insights from simpliﬁed models of reality. I don’t expect complete reintegration of ﬁelds that separated more than a century ago. A metaphorical interpretation of game-theoretic models can nonetheless hold signiﬁcant value. I ﬁnd this conﬂuence of the social sciences interesting and exciting. it provides an audit track that enables researchers and practitioners to go back to basic premises. applicability of game theory in certain real-world situations. Management should formulate the basic assumptions explicitly and consider whether they are of practical relevance. it helps bring discipline by enforcing a common language that enables researchers and managers to compare results and reﬁne earlier models. . In such cases complex modeling may lose its predictive ability. 20. p. For instance. it offers a methodology that is conducive to rigorous analysis and can help derive novel insights. pp. Some microeconomic models are quite tractable for studying new problems.18 First.19 Finally. But I do expect much closer communication and collaboration that will beneﬁt research in all these ﬁelds. which might be counterintuitive in some cases.20 In view of such potential extensions. game theory holds out considerable promise for 17.The Strategy Challenge 33 Box 1. political scientists. 18. A simple game-theoretic framework has several advantages for strategic management. Such insights may hardly stem from a “boxes-and-arrows” conceptual framework. A game-theoretic reﬁnement of Porter’s (1980) framework is offered by Brandenburg and Nalebuff (1996). Saloner (1991) includes Porter’s (1980) ﬁve-forces framework among these conceptual frameworks for strategic management. Simpler models are generally more prescriptive. and even psychologists and anthropologists are learning the value of economists’ conceptual framework of choice and equilibrium and of the issues of endogeneity and identiﬁcation in empirical work. Oftentimes. the commitment theory addressed in chapter 4 can be understood in light of these two pillar models. it results in no outcome or in multiple equilibria.

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. .and second-mover advantages. rent-seeking theory. 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. strategic commitment. some managers already incorporate game-theoretic thinking into their planning.. its use for practical strategic management purposes has remained limited so far. 22. See Saloner (1991.25 Although game theory has witnessed rapid developments since the 1950s.23 organizational design to achieve competitive advantage. cooperation versus competition in R&D. Ferschtman and Judd (1987). 23. and contract theory. • • Organization theory This ﬁeld focuses on the ﬁrm’s internal or organizational aspects such as vertical and horizontal scope and conﬂicting incentives inside an organization (e.g. ﬁrst. pp. for example. D’Apremont and Jacquemin (1988) analyze the effect of R&D spillovers on the incentive to cooperate or compete during the R&D stage and the market competition stage. A normative role for the strategic management literature is to provide a broad qualitative understanding of such strategic interactions and give qualitative prescriptions for managerial action. They include property-rights theory. reputation. game theory has been used to analyze the 1962 Cuban missile crisis. 21. Theories of the ﬁrm attempt to explain why ﬁrms exist and operate as they do. 107–31). adaptation theory. optimal compensation schemes). President Reagan’s 1982 tax cut. ﬁrm entry and exit decisions. a ﬁrm has an incentive to design incentive schemes in a way that would not be optimal for a stand-alone organization. In politics.26 Nevertheless. This exempliﬁes the possible use of industrial organization thinking to better the understanding of ﬁrms’ organizational design. This discussion follows Saloner (1991. managers have an incentive to maximize output in a quantity competition setting. pp. which makes the ﬁrm better off since the rival interprets the incentive contract as a commitment. argue that in case of product market competition.34 Chapter 1 studying human interactions. 24.22 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. and certain public auctions. 26. 119–20). incentive-system theory. 25. In their model. signaling and information asymmetries among different players in an industry. This explains the success of game theory particularly in economics and strategic management. addressing issues such as competitive interactions in oligopolies.

As discussed by Jean Tirole in box 1. For instance. Rivals’ investment decisions have no material impact on project values or optimal strategies. These models represent an improvement over standard models developed with a monopolistic mind-set. 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.4 An Integrative Approach to Strategy Both corporate ﬁnance and game theory provide useful insights for strategic management. it must determine whether the beneﬁts resulting from the exercise of its options are fully appropriable. . In capital markets. Trigeorgis (1991) discusses continuous-time real options models involving strategic uncertainty exogenously. 27.28 In this case. Standard or naïve real options analysis typically assumes a proprietary or monopolistic mind-set. 28. Viewed separately. Kester (1984) distinguishes two categories of real options depending on whether the beneﬁts are proprietary or shared. 29. a monopolist protected by signiﬁcant entry barriers faces such a situation. however. 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. strategic interactions among option holders rarely affect the asset or the option values. The value loss resulting from strategic interactions is seen as a competitive value erosion. disregarding interactive competition.9.or market-related issues.The Strategy Challenge 35 1. retaining all potential beneﬁts for itself. the interface between ﬁnance and game theory enables attaining a better understanding on a number of ﬁrm.29 A ﬁrm here formulates its investment decisions in isolation. it is a shared option. Certain continuous-time real option models attempt to account for market and competitive uncertainty in an exogenous manner. Standard real options analysis overcomes many of the drawbacks of the NPV approach but neglects other aspects. the investment opportunity is a proprietary option. or the opportunity to penetrate a newly deregulated market. ignoring such shared options. such as through a higher dividend yield or a jump process. If management has an exclusive exercise right. Shared options include the opportunity to launch a new product that is unprotected from the entry of close substitutes. One reason why strategic interactions among option holders are not typically considered 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. but fall short of adequately accounting for the endogenous nature of strategic interactions in an oligopolistic setting. except in special cases like valuation of warrants. these approaches have limited applicability.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. Integrating these approaches in a consistent manner is at the core of the option games approach. When management assesses its real options.

Experimental evidence conﬁrms the old notion that we “play games with ourselves. Game theory more and more integrates behavioral approaches. This rational choice approach has served social sciences well by identifying the key strategic features of conﬂict situations. include political sciences. but it is not. You have contributed greatly to extending game theory for the analysis of economic problems. Psychology might look like an outlier as it usually focuses on the individual. from ﬁrms to suborganisms. sociology.” These can be represented as games among successive incarnations of the self. Computer scientists also take a keen interest in game theory. inefﬁcient signals. The most obvious applications. game theory applies to all social sciences and beyond. Part of the appeal of game theory is that it accommodates diverse objective functions. law. 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. besides economics. or ﬁghts. which enables us to conceptualize the behavior of different actors. from consumers to politicians. Mainstream game theory focuses on optimal strategies given the strategic interdependences and the actors’ limited information and various constraints. Biologists use game theory to understand mutualism between species.9 Interview with Jean Tirole 1. and psychology.36 Chapter 1 Box 1. 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 objectives. At the same time. limited cognition and various . As such.

g.The Strategy Challenge 37 Box 1. the industrial organization of ﬁnance and banking is a hot topic on our research agenda. Many areas of corporate ﬁnance have beneﬁted signiﬁcantly from importing ideas coming from game theory. extending the reach of game theory beyond purely rational choice. liquidity hoarding. game theory).9 (continued) behavioral biases are being increasingly incorporated into our thinking about strategic interactions. as this is an area of very fruitful cross-fertilization. 2. Empirical work on estimating demand and strategic choices of price and non–price competition also make substantial use of game-theoretic industrial organization. economics of incentives. Finally. Game theory has already made its way into various subﬁelds of corporate ﬁnance: takeover strategies. bank runs. For example. I am really happy that your book “cross-breeds” options theory and industrial organization and connects it to business.. Your work on industrial organization has helped popularize this important discipline and extend its areas of application. 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. expectations of reﬁnancing and bailouts. Game-theoretic analyses have become a language for antitrust practitioners to conceptualize impacts of behaviors on market outcomes. Do you think industrial organization will become increasingly more useful for managerial practice and understanding or predicting of market developments? Yes. . Conversely. it is hard to fully understand predation or entry into industries without understanding ﬁnancial constraints and therefore corporate ﬁnance. For example. Game theory is taught to MBAs and strategy textbooks now incorporate game-theoretic thinking. and conglomerate strategies are just a few examples. 3. Game theory and its applications to industrial organization have made their way into business books and have affected managerial practice. Not only do ﬁnance and industrial organization share common tools (e. they also interface in many areas. and empiricists use game theory to put more structure on their estimation strategies. experimental economists have been testing our equilibrium concepts and behavioral predictions. issues of securities under asymmetric information. concepts developed in industrial organization are used in deliberations on how to design new platforms and get all sides on board.

Bayesian and perfect Bayesian equilibrium) are designed to address problems involving information uncertainty. where players could accurately predict the evolution of the external environment. and game theory alone fail in providing the necessary tool kit.. Standard game theory falls short of explaining the ﬁrm’s incentive to stay ﬂexible to react to unexpected developments. some solution concepts (e. payoffs may be affected by exogenous factors or shocks. Under uncertainty this prescription of standard game theory is inadequate. real options analysis. ignores (endogenous) competitive interactions Typically disregards market uncertainty involving stochastic variables Real options Incorporates market uncertainty and managerial ﬂexibility. convincing logic. staged. ignores ﬂexibility to adapt to unexpected market developments or strategic interactions Typically applied to the valuation of a monopolist or proprietary option.2 Comparison of main advantages and drawbacks of standard stand-alone approaches Approach Standard NPV Advantages Easy to use. widely used. however.30 The main advantages and drawbacks of each stand-alone approach (standard NPV. For instance. or adjusted under certain future contingencies Incorporates competitive reactions endogenously. often treating investment as a one-time decision (“invest now or never”). This form of uncertainty is not equivalent to what we consider here. The appendix of the book provides a discussion of such stochastic processes. Stand-alone NPV. The NPV paradigm deals with static situations where ﬁrms make now-or-never decisions or precommit to a certain plan of action. and game theory) are summarized in table 1. considers different player payoffs Game theory Game theory has been generally applied to studying strategic interactions in settings involving steady or deterministically changing states.g. require a simultaneous assessment of both market (exogenous) as well as competitive (endogenous) uncertainty. whose future values are not known with certainty but follow a known probability law. Many real-world problems. In stochastic environments. . Different forms of uncertainty are considered in game theory.2.38 Chapter 1 Table 1. recognizes that investment decisions can be delayed. easy to communicate Drawbacks Assumes precommitment to a given plan of action. Real options analysis allows for 30. standard real options analysis.

Static industrial organization rests on static game theory with the related notion of. This ﬁeld rests on dynamic game theory. Nash or Bayesian Nash equilibria.33 We here discuss an integrated approach employed to help overcome the shortcomings of stand-alone approaches. It involves the use of “dynamic” solution concepts such as subgame perfect Nash. Option games are meant to capture dynamic strategic interactions in stochastic environments.3 Classiﬁcation of decision situations and relevant theories Decision theory (no strategic interaction) Static Net present value (DCF) Chapter 1 Deterministic Resource extraction/ forest economics Chapter 9 Real options analysis Chapters 5.34 We indicate in which chapters each approach is most relevant in the book. perfect Bayesian. for example. Dixit (1993). analyzing key value drivers concurrently.31 Static industrial organization (IO) has limited applicability to situations involving simultaneous games where ﬁrms are ignorant of both past and future actions and payoffs. 34.32 Dynamic industrial organization analysis permits a long-term perspective but assumes steady state or a deterministic evolution of the market environment. . 33. See Dockner et al. Fudenberg and Tirole (1986) present a number of dynamic models of oligopoly. or sequential equilibrium. appendix Game theory (strategic interaction) Static industrial organization Chapter 3 Dynamic industrial organization Chapters 4. See Osborne (2004) for an introduction. 9. This method can be extended to stochastic environments.3 positions the option games approach within the traditional decision and game-theory paradigms. The importance of incorporating options analysis and game theory is conﬁrmed by the number of Nobel Prizes awarded in related ﬁelds. Table 1. (2000) for an introduction to differential games. 32. 11. 12 Option games Chapter 6 onward Dynamic Stochastic dynamic decision-making in situations where ﬁrms face exogenous stochastic uncertainty. A 31. with applications in economics and ﬁnance. Stochastic dynamic programming or stochastic control is discussed by Harrison (1985). and Stokey (2008).The Strategy Challenge 39 Table 1. A subﬁeld is differential games that study dynamic strategic interactions in settings where an industry state evolves according to a differential equation. Real options analysis provides many applications for dynamic programming. Option games share some aspects with stochastic timing and differential games. The term “dynamic programming” was originally used by Bellman (1957) to describe a recursive process for solving dynamic problems.

Harsanyi. Simon 1975 L. W. C. Harsanyi. Selten. M.4 Selected Nobel Prizes awarded in Economic Sciences Year 2007 Nobel Prize winner(s) L. It builds on the seminal works of Paul Samuelson. M. Sharpe G. F. J.40 Chapter 1 Table 1. functioning of markets. Stiglitz R. S. Robert C. S. J. expenditure decisions. Aumann. Myerson R. R. Concurrently the analysis of industrial organization has been greatly facilitated by developments in game theory. Fischer Black. E. Schelling.. T. Von Neumann. T. and Nash have made signiﬁcant early contributions to game theory. A. and prices For his research into the decisionmaking process within economic organizations For their contributions to the theory of optimum allocation of resources For developing dynamic economic theory and raising the rigor of analysis in economics 2005 2001 1997 G. production. J. Samuelson Source: Nobel Prize committee website. Merton.4. Real options analysis is a natural extension of major breakthrough developments in ﬁnancial economics to real investments. Stigler 1990 1982 1981 J. selected list of Nobel Prize awards in economic sciences is shown in table 1. Spence. Nash Jr. R. Morgenstern. Akerlof. Scholes 1994 J. B. A. J. V. and Aumann also earned Nobel . F. Schelling Noted contribution For laying the foundations of mechanism design and contract theory For enhancing our understanding of conﬂict and cooperation through game theory analysis For analyzing markets with asymmetric information For developing the option pricing method to value derivatives (and thereby real options) For their analysis of equilibria in the theory of noncooperative games For their pioneering work in the theory of ﬁnancial economics For his studies of industrial structures. Miller. Hurwicz. A. M. Merton. H. and Myron Scholes. Tobin 1978 H. Maskin. C. Kantorovich. C. Markowitz. and causes and effects of public regulation For his analysis of ﬁnancial markets. Koopmans 1970 P. M. employment. A. E. C. Selten H.

. and Options. Stiglitz. Chapters 3 and 4 on “Market Structure Games” introduce game theory principles and industrial organization concepts providing economic foundations for strategic management. Chapter 3. demand volatility. Motivated by various sources of uncertainty electricity utilities face today. attempting in the long term to shape the market in their own advantage or collaborating with rivals for mutual beneﬁt. “Strategy. Chapter 5 on “Uncertainty.The Strategy Challenge 41 Prizes for reﬁnements to the theory.. We describe industry and competitive analysis and discuss how to create sustainable competitive advantage in an industry utilizing generic competitive strategies.” reviews the main strategic management paradigms used to analyze or explain a ﬁrm’s performance in creating value for shareholders.. Games.” supplements the previous analysis by allowing ﬁrms to interact in the marketplace over many periods. being at the intersection of option and game theories. It enables a more complete quantiﬁcation of market opportunities while assessing the sensitivity of strategic decisions to exogenous variables (e.g. beneﬁted from the cumulative developments in these subﬁelds of economic sciences. Flexibility. Maskin. We also brieﬂy discuss discrete-time and continuous-time tools for the pricing of embedded real options. costs) and competitive interactions. as discussed by Ferreira. Chapter 2. “Strategic Management and Competitive Advantage. Today option games represent a powerful strategic management tool that can guide practical managerial decisions in a competitive context. contract theory). and Real Options” discusses the strategyformulation challenges facing the ﬁrm when the underlying market is uncertain. Spence. we discuss how real options analysis can be used to analyze such situations. and optimally chose among them. Part I. industrial organization.” discusses benchmark cases where ﬁrms interact in one-time situations.35 Option games. Hurwicz.” presents the three building blocks or prerequisite ﬁelds for the option games approach.g. We ignore here the fact 35. Kar. value strategic options. Akerlof. and Trigeorgis (2009). Chapter 4. Quantity and price competition are discussed in detail. 1.5 Overview and Organization of the Book The book is organized in three parts. and Myerson won the Nobel Prize for insightful applications of game theory for the understanding of incentives in social groups (e. focusing on “Static Approaches. focusing on “Dynamic Approaches.

is on two-stage competition models where real options analysis tools are combined with industry organization insights. Chapter 13. Chapter 8. “Innovation Investment in Two-Stage Games. The focus. here. Chapter 10. Chapter 6 presents core issues in option games analysis. “Preemption versus Cooperation in a Duopoly. “Option to Invest. .” introduces the methodology employed throughout part III and sets the benchmark case of a monopolist ﬁrm. We provide a number of examples to illustrate the discrete-time option games approach. Chapter 7.” provides a short overview of important contributions on various subjects and other applications discussed in the literature. Chapter 11. “Option Games: Discrete-Time Analysis. such as R&D and advertising. namely optimal investment timing under uncertainty and competition and the trade-off between commitment and ﬂexibility. “Investment and Expansion Option: Monopoly. building upon models developed in chapter 3. We examine appropriate investment strategy applications in different settings. Chapter 12. part III occasionally refers to this appendix when a derivation is more involved. delaying investment until a later date. Two categories of options are discussed. Chapter 9.” extends the analysis to simultaneous investment oligopoly markets. Part III. the option to invest in a new market and the option to expand an existing market. To smooth out the exposition in the text. “Oligopoly: Simultaneous Investment.” deals with preemptive investments and the possibility of tacit collusion among ﬁrms.” discusses at length the trade-off between commitment and ﬂexibility in sequential investment settings. “Extensions and Other Applications. The two-stage analysis provides guidance into how and when strategic investments enhance value creation or are detrimental to the ﬁrm.” rigorously sets the premise for analyzing option games in discrete time.” 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. Part II.42 Chapter 1 that many ﬁrms may face counteracting business opportunities affected by rival behavior. 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. entitled “Option Games: Continuous-Time Models.” extends the analysis of option games by use of continuous-time modeling techniques.” discusses the appeal of having a competitive advantage to turn the investment-timing game into one’s own advantage. “Leadership and Early-Mover Advantage.

Modeling. game theory. Eric. Grant. Finance theory and ﬁnancial strategy. Myers (1984) discusses the gap between ﬁnancial theory and its practical implementation in corporate strategy. 1991. Selected References Grant (2005) discusses the role of strategy in corporate performance. namely game theory and real options analysis. Games and Information: An Introduction to Game Theory. We discussed the development and changes in a challenging business environment and the evolution of strategy.The Strategy Challenge 43 Conclusion In this introductory chapter we discussed key changes ﬁrms have faced over the past decades. emphasizing its prescriptive value in competitive settings involving strategic interactions. Oxford: Blackwell. Myers. Contemporary Strategy Analysis. Malden. and strategic management. 5th ed. We concluded with the need to combine both into an integrative option games approach. Stewart C. 2005. Interfaces 14 (1): 126–37. Strategic Management Journal 12 (Winter): 119–36. Robert M. stressing the need for sound strategy formulation based on consistent principles. Rasmussen. 1984. Garth. can be rigorous and relevant for analyzing and understanding business strategies. MA: Blackwell. 2005. Saloner (1991) and Rasmussen (2005) discuss the usefulness of game theory for strategic management. highlighting the differential insights corporate ﬁnance can add to strategy. Saloner. . and examined to which extent the two pillar approaches underlying this book.

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GAMES. AND OPTIONS .I STRATEGY.

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2 Strategic Management and Competitive Advantage Managing an enterprise in an uncertain competitive environment is not an easy task. 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. Firms make tremendous efforts to sustain competitive advantage and protect their future growth options from duplication efforts by rivals. At the core of strategy is a dilemma between ﬂexibility and commitment. We discuss in section 2. An early investment commitment may yet have strategic value because it can inﬂuence the behavior of rivals in equilibrium. During the 1990s this view became a dominant paradigm in strategic management.2 several approaches used in practice that help provide a deeper understanding of a given industry. In section 2. We then examine. . In recent years competitive advantage has become rather temporary because industries and competition within industries change continually. 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. Flexibility to adapt strategy and operations is clearly valuable when the environment changes unexpectedly. potentially creating a future competitive advantage for the ﬁrm. Strategic management attempts to explain why some ﬁrms are more successful than others in the marketplace.1 we provide an overview of some of the prevailing strategic management concepts and theories.3. 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. the sources of competitive advantage and their sustainability as an industry evolves.

1 Strategic Management Paradigms Various paradigms in strategic management approach the underlying sources of ﬁrm value creation from distinct viewpoints. 2. resources. ﬁnance). ﬁrm-speciﬁc resources and capabilities that enable the ﬁrm to create and exploit advantaged opportunities. The latter focus on internal forces within the ﬁrm. Many of these managerial perspectives trace their roots to primary economic disciplines (microeconomics. synergies. or economies of scale.1 are the main strategic management approaches. continually shape the external environment. and threats in the external environment. The industry and competitive analysis framework popularized by Michael Porter (1980) views strategy in terms of industry structure. These perspectives consider competitive advantage as dependent on unique. entry deterrence. Categorized in ﬁgure 2. as well as product differentiation and availability of information. Behind many of them lies the notion that competitive advantage is a function of the ﬁrm’s position.48 Chapter 2 2. suppliers. resources. opportunities. the opportunities these resources and capabilities create in a dynamic environment.1 External View of the Firm Outside forces. Real options are created by internal adaptive capabilities developed over time but may be affected by the actions of external parties. and strategic positioning. Another external approach is that of strategic . The former consider competitive advantage and value creation through the eyes of an external observer. Real options and option games lie at their intersection and can bring together these complementary perspectives. He emphasizes actions the ﬁrm should take to protect itself from these market forces and threats. and capabilities compared to those of its rivals. Porter proposes to look at rivalry situations among suppliers of a product and analyze the impact of additional forces. and capabilities. and customers. and the bargaining power of suppliers and buyers. Key competitive variables include entry and exit barriers. such as the threat from substitute products and technology disruption. External approaches view the sources of value creation as lying in market imperfections. viewing value creation from in-house combinations of expertise. such as ﬁrm’s rivals. new market entry. and the ﬁrms’ adaptive capability to respond to market changes. focusing on external forces. organization theory. It is commonplace to distinguish between approaches with an external perspective from those with an internal ﬁrm view.1.

. Pisano.Broad field Organization theory Financial economics Microeconomic theory Economic theory Agency theory Property rights Transaction costs Structure conduct performance Game theory/ industrial organization Option pricing Strategic management Resourcebased view Industry and competitive analysis Strategic conﬂict Dynamic capabilities/ core competencies Real options Option games Strategic Management and Competitive Advantage Representative authors Porter (1980) Schelling (1960) Shapiro (1989) Ghemawat (1991) Dixit and Nalebuff (1991) Rumelt (1984) Wernerfelt (1984) Collins and Montgomery (1995) Prahalad and Hamel (1990) Teece.1 Strategic management frameworks Rows 2 and 3 are related: economic theory (row 2) supports notions developed in strategic management (row 3) via formal models. and Shuen (1997) Dixit and Pindyck (1994) Trigeorgis (1996) Grenadier (2000) Huisman (2001) Smit and Trigeorgis (2004) External view of the ﬁrm Internal view of the ﬁrm 49 Figure 2.

Box 2. but rather because it manages to achieve signiﬁcantly lower costs or obtain markedly higher quality or product performance through internal mechanisms. predict rivals’ reactions. 172). The theory of “dynamic capabilities” proposed by Teece. 2. Teece (1984). A ﬁrm becomes proﬁtable not so much because it undertakes strategic investments that may deter entry or raise prices above long-run cost. Rumelt (1984).2 Industry and Competitive Analysis A key objective of strategic management is to help decision makers understand what leads to a ﬁrm’s success. and others by enhancing operational efﬁciency via process innovation? 1.1 Its distinguishing characteristic is that competitive advantage arises from within the ﬁrm. and capabilities. . Pisano. This approach became known subsequently as the resource-based view of the ﬁrm in articles by Wernerfelt (1984). Game theory ideas are used to help management understand better the strategic interactions among rivals.1 discusses the concept and process of strategy and their evolution in a changing and rapidly transformed competitive landscape. and Shuen (1997) views capabilities to adapt in a changing environment as resting on distinctive processes. According to Wernerfelt (1984). shaped by the ﬁrm’s asset position and the evolutionary path it has adopted or inherited. A more recent variant rests on corporate capabilities to adapt in environments of rapid technological change.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).50 Chapter 2 conﬂict (e. know-how.g. the resource-based view aims to understand the relationship between proﬁtability and the different ways of managing resources over time. and others. 2. Strategic management provides both explanation and direction. which focuses on conﬂict behavior and views value creation as the result of strategic moves in a competitive environment. Resources are “those tangible and intangible assets which are tied semi-permanently to the ﬁrm” (p. and determine the optimal competitive strategy.1. 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. Shapiro 1989). Excess economic proﬁts stem from imperfect markets for ﬁrmspeciﬁc intangible assets like distinctive competences..

. regulatory.. and semiconductors. companies will need to understand global forces. . 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. became the focus. this time lag—often a decade—brings with it an interesting conundrum. react quickly. social. The sources of competitive advantage. value chain analysis. political. during this decade. . . certainly for US and European companies. generic strategies. A major competitive disruption during this period. Where management concepts are concerned. However. reengineering. and threats (SWOT) analysis.Strategic Management and Competitive Advantage 51 Box 2. It is hardly surprising that the conceptual models and administrative processes used by managers often outlast their usefulness. was the spectacular success of Japanese manufacturing in industries as diverse as steel. after all.1 Strategy in a changing competitive environment Changes in the Competitive Battleﬁeld C. 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 . and technological environment do managers have to discard established and tested analytical tools equally as fast? How can they identify the ongoing relevance 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. and innovate when deﬁning their business models . accrued to those who could wrest major efﬁciencies in operations through focus on quality.. In an era of rapid and disruptive change in the economic. K. During this period. The concepts and tools—many of them the staples of economists—were adopted and simpliﬁed for the use of managers. Prahalad. . most of these concepts were developed during the late 1970s and the decade of the 1980s. cycle time.. and team work. . strategic group analysis. It takes researchers time. underlying competitive conditions evolved but within a well-understood paradigm. industry structure analysis (ﬁve forces). 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. autos. barriers to entry. consumer electronics. Operational efﬁciencies. . Then there is the time lag between the development of these theories and their conversion into common business practice. opportunities. within a relatively stable industry structure paradigm. While the canvas available to today’s strategists is large and new. to identify new problems and emerging solutions before they can produce theories about them. and others of the genre .

Are these discontinuities changing the very nature of the industry structure—the relationships between consumers.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. collaborators. and evolving games. Strategy in a Discontinuous Competitive Landscape Strategists must start with a new mind-set.. 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. utilities can now determine their own strategic space..52 Chapter 2 Box 2. for example. . competitors. Disruptive changes challenge the business models. Brazil. 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. 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. and ﬁnancial services are being deregulated. Large and key industries like telecoms. All utilities once looked alike and their scope of operations was constrained by public utility commissions and government regulators. the highly regulated power industry. The rules of engagement are written as companies and managers experiment and adjust their approaches to competition. Countries as diverse as India. and China are at various stages of privatizing their public sectors. components. computing. power. Technological convergence—such as that between chemical and electronic companies. food and pharmaceuticals. . Traditional strategic planning processes emphasized resource allocation—which plants. emerging. . and investors? Are they challenging the established competitive positions of incumbents and allowing new types of competitors and new bases for competition to emerge? We can identify a long list of discontinuities and examples to illustrate each one of them . and consumer electronics. what products. what locations. Ecological sensitivities and the emergence of nongovernmental organizations such as the green movement are also new dimensions of the competitive landscape. Today utilities have . and cosmetics and pharmaceuticals—is disrupting traditional industry structures . health care. and sometimes what businesses—within an implicit business model. Because of deregulation. Russia. communications. water. .

” a local cola (which Coke purchased) and promote that product.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. consider the traditional strategic planning process in a • .Strategic Management and Competitive Advantage 53 Box 2. forced to respond to the cleanliness and ambience of McDonald’s. product development. The canvas available to the strategist is large and new. McDonald’s and Coca-Cola—held up as examples of truly global players unconstrained by local customers and national differences. and the convergence of technologies provide untold new opportunities for strategists. One can paint the picture one wants. multiple cultures. globalization will force strategists to come to terms with multiple geographical locations. Globalization may have as much to do with standards—quality. or just remain local? And ﬁnally. capacity for adaptation to local needs. for example. global account management. and logistics. the emergence of the Internet. In India. protection of intellectual property. Global and local distinctions will remain in products and services. At a minimum it will challenge the yearly planning cycle. safety. environmental concerns. The need for local responsiveness. they can change their business portfolio: Should I invest in water. • Business will be global Increasingly the distinction between local and global business will be narrowed. For example. gas lines. Coke had to recognize the power of “Thums Up. the emergence of large developing countries such as India. is very clear. telecoms. Consider. China. Nirula’s. a local fast-food chain in India. especially when global companies want to penetrate markets with different levels of consumer purchasing power. national. was. services? The forces of change—deregulation. new standards. and talent management. McDonald’s had to change its recipe to serve lamb (instead of beef) and vegetarian patties (a radical departure from its normal western fare). and Brazil as major business opportunities—provide a new playing ﬁeld. and collaboration across national and regional boundaries in everything from manufacturing. On the other hand. Speed will be a critical element Given the nature of competitive changes. regional. Needless to say. All businesses will have to be locally responsive and all businesses will be subject to the inﬂuences and standards of global players. This is a case of global standards being imposed on a local player. speed of reaction will be a critical element of strategy. in its own restaurants. service levels. Simultaneously forces of digitalization.

Strategy in the Next Millennium Given the dramatic changes taking place in the competitive landscape. What managers do matters in how industries evolve. they can inﬂuence the competitive environment. how does an auctionbased pricing market (e.54 Chapter 2 Box 2.” Reducing cycle time.. personalization of products and services have on the total logistics chain? Business innovations are crucial in a competitive landscape subject to disruptive changes. This is not just about the reactions of large. and global product launches were the hallmarks of an innovative company. Second. the concept of innovation was tied to product and process innovations. In many large companies.1 (continued) large company. It identiﬁes the strategic issues for the next calendar year and three to four years hence. the innovation process is still called the “product creation process. not tied to a rigid corporate calendar is of the essence. First. Managers will have to start with two clear premises. more importantly. 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. For example. Strategy is not about positioning the company in a given industry space but increasingly one of inﬂuencing. What is the use of such a process in an Internet-based start up? Speed of reaction. . . 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 customization or. not how to improve what is available but how radically to alter it. tracking sales from new products introduced during the last two years as a percentage of total sales.g. However. I believe that both the concept of strategy and the process of strategy making will change. Increasingly the focus of innovation has to shift toward innovation in business models. shaping and creating it. Smaller companies can also have an impact on industry evolution . Imagining a new competitive space . Older approaches will not sufﬁce. well-endowed companies. increasing modularity. The process of strategy discussion and commitments typically starts in October. As all traditional companies are confronted with disruptive changes. 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. airlines. 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.

competitors. . or budgets. and the increasing dependence of all countries on global trade. Knowing the broad contours of the future is not as difﬁcult as people normally assume. are rather removed from the new and emerging competitive reality.” This process needs a different starting point. This requirement is so well understood that it is hardly worth elaborating here. in an era of discontinuous change. Alliances and networks are an integral part of the total process.Strategic Management and Competitive Advantage 55 Box 2. and customers appear as managers in the middle.1 (continued) and acting to inﬂuence the migration toward that future is critical. the major milestones on the way. we know with great uncertainty the demographic composition of every country. The problem is not information about the future but insights about how these trends will transform industries and what new opportunities will emerge. Resources available . They have the information. Middle managers must take more responsibility for developing a strategic direction and. For example.” the sandbox being the broad strategic direction. infrastructure. We can recognize the trends—the desire for mobility. Finally. Tactical changes are difﬁcult if there is no overarching point of view. This is about providing a strategic direction—a point of view—and identifying. and motivation to act. People who are close to the new technologies. While a broad strategic direction (or strategic intent and strategic architecture) is critical to the process. Top managers. partners. The need constantly to adjust resource conﬁguration as competitive conditions change is becoming recognized. urgency. creating the future is a task that involves more than the traditional stand-alone company. more important. at best. Managers have to make alliances and collaborate with suppliers. . access to information. or new operating systems. the spread of the web. Strategy is therefore not an extrapolation of the current situation but an exercise in “imagining and then folding the future in. . By its very nature discontinuous change in the competitive environment is creating a whole new dynamic. in making decentralized decisions consistent with the broad direction of the company. This may be described as “inventing new games within a sandbox. They are also the ones who have direct control over people and physical resources. A critical part of being strategic is the ability quickly to adjust and adapt within a given strategic direction. 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. The involvement of middle managers is a critical element of the strategy process. There is no attempt to be precise on product plans. and often competitors to develop new standards. 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.

Reprinted from Financial Times. It is clear the disruptive forces that have wrought this change are accelerating.g.56 Chapter 2 Box 2. requiring a closer look at the revenue or cost position of the ﬁrm relative to its competitors. tools and concepts and embrace the new. The ﬁrst driver determines whether a ﬁrm operates in an attractive market or industry. (2004). . p. as can be ascertained via detailed industry analysis.1 (continued) to the company are dramatically enhanced through alliances and networks. Those who take up the challenge and proactively change will create the future. Industry and market attractiveness Firm proﬁtability Firm’s relative competitive positioning in the industry Revenue position compared to rivals Cost position compared to rivals Figure 2. some of which may be beyond the ﬁrm’s control (e. It is time for managers to abandon the comfort of the traditional. The shift in emphasis in the concept of strategy and the process of strategy making is dramatic. The markets will decide the drivers. Analyzing the ﬁrm’s environment involves taking a close look at a range of factors. We examine below how to analyze the macroeconomic environment and subsequently examine industry-speciﬁc factors. and tried and tested... The New View of Strategy The emerging view of strategy contrasts dramatically with the traditional view . macroeconomic factors) as well as at industry-speciﬁc factors. and the rate of “roadkill” soon enough. passengers. Disruptive competitive changes will challenge the status quo. 1999. Publication date: October 4.2 Drivers of ﬁrm proﬁtability From Besanko et al. 360) Figure 2. (2004. Proﬁtability does not only vary across industries but also across ﬁrms within a given industry. . .2 summarizes the drivers of ﬁrm proﬁtability according to Besanko et al.

health and ﬁtness trends. or the growth in discretionary spending by the young. These economic factors determine the growth potential. enables a ﬁrm to shift operations among several countries. typewriters or argentic photo cameras). differences in purchasing behavior due to social and cultural idiosyncrasies must be taken into account. A ﬁrm must carefully monitor these factors and devise appropriate strategies to ride out an unfavorable economic environment or take advantage of opportunities arising from an expanding economy. in particular. taking advantage of opportunities or reducing risks as relative labor costs. environmental legislation. Moreover. For multinational corporations (MNCs).2. Multinationality. antitrust rulings.Strategic Management and Competitive Advantage 57 2. A ﬁrm should monitor these trends to ensure that its products and services meet changing consumer needs. tax policies. One way suggested to analyze the external environment is the PEST framework (standing for politics. Today one can travel faster. social culture. Businesses • • • . A poor economic situation. trade restrictions. tax policies. assessing the impact of such political factors can be involved as MNCs have to constantly monitor governmental stability. the relative value of the domestic versus foreign currencies. growth.. and productivity can inﬂuence the health of the economy. exchange rates. The unemployment level. may lead to reduced spending by consumers. as well as speciﬁc ﬁrms within it. as the ﬁrm expands into new markets or countries.1 Macroeconomic Analysis The ﬁrm’s macroeconomic environment can have a critical impact on industry attractiveness. such as the proportion of women in the workforce. and produce in more efﬁcient ways than ever before.. change. by way of consumer demand or conﬁdence. such as the recent ﬁnancial crisis. can also have a signiﬁcant impact. and be abreast of local business legislations. and technology). • Politics (e. New industries have emerged (e. Social-cultural factors. employment laws. Economics can have a serious impact on the proﬁtability of an industry or ﬁrm. while others have entirely disappeared (e. inﬂation.. monitor import and export regulations. economics. tariffs) may inﬂuence the proﬁtability and viability of the overall industry. and the like.g. cellular phones and dot-coms). communicate instantly globally.g. Technological changes have been unprecedented in recent decades in terms of incremental improvements and technological disruptions.g.

as proxied by the number and market power of ﬁrms in the industry. The SCP paradigm was developed by the “Harvard School. 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. and the customer base is relatively large and homogeneous. there are high entry and exit barriers (e. but many industries are organized quite differently in the two countries (e.g. This also works in the reverse direction.. For example. many ﬁrms (facing no entry or exit barriers) populate the market.2 At its core this paradigm assumes a causal link from market structure to ﬁrm conduct and performance: market structure determines ﬁrm conduct. is an important driver of industry 2. 2.2.g. Microeconomic analysis enables a better understanding of the overall attractiveness of a particular market and the achievable proﬁtability of the typical ﬁrm within that industry.. the banking system or the waste management industry).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. Moreover clients have a perfect ﬂow of information. 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. large ﬁxed costs).2 Industry Analysis: Structure–Conduct–Performance Paradigm A thorough industry and microeconomic analysis must complement the analysis of the macroeconomic environment. Government intervention and basic demand and supply conditions may also inﬂuence the components discussed above. in an industry characterized by a monopoly structure. Market Structure In perfect competition. based on empirical observations. France and Germany are roughly similar in terms of macroeconomic features. since ﬁrms may pursue strategies that can alter the market structure (e. which in turn determines industry and ﬁrm performance. Market structure.” including Joe Bain and Edward Mason. A well-known industry analysis framework is the “structure–conduct– performance” (SCP) paradigm.g. M&A activities). . Two countries with similar macroeconomic environments may be quite different with respect to their microeconomic proﬁles. Firms offer homogeneous products and behave as price takers..

This issue has raised a big debate among economists with no clear consensus emerging on whether monopoly and the existence of patents is beneﬁcial or harmful in terms of encouraging innovation.” 5.5 2. preventing potential rivals from market entry. 8): “the best of all monopoly proﬁts is a quiet life. the greater their ability to wield market power and earn excess proﬁts. ﬁrms may collude (explicitly or tacitly) in an oligopolistic industry to sustain a higher price and earn excess proﬁts. Excess proﬁts earned by incumbent ﬁrms imply that the given industry is not perfectly competitive as some ﬁrms wield market power. 4. Industry Performance The performance of an industry is based on its proﬁtability as well as its static and dynamic efﬁciency. The structure and bargaining power of suppliers and customers may also inﬂuence whether a ﬁrm exercises market power. p. The fewer the number of producers in the market. A secure incumbent may have little incentive to improve its production processes. The stability of a cartel is another matter. In addition to individual exercise of market power.2. such as engaging in advertisement campaigns or investing heavily in research and development. A complementary approach to the industry analysis above is Michael Porter’s (1980) “ﬁve-forces” 3. ch. Firm Conduct in the Industry Conduct refers to whether a ﬁrm actually exercises its market power to earn excess proﬁts.4 Although a consolidated industry can attain higher static efﬁciency resulting from larger production scale. . This “extended rivalry” can put signiﬁcant pressure on the ﬁrm. 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. See Tirole (1988. A widely known remark on monopolistic industries is that of Hicks (1935.Strategic Management and Competitive Advantage 59 proﬁtability.3 The ability to exercise market power is inﬂuenced by strategic investments.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. 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 technology employed may not be the most efﬁcient. 10) for a comprehensive economic analysis of the incentives to conduct R&D in oligopolistic industry structures. whereas market structure refers to whether market power is structurally possible in the industry. with ﬁrms investing less in R&D compared to a highly competitive industry.

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. Porter categorizes the relevant economic factors into ﬁve groups or forces (hence. such as potential entrants and the threat of substitute products or services. depicted along the horizontal axis in ﬁgure 2. the attractiveness of an industry depends on two kinds of strategic interactions: Interactions along the “value chain” These relationships. He proposes a thorough assessment of (1) the impact of these factors on the intensity of competition within the industry or internal rivalry. involve the relative bargaining power of different parties along the value chain. (2) the threat of substitute products or services. According to Porter (1980). it has become a well-known paradigm used both in academe and in practice for analyzing industry performance. the “ﬁve-forces” analysis). Since the early 1980s. These “extended-rivalry” interactions are illustrated along the vertical axis in the ﬁgure. to end customers. (3) the threat of new ﬁrms entering the market.3.60 Chapter 2 Potential entrants Threat of new entrants Competitors Bargaining power of suppliers Bargaining power of customers Suppliers Rivalry among existing ﬁrms Threat of substitute products or services Customers Substitutes Figure 2. from suppliers to manufacturers and distributors.3 Porter’s “ﬁve-forces” industry and competitive analysis From Porter (1980) framework. (4) .

A simple proxy of the concentration in a industry with n active ﬁrms is the cumulative market share of the k biggest ﬁrms (k ≤ n). These forces are in turn affected by industry structure and other relevant variables. i =1 k (2. Its primary beneﬁt is that it helps frame an industry and identify key forces affecting market attractiveness.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.1 below.1) The market shares of the few “big” players are generally available in market reports. A means to assess the intensity of competition within an industry is to use a concentration ratio. commonly referred to as HHI. that is. These concentration ratios fail to capture whether external parties can easily enter these markets. 7. 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. 6. Although conceptually very useful. 8. A common feature is that they are based on the market shares of the ﬁrms already active in the industry. Tirole (1988) provides an alternative to these concentration indexes. Ck ≡ ∑ si . Internal Rivalry Internal rivalry is a central piece of Porter’s analysis.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. Industrial economists and antitrust authorities have long attempted to ﬁnd a quantitative measure of the intensity of rivalry using various concentration ratios. product differentiation and availability of information.Strategic Management and Competitive Advantage 61 the bargaining power of suppliers. . It refers to competitive actions taken by each ﬁrm to gain market share within the industry. For this reason industrial economists and antitrust authorities generally prefer alternative concentration measures. and (2) the Herﬁndhal–Hirschman index. Ck. like entry and exit barriers. 1964).6 We look at these forces in detail next. This concentration ratio has a major drawback: it fails to capture heterogeneity among the largest ﬁrms. developed by Herﬁndhal (1950) and Hirschman (1945. and (5) customers. Porter’s (1980) framework does not give a clear prescription as to whether to invest in a given industry. Here we only discuss the Ck and HHI indexes due to their relative simplicity. such as the Herﬁndhal–Hirschman index. namely the entropy index that involves a logarithmic function of the market shares. This is discussed in example 2.

as the market shares are less uniformly distributed.1 Concentration Indexes Consider the market share distribution of ﬁve ﬁrms in the three different industry situations described in table 2. as the index is equal to 88 percent in both cases. A monopoly is generally characterized by only one seller and very high barriers to entry and exit.1 Concentration indexes based on the ﬁrst three (C3 ). from the diamond business. one cannot distinguish the difference in concentration within the industry in case 3 or 2. The industry in case 3 is clearly more concentrated than in case 2. four (C4 ). The last two columns give the values of C 4 and HHI in each case. compared to case 2 where the three biggest ﬁrms have comparable power. which has exclusive access to scarce Table 2. . i =1 n (2.2). not just the ﬁve (or k ) biggest ﬁrms.2) From a practical viewpoint. The Herﬁndhal– Hirschman index is given by HHI ≡ ∑ si ². it is more difﬁcult to gather information (market shares) on all ﬁrms operating in a given industry.000 times the HHI number given by the deﬁnition in equation (2.000 2. Using the C4 index. As summarized in ﬁgure 2. which in turn is more concentrated than in case 1.125 1 2 3 1 1 Note: By convention. is DeBeers.62 Chapter 2 Herﬁndhal–Hirschman Index (HHI) The HHI index has the merit of combining information about all ﬁrms in the market. The C4 index does not capture the fact that in case 3 a single ﬁrm is dominant with a 50 percent market share. The HHI does a better job since it properly captures this difference. giving a higher value in case 3 relative to case 2. Example 2.188 3. An example. or all ﬁrms in an industry Case Market share distribution s1 /5 ¼ ½ s2 /5 ¼ ⅛ s3 1 /5 ¼ ⅛ s4 1 /5 ⅛ ⅛ s5 1 /5 ⅛ ⅛ Concentration index C4 80% 88% 88% HHI 2. concentration indexes are used by economists and antitrust authorities to identify and differentiate among different market structures.1. the HHI is often given as 10.4.

fashion followers. valves for public water management pipes turn counterclockwise. Barriers to entry and exit are fairly high. 10. A classic case is the duopoly involving Airbus and Boeing in the airframe industry.000 0 < C4 < 40 40 ≤ C4 < 60 60 ≤ C1 < 90 HHI ≥ 1.Strategic Management and Competitive Advantage 63 Perfect competition Monopolistic competition Oligopoly Dominant firm Monopoly Ck(%) HHI 0 HHI < 1. An oligopoly is characterized by few competing ﬁrms with 40% ≤ C 4 < 60%. Firm dominance is characterized by 60% ≤ C1 < 90% (and HHI ≥ 1. 000.800 Figure 2.10 Differentiated competition is characterized by 0 ≤ C4 < 40 percent. In France.000 ≤ HHI < 1.9 Monopolistic/differentiated competition is characterized by many suppliers with heterogeneous products appealing to different customer or market segments.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 case in point is the French pipeline and valve industry. whereas in most other European countries valves turn clockwise.). mostly French companies. Typically HHI is below 1. Apple and its iPod® have a dominant position in the portable music industry: despite smaller competitors. National quality standards may also raise entry barriers for foreign competitors and explain oligopoly situations. Perfect competition involves a homogeneous product (commodity) with no single ﬁrm having signiﬁcant market power to inﬂuence the price-setting process. For this reason only manufacturers that meet French standards are active in France. In an industry with a dominant ﬁrm and some fringe competitors. for example corn production. etc. A monopoly is characterized by C1 ≥ 90 percent. The agricultural sector.800 C1 ≥ 90 1. 9. is considered a good approximation to a perfectly competitive industry. A good example is the luxury goods industry where distinct brands lure different customer groups (youth. Barriers to entry due to technological expertise or huge sunk capital costs are generally very high. . the dominant ﬁrm can typically ignore strategic interactions with the smaller rivals. In monopolistic competition free entry of new brands leads to zero economic proﬁt with gains from pricing over marginal costs exactly offsetting ﬁxed cost. Product differentiation makes it possible for ﬁrms to price products above the marginal cost even if many ﬁrms compete in the marketplace. Apple has built an uncontestable entry barrier thanks to its unique brand name. 800).

economists utilize various measurement tools. However. market or environmental regulation). property rights. copyrights. 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.13 Entry barriers may be structural (exogenous) or strategic (endogenous). 12. such as cross-price elasticity of demand. would ﬁnd it proﬁtable to raise prices signiﬁcantly (and permanently). Threat of Substitutes In assessing the threat of substitute products. Bain (1956) has extensively analyzed entry barriers. How easy or difﬁcult it is for a potential entrant to penetrate a market depends on entry barriers. This travel option has become more attractive especially after September 11 since it reduces substantially the time to check in and out. New entrants pose a threat to incumbent ﬁrms as higher rivalry generally leads to lower proﬁt margins (negative externality). should it become dominant.g. only a limited number of ﬁrms can afford incurring these high ﬁxed costs. The extent to which a company might be affected by substitute products depends on several factors. including the propensity of buyers to substitute. 11. 14. An example of structural entry barriers is when the incumbent is protected by a favorable government policy or other administrative barriers (e. 13. switching costs.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..11 Many economists and antitrust authorities deﬁne the relevant market as the smallest set of products for which a ﬁrm.14 state. the threat of close substitutes can be assessed. . no external party enters since it cannot recoup its large ﬁxed costs. Examples include patents. and licenses. To determine the relevant product market. A barrier to entry is a mechanism that allows incumbents to make economic proﬁts without threat of entry by competition. Are train and plane substitutes in the transportation market? To travel from France to Cyprus. Even when the market-clearing price exceeds marginal production costs. as well as the price-performance characteristics of substitute offerings. a key prerequisite is to determine what the relevant product market is and deﬁne the relevant substitute products. and shock analysis. Potential Entrants Another key force affecting ﬁrm performance is the threat of entry. the value added by the company’s product or service in the clients’ perception.12 Once the relevant market is deﬁned. from Paris to London the train is a valuable option thanks to the Eurotunnel. the train is certainly not an option. price correlation analysis.

For instance. 16. by massively investing in automated production processes and reducing its production costs (a strategic ﬁrst-stage investment). process innovation.15 reputation.16 product differentiation advantages. A case in point is Nutella. The combination “PC + MS DOS” won the computer war against “Apple Mac OS” partly because IBM had a less restrictive licensing policy than Apple. a ﬁrm may ensure that the rival’s post-entry proﬁts are driven close to zero. via excess capacity or strong brand image).. but nonetheless strategically justiﬁed. such as ﬁxed entry costs. B-to-B clients) but suppliers are numerous. so no entrant can imitate Nutella’s unique taste. The ﬁrm has an exclusive right to acquire a given species of nuts.g. access to scarce resources. 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 manufacturer buys or sells. by building excess capacity. We elaborate on corporate strategies to deter entry later in chapter 4. • 15. network effects. This kind of deterrence strategy may be extremely expensive to pursue.g. Entry is accommodated when the incumbent ﬁnds it preferable to allow entry than to erect costly barriers. If the customer base is small (e. or by launching aggressive advertising campaigns to create brand loyalty. economies of scale. 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. .Strategic Management and Competitive Advantage 65 Structural barriers may also stem from other economic phenomena. Entry is deterred if the incumbent is not exogenously protected and behaves strategically to make it unproﬁtable for new competitors to enter. or learning. Bain (1956) identiﬁes three kinds of behavior by incumbents in the face of an entry threat. scope. The ﬁrm’s ability to inﬂuence or set prices depends on a number of factors: The concentration and market power of customers and suppliers. Strategic entry barriers involve actions taken by incumbents to deter the entrance of new competitors into the market. by manipulating prices before (limit pricing) or after entrance (predatory pricing). The incumbent can ignore the threat of entry so that strategic interactions play a minor role in this case. Entry is blockaded if the incumbent is well protected by insurmountable structural barriers to entry and exit so that it continues to enjoy incumbency proﬁts. They may also create a new brand to capture a previously unsatisﬁed customer segment (product proliferation). for example.. and vertical integration.

the customer will reject the product. We review the “generic strategies” proposed by Michael Porter (1980).. or focused on a speciﬁc customer segment. This maximal value (“willingness to pay” or “consumer value”) determines whether the customer purchases the product. If the price is lower.g. market power. “earning” the difference (between the 17. 8 and 9). refer to Besanko et al. the customer will purchase it. one of the major cosmetic companies worldwide. L’Oréal. A key to superior performance is creating more value for customers than one’s rivals by exploiting some competitive advantage. a ﬁrm must strive to be superior to its competitors in the industry. For each product there is a maximum value the consumer is willing to pay. 11) and Grant (2005.17 2. we need to go back to basic microeconomics.3. To assess the value created by a ﬁrm. • The relation speciﬁcity of the ﬁrms’ assets (speciﬁc to clients or suppliers). competitive pressures. namely the incentive to be a cost leader. . 2. bargaining power) as well as on ﬁrm-speciﬁc attributes. 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. To understand these concepts from a microeconomic viewpoint. a differentiation leader. We already discussed the main strategic management frameworks for assessing industry attractiveness. it is necessary to ﬁrst address the notion of value creation and competitive advantage. Customer and supplier switching costs (purchase from another party).3 Creating and Sustaining Competitive Advantage The proﬁtability of a ﬁrm depends both on industrywide characteristics (e.66 Chapter 2 customers will wield more bargaining power. (2004. which have to toe the line. The ability of customers to backward integrate or of suppliers to forward integrate. Firms’ strategies aim to create such comparative advantages. chs. If the price asked for the good exceeds the customer’s willingness to pay. ch. For a more detailed analysis of how ﬁrms can create competitive advantage. • • • The price elasticity of demand for the product (inputs or outputs).1 Value Creation To earn proﬁts in excess of the industry average. puts signiﬁcant pressure on its packaging services suppliers.

If p denotes the price and u the consumer’s willingness to pay (utility). The value created by the producer is the difference between the price at which the ﬁrm sells the good.Strategic Management and Competitive Advantage 67 customer value and the product price) as consumer surplus or utility. ﬁrms need to ﬁnd ways to deviate from perfect competition. the nature and degree of competition. p − c. In equilibrium the producer does not set the price arbitrarily. A ﬁrm has a competitive advantage when it is able to deliver more economic value than its rivals.” A ﬁnancial translation of this economic concept is economic value added (EVA). the consumer surplus is represented by u − p if p ≤ u. meaning the products offered by rivals are considered perfectly identical. and the remaining part is earned by the producer as economic proﬁt. as well as the size of the customer base. Total value created = consumer surplus + producer surplus u−c = + (u − p) ( p − c) (2. and cost of capital per unit of the product. and represents the bottom-line criterion for many managerial decisions. 18. and 0 otherwise. the production cost. If the product is homogeneous. 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 this case both the consumer and the producer gain. c. she would choose to ﬂy with a low-cost airline like Ryanair. this choice is closely related to the consumer price elasticity of demand. Included in c are the labor costs. For instance. This incentive is captured by the producer surplus or economic proﬁt.3) The relation above is depicted in ﬁgure 2. A portion of this value is captured by the consumer in the form of consumer surplus. In order to be economically proﬁtable. That is. and its unit cost of producing it. a rational consumer will purchase from the lowest price supplier. The proﬁt and value measures we discuss here are net of the opportunity cost of capital. 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). u − p. input prices.5. We must also consider the incentive of a given ﬁrm to sell in the marketplace. p. .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. if a consumer sees no signiﬁcant difference among airline carriers and does not care much about small differences in the time schedules. namely u − c. The term used for proﬁts in this case is “economic proﬁt.

Distinct market segments can be identiﬁed in which consumers (with uniform preferences) are more willing to accept one particular offering versus another.5 Total value created consisting of consumer surplus plus producer surplus In reality. ﬁrms pay considerable attention to what drives customer value and production costs. • • Perception by customers. The following factors typically drive the customer’s willingness to pay: The appeal of physical characteristics and the perceived ﬁtness of the product (e. To create higher economic value. . namely the one for which their consumer surplus (u − p) is the highest.68 Chapter 2 Consumer value u Consumer surplus (u−p) Price p Producer surplus (p− c) Cost c Total economic value u− c Figure 2. the size of furniture may be an important criterion if one’s ﬂat is only 20 square meters or 200 square feet). if consumers are not identical. This basic economic principle underlies market segmentation.g. • Brand name (Apple®’s brand name creates a unique competitive advantage for the iPhone® in the now-commoditized mobile telephony market). a given product may represent a higher utility for one consumer than for another. • 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)..

ﬁnance. accounting. 411–18).Strategic Management and Competitive Advantage 69 Firm infrastructure (e. Primary activities are involved with the physical creation of the product or development of the service until it reaches the end customer. (2004.. capacity utilization and bargaining power). production in a low labor cost country). . marketing and sales. • • • Experience of the ﬁrm (learning-curve effects). pp. 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. and 19. For more details on beneﬁt and cost drivers. Factors related to organizational structure (organization of transactions.19 To understand how value is created along the vertical chain. Additional activities support these primary activities by providing procurement and technology services. Porter (1980) proposes a conceptual framework (shown in ﬁgure 2. production or operations. vertical chain).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. Porter’s value chain essentially divides the organization into a series of value-creating activities that can be broadly classiﬁed as supportive or primary. accounting. Regardless of whether an activity belongs in the ﬁrst or the second category. see Besanko et al.6) involving the organization of value-creating activities referred to as the value chain. agency efﬁciency. legal) Support activities Human resource management Technology development Procurement Primary activities Inbound logistics Production Outbound logistics Main activities Marketing and sales Services Figure 2. outbound logistics.g. Inbound logistics. and various ﬁrmwide functions such as ﬁnance. • Other costs (lower input prices. human resources management. and services are typical primary activities.

70 Chapter 2 legal services. 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. following a focus strategy. These activities are all interrelated. and buyers’ value chains. Such savings may have a material impact on the equilibrium market structure. scope. which together with the ﬁrm’s value chain form the so-called value system.2 Generic Competitive Strategies A generic competitive strategy refers to how a ﬁrm positions itself to compete in the marketplace. It is more likely to succeed when customers are sensitive to prices. The organization as a whole is embedded in a larger stream of activities that include suppliers. A third strategic alternative is to specialize in a narrow customer segment. differentiation. Cost Leadership In homogeneous goods markets. distributors. ﬁrms can mainly pursue two generic strategies: cost leadership or differentiation. The notions of value creation and value chain are essential for understanding the “generic competitive strategies” proposed by Porter (1980). so events in one of them may affect the company’s overall strategy basis. Porter (1980) identiﬁes three generic strategies—cost leadership. Cost advantage can result from economies of scale. and focus strategy. If ﬁxed costs are large. When covering a broad market. the ﬁxed-cost component per unit declines.3. This strategy typically involves producing larger quantities and appealing to a broader market (broad scope). In homogeneous goods markets. Economies of scope . cost leadership consists in offering similar products as rivals but at lower price. a beneﬁt leader or differentiated ﬁrm that offers a perceived superior product may obtain a stronger competitive advantage. as measured by the price elasticity of demand. 2. In a market where customers prefer customized products. Fixed costs here play a critical role: when volume rises. namely develop a niche. A costleadership strategy is advisable when products are commodity-like or customer services are hard to differentiate. or learning-curve effects. cost leadership can play a central role since customers primarily decide based on the price. The choice of one strategy over another partly depends on the size of the market the ﬁrm wants to cover. Increased value added may also be a result of these ﬁrmwide functions. 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.

mainly focused on corporate customers). the cost leader offers a product identical to the products offered by competitors but the cost of producing it is signiﬁcantly lower. Whether achieving cost leadership enhances ﬁrm value also depends on the size of the initial investment. . This strategy is more appealing when price elasticity is low or when cost advantages are limited.g. In case of horizontal differentiation. or location advantages (manufacturing in low-cost countries). A differentiation strategy may encompass the whole value chain. the cost of producing the good is lower but the consumer perceives the product to be of lower quality.Strategic Management and Competitive Advantage 71 correspond to cost savings gained by operating several product lines or businesses: the production of good A reduces the production cost of product B. Within the same market some customers may have preferences for speciﬁc product features and others for other features. lean organizational structure. Alternatively. higher capacity utilization (especially when ﬁxed costs are high). and product redesign. Differentiation Strategy Consumer preferences in the marketplace may not be homogeneous. cost leadership under beneﬁt proximity. leveraging on learning-curve effects.g. The classic BCG matrix originated from work related to the learning-curve effect. The BCG matrix paradigm asserts that a conglomerate should ﬁnance promising “stars” with excess cash generated by “cash cows. a consumer may be willing to pay a price premium. Firms employ several approaches to achieve cost leadership: cost leadership under beneﬁt parity. better compensation systems. the “stars” commence production early on and accumulate experience ahead of competitors.. online shopping for people living on the fast lane). In case of beneﬁt proximity. 20. 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. 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. better marketing differentiation (lenovo® laptop.. increased bargaining power with suppliers. MP3-player for mobile telephone handsets). a ﬁrm may offer a product to consumers that is qualitatively different from competitors’ offerings (product redesign). new distribution or sales outlets (e.” By so doing.20 Cost leadership can also result from improved process efﬁciencies. product differentiation can be achieved thanks to new combinations of product characteristics (e. Traditionally one distinguishes two kinds of differentiation. In exchange for this higher consumer surplus. here the increase in consumer surplus due to the lower price offsets the quality decrease. In case of beneﬁt parity.

Many once-leading ﬁrms have been dethroned abruptly for not being able to protect and sustain their once-formidable competitive advantage. 2. In doing so.g. Focus Strategy Alternatively.g. One type of focused strategy is to be a local player or appeal to a given population group (e. Product redesign consists in offering a product with new characteristics that appeal to new or existing customers.. . To avoid this.72 Chapter 2 or better complementarities owing to network effects (e. the cost of producing the good remains unchanged. it is more likely that a ﬁrm will enter when it sees a window of opportunity. the ﬁrm creates higher economic value for this speciﬁc segment. there exist mechanisms within an industry to protect a ﬁrm’s competitive advantage from rivals’ 21.3 Sustaining Competitive Advantage It is said that history repeats itself in cycles. three cases may be distinguished here..21 Vertical differentiation is achieved when all perceive the product as being of higher quality. Just as there are various mechanisms to protect the proﬁtability of an industry (e. Blu-ray players on Sony’s PlayStation3®). See Besanko et al. Imitators and new entrants with superior technologies can quickly erode competitive advantages that have taken years to build.3. Sustainability of competitive advantage invariably depends on the dynamics of the market. In case of cost proximity. the differentiated product implies higher production costs (than the standard product). Again. a ﬁrm can devise a focus strategy and tailor its products and services to the requirements of a speciﬁc customer group. p. enabling the focused ﬁrm to enjoy a quasi-monopolistic position within its segment. an incumbent can erect entry barriers. Firms that persistently outperform their peers are those able to sustain or renew their competitive advantage over the long run. Customers without budget constraints would be willing to pay a premium for it. (2004. In a market with low entry and exit barriers. erection of entry and exit barriers).g. Mecca Cola® as an alternative to CocaCola® and Pepsi® for Muslim consumers). In case of cost parity. 415). A key advantage of a focused strategy is that the targeted market may not be large enough to accommodate many producers. but consumers appreciate the higher quality and willingly pay a price premium that compensates for these higher costs. but the differentiated product is perceived as being of higher quality by a given customer segment..

and reputation a ﬁrm has built over time enable it to leverage its resources and capabilities and represent sources of uniqueness. has successfully leveraged its brand image to sustain its proﬁtability over time. Isolating mechanisms fall into two main categories: (1) barriers to imitation (e. relationships. When a ﬁrm cannot acquire distinctive key resources. In its history of investment and commitment. The experience. Heterogeneity among ﬁrms is the cornerstone of the resource-based view of the ﬁrm. a ﬁrm can build competitive advantage through production efﬁciency (cost leadership).g. we discussed the importance of sustaining competitive advantage dynamically. emphasizing ﬁrm speciﬁcity and uniqueness. within a given industry. ﬁrms can erect isolating mechanisms to prevent rivals from internally developing similar resources. or a focus strategy. property rights or exclusive access to scarce resources) and (2) early-mover advantages. focusing on how prevalent frameworks view the key drivers of market attractiveness and ﬁrm proﬁtability. Besides the scarcity and immobility of unique resources. it has to build them up over time. and resources involving path dependencies. Apple®. We elaborated on market structure and discussed how limited access to a market and the existence of entry barriers can enhance a ﬁrm’s proﬁtability. branding (differentiation leadership). such as learning-curve effects and brand-name building. Imitation can only be precluded if there is heterogeneity and imperfect transferability of key resources.Strategic Management and Competitive Advantage 73 imitation. 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. frequently ranked as one of the most famous brands in the world. To keep competitors from duplicating its competitive advantage. We also discussed how. 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. . a ﬁrm accumulates skills. Conclusion In this chapter we provided a brief overview of the main paradigms and issues in strategic management. It is the exploitation of ﬁrm-speciﬁc resources and capabilities in a dynamic way that enables a ﬁrm to enjoy higher (excess) proﬁt ﬂows.. assets. Finally. We described Porter’s ﬁve-forces paradigm and how it can help structure market analysis.

Economics of Strategy. Besanko.74 Chapter 2 Selected References Bain (1956) examines barriers to market entrance in detail. New York: Wiley. Competitive Strategy. . Michael E. Cambridge: Harvard University Press. David Dranove. and Scott Schaefer. David. 1980. Besanko et al. Porter. Barriers to New Competition. Joe S. Bain. London: Macmillan. Mark Shanley. 1956. 2004. Porter’s (1980) seminal work on industry and competitive analysis is a cornerstone for understanding the art of strategy and competitive advantage. (2004) provide an easy-to-read economic perspective on strategy. 3rd ed.

helping explain phenomena such as restraining one’s own freedom (commitment) or collaboration among rival ﬁrms.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. Basic ideas developed in these chapters serve as building blocks in subsequent discussions. This chapter is organized as follows.2 introduces static models of duopoly. Section 3. commitment. . discuss industry structures. Going beyond earlier models that involved complete information. We discuss simple economic models that characterize optimal ﬁrm behavior under different industry structures. and examine information asymmetry. 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.4 explores the impact of incomplete information on market structure in a duopoly. section 3. dynamic strategy formulation. We then turn to oligopolistic situations where ﬁrms have enough market power to inﬂuence the decisions of rivals. Section 3.1 discusses the benchmark case of a monopolist. obtaining the market equilibrium in perfect competition as a polar case. Chapter 4 extends the discussion to include long-term. Section 3.3 extends the standard Cournot quantity competition analysis to accommodate a larger number of ﬁrms in oligopoly. developing the basic building blocks for subsequent models. presenting ﬁrst the case of Bertrand price competition and then discussing the classic Cournot quantity duopoly model. we review some basic principles and models in this area. and collaboration. In this chapter and the following one. Such analysis requires the use of game-theoretic tools.

. as a function of the quantity Q supplied in the marketplace. The equilibrium market structure critically depends on such ﬁxed costs. making it difﬁcult or impossible for more electricity utilities to make a proﬁt once large ﬁxed costs are considered. This trade-off is linked to marginal revenues. Under certain conditions we show that ﬁrms can make excess economic proﬁts (gross of ﬁxed costs).. patents). π (Q) = R (Q) − C (Q). while a duopolist cannot. 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. π (2) < 0 < π (1) holds for natural monopoly. Q. Customers take price as given and cannot inﬂuence the price-setting process. The monopolist’s proﬁt function is concave in its own quantity. If π (i) indicates the equilibrium proﬁt of a ﬁrm in an industry with i incumbent(s). Price setting in a competitive market leads to lower prices.2 In this chapter we simplify and ignore ﬁxed production costs. Considering ﬁxed costs might invalidate some of these results. When large-scale production plants are needed (e.g.1 In western Europe the electricity market used to be considered a national natural monopoly because of the prohibitive ﬁxed costs.76 Chapter 3 3.3 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. A natural monopoly may exist when a ﬁrm can make excess economic proﬁts when operating alone. 1. In contrast. Economies of scale and scope are thus one of the main drivers of industry structures (Viner 1932). following deregulation. if the monopolist sells an additional unit of output. it moves down the (inverse) market demand curve. Inversely. a monopoly is economically justiﬁed and may be socially preferable.1 Monopoly In monopoly entry barriers are typically sufﬁciently high to shield the incumbent ﬁrm from competitive entry (blockaded entry). suffering a (marginal) price reduction.g. the electricity market is sufﬁciently mature to accommodate more suppliers. nuclear power plants). focusing instead on the relationship between the market-clearing price and marginal production costs. the monopolist faces a trade-off between price and quantity. Given a downward-sloping demand (∂p ∂Q < 0). Consider a monopolist facing (inverse) demand function p (⋅) and variable production cost C (Q). Today. . 2. 3. Setting a higher price p implies earning a higher proﬁt margin but selling a lower quantity. a monopolist is a price setter.

since the ﬁrm’s output decision inﬂuences the market-clearing price and ∂p ∂Q < 0.3). Box 3. the marginal revenue equals the price (since the output decision of an individual ﬁrm does not affect the price-setting process. MR (Q *) = MC (Q *). In monopoly we thus have a − 2bQM = c. holds whatever the industry structure and the assumed proﬁt function. the ﬁrm must choose to produce that output.2 for QM into the inverse demand function 3. MC (Q) ≡ C ′ (Q).2) The equilibrium price. ∂Q ∂Q The ﬁrst two terms yield the proﬁtability of an extra unit of output (i. corresponding to point E′ in ﬁgure 3. that equates its marginal cost.1) and a linear cost function C (Q) = cQ with c < a.1 describe common types of demand functions. . The marginal beneﬁt (revenue) is MR (Q) ≡ R′ (Q) = p (Q) + ∂p (Q) × Q. To earn maximum proﬁt. In monopoly. the equilibrium proﬁt for the monopolist is 4. The equilibrium quantity produced by the monopolist is QM = a−c .3) From the equilibrium quantity and price. to its marginal revenue.1) is pM = a+c a−c = c+ 2 2 (> c ) . while the third term recognizes that an increase in output (implying a decrease in ∂p ∂Q < 0 ) affects the proﬁtability of units already produced. the difference between the price and marginal cost).Market Structure Games: Static 77 where total revenues are given by R (Q) = p (Q) × Q. (3. In perfect competition.1 and ﬁgure 3. 2b (3. MR (Q) ≡ R ′ (Q).. ∂Q The proﬁt function is concave so the ﬁrst-order condition is both sufﬁcient and necessary for a maximum output (Q *) to obtain.2 (determined by substituting equation 3. The ﬁrst-order derivative of the proﬁt function is ∂π ∂p (Q) = p(Q) − C ′(Q) + (Q) × Q .4 This principle. In this case the marginal revenue is MR (Q) = R ′ (Q) = a − 2bQ and the marginal cost is MC (Q) = C ′ (Q) = c. the ﬁrm loses revenue on already produced output when it decides to produce more. p = MC in equilibrium).2) and (3. Consider the linear (inverse) demand function p (Q) = a − bQ (3.e. equations (3. b > 0. Q *.

and a is the demand intercept. where a high price may signal a more exclusive product). There are several deterministic inverse demand functions. One limitation. (b) isoelastic demand. total industry output must be limited to a certain range (if Q > a b.78 Chapter 3 Box 3. is that for the price to be (or remain) positive.1a depicts this linear demand function. indicating that for an increased industry output ( Q) the market-clearing price ( p (Q)) declines. b > 0 . This curvi-linear demand is depicted in ﬁgure 3. p(Q) = a − bQ. One key assumption relates to the (inverse) demand function used to determine marketclearing prices and ﬁrm proﬁts. however. Figure 3.1 Different (inverse) demand functions (a) Linear demand. p(Q) = 1 (Q + W ). where W is a positive constant.1 Common demand functions Industry structure models rely on certain assumptions. Here • Price (p) a Price (p) p(Q) = a−bQ Slope − b 0 p(Q) = 1 Q+W a /b Quantity (Q) 0 Quantity (Q) (a) Price (p) (b) Price (p) p(Q) = Q−1 ⁄ ep p(Q) = a × exp(−e p Q) 0 0 Quantity (Q) Quantity (Q) (c) (d) Figure 3. the price is negative).1b. • The isoelastic demand function. (c) exponential demand. Q the total quantity produced by all ﬁrms in the industry. Here p(·) is downward sloping (with slope − b < 0 ). This property holds for most markets (with notable exception the luxury market. We assume that ﬁrms can observe customer demand. (d) constantelasticity demand . The most widely used are the following: The linear demand function. where p (Q) is the marketclearing price.

This demand function is often used because of its relative simplicity. p (Q) = Q ε p .Market Structure Games: Static 79 Box 3. It is depicted in ﬁgure 3. many industrial organization models rely on it to obtain simple expressions for equilibrium quantities. and proﬁts. A condition on the price elasticity parameter ε p is often imposed to obtain nice mathematical properties. 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.1c. Since the linear (inverse) demand function is the simplest and most widely used.1d.1 (continued) whatever the total industry output Q. prices. This is illustrated in ﬁgure 3. p(Q) = a exp ( − ε p × Q). • The exponential demand function. the market-clearing price remains positive.2 Equilibrium price and quantity in a monopoly . Price (p) a Equilibrium price pM = a+c 2 E' c E Marginal cost (c) Demand function p(Q) = a−bQ Marginal revenue MR(Q) = a−2bQ −b −2b 0 Equilibrium quantity QM = a− c 2b Quantity (Q) Figure 3. where ε p is the price elasticity of demand. −1 • The constant-elasticity demand function.

2. c.1). The price distortion is larger when customers reduce their demand only slightly in response to an increased price. the monopolist can set a very high price ( pM ) and still enjoy a high proﬁt margin (L).4) As conﬁrmed in ﬁgure 3. all other things equal. εp pM (3. if the price elasticity of demand is low such that customers are hardly sensitive to the price increase.80 Chapter 3 πM = (a − c ) ² 4b . ε p is high) and would refrain from purchasing the product in case of a price increase. obtaining MR (Q) = p + ∂p (Q) × Q = ∂Q ⎛ 1 ⎞ Q ∂p ⎛ ⎞ p⎜1 + (Q)⎟ = p ⎜ 1 − . L. . In contrast. giving L ≡ 1 e p.. (3.e. ⎝ ⎠ ⎝ ⎠ ε p (Q) ⎟ p ∂Q Expression (3.6) obtains from the ﬁrst-order condition in the special case of a linear cost function. is inversely proportional to the price elasticity of demand. 5. It is given by p (Q ) ≡ − ∂Q Q pQ . If customers are highly sensitive to a price increase (i. just equal to its marginal cost. ε p ≡ ε p(QM ). the ﬁrm’s proﬁt margin L will be low. the monopolist ﬁrm maximizes its proﬁt by selecting the output that makes its marginal revenue. We can rewrite the marginal revenue in note 4 based on the price-elasticity formula (3. Table 3. MR (Q). This elasticity measure corresponds to the percentage decrease in quantity sold due to a 1 percent increase in price.1 gives an indication of price-elasticity ranges.6) This markup rule. provides a practical rule of thumb for pricing a product in a monopoly. as represented by the intersection point E. it obtains from (3. ε p.5).3) that L = (a − c ) (a + c ) and ε p = (a + c ) (a − c ). Inverse Elasticity Markup Rule or Lerner Index Lerner (1934) complements the discussion on price setting by a monopolist by adopting an approach based on the price elasticity of demand. commonly known as the Lerner index. It asserts that the proﬁt margin received by a monopolist in equilibrium. a markup formula measuring the ﬁrm proﬁt margin in equilibrium obtains as5 L≡ pM − c 1 = . since ∂L ∂ε p < 0. =− ∂p p ∂p ∂Q (3. If demand is linear as in (3.5) From the proﬁt-maximizing condition.

Market Structure Games: Static 81 Table 3.5 5. used throughout the book. ⎝ ⎠ pM 5. In box 3.1 Range of price elasticity of demand Perfectly elastic Elastic Unit elastic Inelastic Perfectly inelastic εp → ∞ 1 < εp < ∞ εp = 1 0 < εp < 1 εp = 0 Example 3. The tools borrowed from game theory. A game has a certain structure.5 ⎛ 1 ⎞ = = = .2. In this case equations (3. 3. An appropriate tool kit is offered by game theory that gives prediction about the likely outcome of such strategic interactions. pM = = = 5.22 .2 Duopoly A duopoly is characterized by competition among two ﬁrms in an industry. and the proﬁt function is π (Q) = ( p (Q) − 1) × Q.3 Reinhard Selten addresses . 4.5 ⎜ ε p ⎟ Figure 3.2) to (3. c = 1. 4b 2b 2 2 2 2 e p (QM ) = − and L= pM / Q M 5.3 illustrates the price-setting trade-off (higher proﬁt margin vs. The marginal cost is constant. lower sales) that occurs in this situation and the optimal price markup using the Lerner index. The analysis of duopoly or oligopoly situations requires a clear depiction of the inﬂuence of each ﬁrm on the other ﬁrms in the industry. π M = = 20.5 .6) give QM = a − c 10 − 1 a + c 10 + 1 (a − c ) = = 4.5 − 1 4. and characteristics as discussed in box 3. rules. p (Q) = 10 − Q.5 . that is.25.5 ∂p / ∂Q pM − c 5.1 Market Equilibrium in Monopoly Assume a linear demand as in equation (3.5 = − ( −1) = 1. are sometimes criticized for being based on the strong assumption of rationality by all agents.1) with parameters a = 10 and b = 1.

”a Alternative actions and strategies Each time players are called upon to “play” (possibly only once).25 20 pM = 5. especially in option games modeling demand uncertainty. a player’s actions depend not only on the strategies played but also on external events.5 1. marginal revenue 12 Profit 25 a =10 10 8 Equilibrium price 5.5 6 E' Demand function Profit function 15 p(Q)=10−Q 10 4 Marginal revenue 2 MR(Q)=10−2Q E 5 c=1 0 0 2 −1 4 Equilibrium quantity 6 8 10 0 QM = 4. Nature selects the state of the world at random regardless of the players’ actions. such as nature. called “states of the world.g. . Occasionally so-called pseudoplayers. In games under exogenous uncertainty. A strategy is a contingent a.82 Chapter 3 Demand function.5 Quantity (Q) Figure 3. they face different alternative actions they can choose from. a decision on the output to supply or the size of the production capacity expansion). are used to account for or explain outside exogenous factors. such as R&D success or demand realization..5−1 1 L≡ ≈ 5. ﬁrms.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).2 “Rules of the game” The players These are the individuals.g. It is either discrete (e. Box 3. involving choices whether or not to enter a market) or continuous (e.22 πM = 20.. or actors who make decisions. The collection of alternative actions at a given stage is called the action set. entities. The probability distribution of nature’s moves is a key element of certain games.

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). what to do at each subsequent decision node. A two-period game where the second player faces information asymmetry concerning the move of the ﬁrst player is tantamount to a simultaneous game.2 (continued) plan of actions indicating which action to take at each and every stage or state. all players make their decisions at the same time so that no player observes other players’ actions before making its own decision. we face a sequential or dynamic game. conditional on information available then. An information set consists of all relevant information available to a player at the time of a decision..b Information set Players condition their actions on the information they possess.e.d Payoff structure Each strategy combination. 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). each player determines. Under incomplete information.f b. e. In a business context. f. results in a speciﬁed payoff value for each player. Under perfect information. d.c Over time players generally collect more information. A key question is whether players can react to information revealed over time or if they stay committed. In such games. decision makers know the previous moves over the play of the game. not necessarily real time. c. having observed the earlier actions. decision nodes off the equilibrium path). Strategies that take account of previous plays as well are closed-loop. In equilibrium. One often distinguishes various types of information structure. A strategy prescribes action choices at decision nodes that might not be reached during the actual (equilibrium) evolution of the game (i. incomplete. 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. ignoring agency problems. At the start of the game. such as perfect. or imperfect information. as part of a contingent rule.e If one player makes its decision after the other. players do not know the exact payoffs received by rivals. . Order (sequence) of decisions In a simultaneous game. also called strategy proﬁle. This distinction can substantially affect the resulting equilibrium outcome.Market Structure Games: Static 83 Box 3. “time” is interpreted in terms of decision time. each player pursues a strategy that maximizes its expected well-being. A strategy proﬁle encompasses the strategies pursued by all the players. When competing ﬁrms face such a problem under perfect information. this corresponds to managers acting to maximize shareholder value. We come back to this distinction later when discussing commitment and games of timing. strategies that depend on calendar time but not on previous plays are called open-loop. In dynamic games.

duopolists make no excess proﬁts at all (a fortiori if ﬁxed costs are material). due to competitive pressures. Bertrand (1883) criticized the model’s fundamental premise. tactical approach.84 Chapter 3 this issue and suggests how to reﬁne the standard approach by incorporating behavioral considerations. arguing that in the real world ﬁrms do not compete in quantity but in prices. Cournot quantity competition and Bertrand price competition. and once all delivered quantities are aggregated. For this reason we ﬁrst present the basic Bertrand model where identical ﬁrms compete in price over homogeneous products. economists have interpreted (for reasons explained later) Bertrand price competition as a short-run. The theory of industrial organization has since largely relied upon these two cornerstone models. rather than assuming that the market price is exogenously determined. Bertrand posited that individual incumbent ﬁrms directly set their prices. we discuss a reﬁnement allowing ﬁrms to produce differentiated products (differentiated Bertrand model). 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. These two basic models serve to illustrate how competitive advantage can result from a better cost position or from product differentiation. Apart from the early criticisms of these models. but Cournot (1838) roughly anticipated the equilibrium concept developed by Nash (1950) over a century later. This extended model gives interesting insights for understanding the incentive of ﬁrms to differentiate their product offerings from those of rivals. Subsequently. The basic Cournot model essentially assumes that each individual ﬁrm sets the quantity it wishes to provide to the market. while Cournot quantity competition is thought to involve long-term capacity commitments. We next consider the basic Cournot model of duopoly where ﬁrms compete in quantity . A half century after Cournot presented his analysis of quantity competition. The original treatise did not explicitly rely on game theory. Cournot (1838) ﬁrst introduced the quantity competition model. describing a situation where. 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. In contrast. This model leads to what is called the Bertrand paradox. There are two archetypical economic models of duopoly competition. avoiding cutthroat competition.

Do you believe that experimental economics has revealed limited usefulness or relevance of mathematical modeling in economic analysis? Experimental economics is very important for the development of a behavioral approach of decision and game theory. 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. Game theory generally hinges on the assumption of rationality by all players. I think that rational game theory has to be complemented by a descriptive approach. Your work on game theory reﬁned existing solution concepts to select equilibria more in line with intuitive prediction. but they are different from those used in the mainstream of economic theory. 3. for example. 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. They might involve the analysis of dynamic systems. learning processes and stationary concepts replacing game equilibrium. You are a pioneer of experimental economics. Mathematical methods are also needed for that purpose.Market Structure Games: Static 85 Box 3.3 Interview with Reinhard Selten. Nobel Laureate in Economics (1994) 1. 2. These heuristics involve plausible assumptions about nonoptimizing decision procedures that are within the boundaries of human cognitive abilities. This leaves room for heuristics but of a different kind. When rationality is deﬁned in terms of Bayesian decision .

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). however. as long as its proﬁt margin is nonnegative. 3. However. facing the same production cost and subsequently extend the analysis to allow for (variable) cost asymmetry. about the descriptive validity of rational decision and game theory. 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 marginal cost of production. at which point they stop further pointless price reduction. 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. Consequently the duopolists will make no excess economic proﬁt. Therefore it is necessary to build a theory of bounded rationality. and as long as we do not have a good substitute. Firms decide what price to set. a result analogous to the outcome found in perfectly competitive markets. namely pj = pi − ε. Firm j will likely follow suit. 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). Eventually. we distinguish between two cases. have no capacity constraint and can supply whatever quantity is required.86 Chapter 3 Box 3. where ε (> 0) is small. and so on and on. As the products offered by the rival ﬁrms are not distinguishable (they are perfect substitutes).2. The best response for ﬁrm j is to set a price pj just lower than its rival’s. We must be very skeptical.3 (continued) theory. this task is far from being completed. 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. customers have an incentive to purchase from the ﬁrm with the lowest price. to analyze strategic interactions based on the Bertrand model of price competition.1 Bertrand Price Competition Here. Suppose that ﬁrm i sets a price pi. human behavior is not rational in this sense but it is not irrational.

and parameter s ∈ [ 0. the market is thus likely to yield a monopoly. here each ﬁrm can disregard the rival’s price decision since it has no impact on its own. according to the standard Bertrand model of price competition. A ﬁrm typically incurs a ﬁxed cost upon entry.1′) reducing to the linear demand in (3. 7. where qi is the quantity produced by ﬁrm i. pi) is given by pi (qi .7 Products are unrelated if s = 0. Porter’s business strategies are essentially meant to circumvent such undesirable outcome. 1) represents the substitution effect between the two differentiated product offerings. perfect competition). however small the ﬁxed entry cost. This is the differentiation strategy proposed by Porter (1980). Economists can justify this strategy thanks to the differentiated Bertrand model.Market Structure Games: Static 87 Thus. The substitution effect captures the price change of one product for a unit change in the supply of its substitute product.1) faced by a monopolist. b > 0. the other ﬁrm will not invest. allowing for ﬁrms to earn excess proﬁts. We formulate the demand function somewhat differently than Gibbons (1992). produce a differentiated product while facing symmetric (linear) cost6 Ci (qi ) = cqi. q j ) = a − b ( qi + sq j ). Following Gibbons (1992). ﬁrms compete over dimensions other than price.. 6. The (modiﬁed) linear inverse market demand function for each differentiated good (allowing to charge a different price by ﬁrm i. If s approaches 1. One may wonder why ﬁrms bother to enter the market if they make no economic proﬁt once they enter. This outcome has been coined the “Bertrand paradox” in industrial organization since it challenges common business sense. 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. To achieve this.1′) where a > c ≥ 0. i and j. . with demand function (3. If a ﬁrm already operates. with constant marginal cost of production c. suppose that two ﬁrms. Differentiated Bertrand Model One noted business strategy is for ﬁrms to differentiate their product offerings. Two ﬁrms competing in price over an undifferentiated product sufﬁce to create a situation involving no excess economic proﬁt for any ﬁrm and the highest possible consumer surplus. This standard Bertrand model rests on strong assumptions that can be relaxed but derives its appeal by illustrating cutthroat competition among a few ﬁrms. (3.e.

by inverting (3. ∂pi 2 b (1 − s 2 ) . ∀pi ≥ 0. pj ) = a (1 − s ) − pi + spj . whereby the characteristics of a differentiated product appeal to a certain customer base with particular taste.9) 8. just individual preferences. In this case there are no commonly agreed best features for the product.8) 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: 1− s ⎧ B B B ⎪ p = pi = pj = c + 2 − s (a − c ) ( > c ) .1′). equation (3. pj ) = b (1 − s 2 ) ∂pi Firm i’s best-reply or reaction function is piB ( pj ) = a (1 − s ) + c s + pj. pB ) . pB ) are such that each ﬁrm’s price choice is the best response j to the other’s optimal price decision (see related box 3. In the continuous case the ﬁrst-order proﬁt maximizing condition for a Nash equilibrium is a(1 − s) − 2 pi + spj + c ∂π i = 0. pj ) ≥ π j ( pi .7) Firms select their prices pi . as can be seen from ∂ 2π i 2 =− < 0.1′) then reduces to the traditional linear demand faced by duopolists in the homogeneous-product case. pj ) . ⎪ ⎨ a−c ⎪ q B = qiB = q B = . This category of differentiated products (Ferrari vs. Products are not qualitatively ranked on a scale where customers desire the top-quality products but cannot afford them due to budget constraints. Horizontal differentiation refers to situations where customers have taste preferences among a pool of products with comparable quality standards. a standard car) relates to vertical differentiation.4): ⎧ π i ( piB . j b(1 + s)(2 − s) ⎪ ⎩ (3. pB ) ≥ π i ( pi . ( pi . Note that here products are horizontally differentiated. j j ⎨ B B B ⎩π j ( pi .8 In the case above. The Nash equilibrium prices under Bertrand competition ( piB . ∀pj ≥ 0. pj (≥ 0 ) simultaneously not knowing the rival’s price decision. 9. 2 2 (3.88 Chapter 3 products are undifferentiated or perfect substitutes. b (1 − s 2 ) (3. The resulting proﬁt function is (twice) differentiable and concave. one gets the demand function9 qi ( pi .

c To obtain stronger predictions about a game outcome. a −i represents the strategies played by all other players except i . 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. A Nash equilibrium is a set of decisions—strategy proﬁle—such that no player can do better by unilaterally changing their decision. i = 1. a − i ). A strategy proﬁle (a i*. one may impose assumptions beyond common knowledge of rationality. n. Reagan’s foreign policy toward the Soviet Union might be interpreted in this light. . By employing mixed strategies. Depending on the game speciﬁcation.a A solution concept is a methodology for predicting players’ behavior intended to determine the decisions (actions or strategies) that maximize each player’s payoff. Equivalently. namely convex combinations of pure strategies. We are being vague on the optimality notion. a i ∈Ai We can interpret the above in terms of best-reply or reaction functions.4 Solution concepts and Nash equilibrium Once model assumptions are laid out. in multiplayer decision settings “optimality” is not a well-deﬁned concept. . . By iteration. pure strategies. Let R(a − i ) denote ﬁrm i ’s best response to her rivals’ strategies a −i . The rationality assumption imposes an important limitation in situations where pride and irrationality play a role. Based on the weak assumption that payoffs and players’ rationality are common knowledge.. We consider. a − i*). Let a i (∈ Ai ) denote ﬁrm i ’s pure strategic action (and Ai its strategy set).a − i*) forms a Nash equilibrium if. n. here.Box 3.d Here equilibrium strategy proﬁles must form a Nash equilibrium. the solution concept used may be more stringent as discussed in chapter 4. By convention. c. However. a − i*) ∀a i ∈ Ai . Readers should refer to the readings suggested at the end of this chapter for a more formal discussion of game theory. In Nash equilibrium each player formulates her best response to the other players’ optimal decision. . a − i*) ≥ p i (a i . i = 1. …. 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. An equivalent deﬁnition exists for mixed strategies. it predicts that a player will not play a strategy that is not a best response to some beliefs about her opponents’ strategies. one can solve a game-theoretic model using a so-called solution concept. We do not intend here to provide a mathematical account of game theory. When ﬁrm i chooses strategy a i and her rivals a −i . Consider n players. each ﬁrm i. building up a reputation as being irrational or unpredictable can also make strategic sense: One can turn such reputation to its advantage by altering opponents’ beliefs. b. By design. Rationalizability. a. d. introduced by Bernheim (1984) and Pearce (1984). While in problems involving a single decision maker optimality has an unambiguous meaning. is faced with the following proﬁtoptimization problem: max p (a i . such as the order of the play or the available information. namely each player is aware of the rationality of the other players and acts accordingly. one ensures that (at least) one Nash equilibrium exists (Nash 1950b). Nash’s (1950b) equilibrium concept is usually preferred for being more restrictive. Its understanding is closely related to the solution concept chosen. a i * ∈ R(a − i*). that is. e. we can narrow down the set of strategies that could be reasonably played (so-called rationalizable strategies). is considered a fundamental solution concept. for any player i.e p i (a i*.b The rationality of each player is typically accepted as a common knowledge. ﬁrm i receives payoff p i (a i .

departing from the undesirable Bertrand paradox where no ﬁrm makes excess proﬁts.5 + 1 p j. 10. a result equivalent to the outcome obtained in the standard Bertrand price competition case. strictly higher than the marginal cost of production. q B = 14. in differentiated Bertrand–Nash equilibrium ﬁrms set a price. In (differentiated) Bertrand price competition. From equation (3. ﬁrm i’s reaction function is piB ( pj ) = 7.2 Differentiated Price Competition Assume the linear market demand function of equation (3. Moreover.7) the demand functions are given by ⎧ qi ( pi . prices for both differentiated products are equal ( piB = pB). From (3. pB.9) and (3. are pB = 10.10). equilibrium prices. This contrasts to the previous standard Bertrand case involving perfect substitutes (homogeneous products). 4 Firm j’s reaction function is obtained symmetrically. ﬁrms have an incentive to differentiate their product offerings to soften price competition. b = 2 3. Finally.9) ﬁrm proﬁts are π B = π iB = π B = j 1− s ⎛ a − c⎞ ⎜ ⎟ b (1 + s ) ⎝ 2 − s ⎠ 2 (> 0) .4. ⎨ ⎩q j ( pi . and proﬁts. the excess proﬁts for the duopolists become zero. In Nash equilibrium. reaction functions are upward-sloping.1′) with parameters a = 24. obtained from equations (3. respectively. This situation is illustrated in ﬁgure 3. Clearly. (3. From (3.90 Chapter 3 Thus. the equilibrium price decreases with the degree of substitutability s (∂pB ∂s = − (a − c ) ( 2 − s ) < 0). this results j 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. earning excess proﬁts. pj ) = 24 − 2 pi + pj .10) Thus. This is in line with most marketing and strategic management practices. quantities.10 Example 3. . and π B = 98. pp. pj ) = 24 − 2 pj + pi . s = 1 2 and constant variable production cost c = 3.8). for products that are close to being perfect substitutes (s → 1). refer to Tirole (1988. c. in equilibrium. For an economic discussion of the advisable degree of differentiation. 286–87).

s = 1 2 .4 Upward-sloping reaction functions in differentiated Bertrand competition a = 24. . such as heterogeneous tastes among customers. Cournot 11. b = 2 3. The output is brought to the market and a “market auctioneer” sets the market-clearing price. In Cournot quantity competition.11 Although Bertrand price competition seems more descriptive of certain real-world situations in the short run. In (differentiated) Bertrand price competition. producers simultaneously and independently make production quantity decisions. producers simultaneously and independently set prices and there is no need for a price-setting party. and c = 3 The differentiated Bertrand model above is fairly descriptive of many real-world rivalry situations in the short term. The main alternative to price competition is quantity competition represented by the Cournot model.Market Structure Games: Static 91 Price by firm j ( pj ) 20 15 Firm i’s reaction function piB(pj ) 10 E Firm j’s reaction function pjB( pi) 5 0 0 5 10 15 20 Price by firm i (pi) Figure 3. This model underscores that competition is not just about price but that additional parameters may come into play. Kreps and Scheinkman (1983) suggest that the implicit assumption of a “market auctioneer” in the Cournot model is not necessary.

Most of the models discussed in subsequent chapters deal with long-horizon investment problems and therefore build upon the Cournot quantity setting. driven by the total quantity supplied in the market Q ( = qi + q j ). while price is a short-run.1) with a > c and b > 0.14 Equivalently. and once these capacity choices become common information. 14. ﬁrms set prices as in Bertrand price competition under capacity constraints. Firms’ strategies consist in selecting an output that maximizes proﬁt. so ﬁrms cannot inﬂuence the market-clearing price-setting process in the short-run. The price-setting process is driven by the capacity or quantity chosen by the active ﬁrms in the industry. For this reason capacity (quantity) is often thought of as a long-term strategic variable.2 Cournot Quantity Competition Cournot’s (1838) classic quantity competition model characterizes industries in which ﬁrms set production schedules in advance and cannot alter them in the short run. tactical action variable.” Investment in new capacity units must be costly for this result to hold. The ex ante chosen production schedules are hard to reverse.92 Chapter 3 outcomes may also result from a two-stage competition game where duopolists ﬁrst make a capacity choice.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. 13. 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. 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. We discuss next two variants of the Cournot duopoly model. . A comparison of these two models helps illustrate why ﬁrms have an incentive to be cost leader in quantity competition involving a homogeneous good. one can assume that they maximize net 12. The appropriate solution concept is the “simple” Nash equilibrium.13 Firms produce a homogeneous good.2. The linear (inverse) demand function. (3. 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 “efﬁcientrationing rule. is given by p(Q) = a − bQ. 3. and then relax the symmetric cost assumption. constant unit variable production cost c (≥ 0 ). Cost Symmetry Consider two identical ﬁrms (i and j) that face the same. We consider ﬁrst the situation where ﬁrms have symmetric costs.

as in monopoly. The Nash equilibrium outputs ( qiC .13) into ﬁrm j j’s (and reciprocally).e.Market Structure Games: Static 93 present value (NPV) where value is given by the perpetuity of proﬁts (π k . or qiC (q j ) = 1⎛a−c − qj ⎞. (3. . the sole active ﬁrm i will supply in equilibrium QM = (a − c ) 2b. where k is the risk-adjusted discount rate). ⋅) is concave and twice continuously differentiable in qi. Taking the rival’s quantity choice as given. however. the Cournot–Nash equilibrium output by each ﬁrm is 15. as depicted in ﬁgure 3. If one of the ﬁrms does not produce (i. q j ).13) (3. The proﬁt function π i (⋅. decreasing in rival’s capacity-setting action). qC ) are such that each ﬁrm’s quantity choice is the best j response to the other’s optimal quantity decision. the ﬁrst-order condition for ﬁrm i’s proﬁt maximization (∂π i ∂qi = 0) yields a − 2bqiC − bq j = c. ⎜ ⎟⎟ ⎠⎠ 2⎝ b 2⎝ b Since symmetric ﬁrms presumably produce the same output.13) are downward sloping (i. In quantity competition.e.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. The Nash equilibrium outputs can be determined by solving the system of the two equations (3. the rival inﬂuences it as well. The equilibrium is found at the intersection (point E) of the two reaction functions: qiC ≡ qiC (qC ( qiC )) = j 1⎛a−c 1⎛a−c − ⎜ − qiC ⎞ ⎞ .15 Firm i’s proﬁt. if q j = 0).. resulting from the action proﬁle ( qi ..12) Firm j’s ﬁrst-order proﬁt maximizing condition is obtained symmetrically. 16. is given by16 p i ( qi . q j ) = [ p (Q) − c ] qi. We assume that ﬁrms settle in steady state and that there is no (expected) growth for the underlying proﬁt ﬂow π . ⎜ ⎟ ⎠ 2⎝ b (3.12) (for ﬁrms i and j) with two unknowns (qiC and qC) or by substituting ﬁrm i’s reaction function from (3.5. the ﬁrm’s own output choice is not the only factor inﬂuencing the pricesetting process. the reaction functions of duopolists given by (3. This time.

14) The total industry output then is QC = qiC + qC = j 2 ⎛ a − c⎞ ⎜ ⎟. First. ﬁrms collectively produce more than does a monopolist: QC ≥ QM ⎛ 2 a − c ≥ 1 a − c⎞ . the market-clearing price in Cournot duopoly is lower than in monopoly. ⎜ ⎟ ⎝3 b 2 b ⎠ Consequently. ( a−c ) / 2b) (qiC . 0 ) Quantity supplied by firm i (qi) Figure 3.15) Two observations are of particular interest. (a−c )/ b) Firm i’s reaction function ( 0. qjC ) E Firm j’s reaction function (( a−c ) / 2b. 0 ) (( a−c )/ b. 3b (3. given the downward-sloping demand (∂p ∂Q < 0).5 Downward-sloping reaction functions in (symmetric) Cournot quantity competition qC = qiC = qC = j a−c . 3⎝ b ⎠ (3. . 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.94 Chapter 3 Quantity supplied by firm j (qj) ( 0.

Substituting half the monopoly quantity given in (3.Market Structure Games: Static 95 One can readily deduce the equilibrium price and proﬁt. for example. Cournot duopoly is better than monopoly as the total quantity supplied is higher.2) into ﬁrm i’s reaction function in (3. In this case the symmetric duopolists would select the optimal cumulated quantity. 18.17) Due to the lower individual output and lower market-clearing price. Since π M 2 ≥ π iC. a Cournot duopolist earns lower proﬁts than a monopolist (π iC ≤ π iM ). and the proﬁt or producer surplus lower. The equilibrium market-clearing price in Cournot duopoly. is pC = c + a−c 3 (> c ) . creating an incentive to deviate from the cartel agreement: πD = 9 πM ⎛ πM ⎞ ⎜> ⎟.18 Firms would increase their output until the Cournot–Nash equilibrium output ((a − c ) 3b . the best reply obtains qiC (Q M 2 ) = 3 (a − c ) 8b . Q. produce half of it and earn half of the monopoly rent. (3.g. however. This strategy proﬁle is not stable. a collusive agreement seems preferable at ﬁrst sight. From a social-welfare viewpoint. QM. choosing to maximize their joint proﬁt instead of their individual proﬁts. (a − c ) 3b) is reached. The contract ruling the cartel is not self-enforceable because each ﬁrm has an incentive to cheat. The presence of material ﬁxed costs might substantially alter this result.16) The equilibrium proﬁt for ﬁrm i ( j) is π C = π iC = π C = j (a − c )2 9b . consider ﬁrst the optimal reaction of the deviating party (e. since a natural monopoly might turn out to be socially optimal.17 What would happen if the duopolists could collaborate to improve their joint proﬁts? Suppose that ﬁrms could (tacitly) collude. The optimal total industry output selected by the cartel would be the monopoly quantity. 8 2 ⎝ 2 ⎠ . pC. obtained by substituting the equilibrium quantity of equation (3. the equilibrium marketclearing price lower. To demonstrate the instability of the collaborative outcome.15) into demand equation (3..1). (3. This efﬁciency result is based on the premise that ﬁxed costs are immaterial. Collusion is not likely 17. This is the only stable equilibrium in this simultaneous quantity game. Each ﬁrm could. The proﬁt for the deviating party is higher than half the monopoly proﬁt. The resulting market-clearing price is p = c + 3 (a − c ) 8 . increasing the quantity it supplies to beneﬁt from a higher price. ﬁrm i).13). and then divide up the higher joint-proﬁt pie.

This provides an economic rationale for the cost leadership strategy proposed by Porter (1980). does matter. 3b (3. The formulas for ﬁrm j are analogous. ⎜ ⎟ ⎠ 2⎝ b (3. From the ﬁrst-order proﬁt-maximizing condition.18) Substituting the reaction functions (into each other). As the ﬁrm’s proﬁt decreases in its 19.19 Cost Asymmetry Suppose now that the two ﬁrms have different marginal costs ci ≠ c j. ﬁrm i produces the (homogeneous) good more efﬁciently than ﬁrm j. ﬁrm i’s quantity choice ultimately depends on its own cost ci as well as on its rival’s cost c j. We discuss later how (tacit) collusion can sustain itself as stable industry equilibrium in certain repeated games.19) 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). ﬁrm i’s reaction function is qiC (q j ) = 1 ⎛ a − ci − qj ⎞ . . with ﬁrm i’s cost function given by Ci (qi ) = ci qi .96 Chapter 3 to occur since each ﬁrm has an incentive to deviate. c j − ci (≠ 0 ). This ultimately beneﬁts consumers who can purchase the product at a lower price. being pulled as in a prisoner’s dilemma to the inferior Nash equilibrium outcome. The cost differential. Assuming the same (inverse) demand function as before. Due to strategic interaction. (3. The cost leader (here ﬁrm i) earns higher proﬁts in the market than its less efﬁcient rival. 3 (3.20) Firm i’s resulting equilibrium proﬁt is π = C i (a − 2ci + c j )2 9b . 20.21) Useful insights can be deduced from the latter expression. ﬁrm i’s proﬁt function is p i (Q) = ( p (Q) − ci ) qi. ci ≥ 0. enjoying a cost-leader advantage. meaning one can obtain ﬁrm j’s quantity by substituting j for i and i for j in the expression above. ﬁrm i’s equilibrium quantity is20 qiC = a − 2ci + c j . If ci < c j . The resulting industry equilibrium price is pC = a + ci + c j . Collusion will thus not occur in such a static one-shot duopoly game.

6. 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. An alternative. This distinction between these two kinds of reactions is at the core of the notion of strategic substitutes versus strategic complements introduced by Bulow. the cost leader would further beneﬁt from an improved cost position.Market Structure Games: Static 97 own cost (∂π iC ∂ci < 0). its rival will do the opposite by reducing it. a contrarian reaction. ﬁrm i’s reaction function is obtained in (3.13) as qiC (q j ) = a−c 1 − qj. The notion of commitment—analyzed extensively in industrial organization—rests on these types of reaction functions. for example. by limiting its access to scarce resources it needs. if a Cournot duopolist increases its output. Assuming a linear (inverse) demand function as in equation (3. reaction functions may be downward sloping (as in the Cournot quantity competition model) or upward sloping (as in differentiated Bertrand price competition). In the (differentiated) Bertrand model. Geanakoplos. competitive reactions are similar or reciprocating. In case of strategic complements. This distinction is informative on whether a ﬁrm reacts to its rivals’ strategic actions in a reciprocating or in a contrarian way. a particular case of interest is the reaction function in Cournot quantity competition.6a. 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. We assume that the ﬁrms’ reaction functions are characterized by slopes of the same sign.1) and a linear cost function. When reaction functions are upward sloping.6b.3 Strategic Substitutes versus Complements As noted earlier. Ci (qi ) = cqi with c constant. 3. . meaning both are downward sloping or both upward sloping. Cournot quantity competition is a game where actions are strategic substitutes. the ﬁrms’ actions are strategic complements or reciprocal. we deal with strategic complements 21.2. The distinction again relates to the shape (slope) of the reaction function. as in ﬁgure 3. indirect tactic to achieve cost leadership is to increase the rival’s cost (∂π iC ∂c j > 0). such as price or quantity. and Klemperer (1985).21 The general form of the equilibrium in case of strategic substitutes is depicted in ﬁgure 3. When reaction functions are downward sloping. the actions are strategic substitutes. In ﬁgure 3. 2b 2 Since ∂qiC ∂q j < 0.

a reciprocating reaction. If the inverse demand function is linear as in equation (3. 2 2 Since ∂piB ∂pj ≥ 0. its rival will follow suit and decrease its price as well. when a Bertrand duopolist decreases its price.1′). such reciprocating reactions can lead . namely piB ( pj ) = a (1 − s ) + c s + pj .98 Chapter 3 aj R i (a j) a j* E R j (a i ) a i* ai (a) aj R i (a j) a j* E' R j (a i ) a i* ai (b) Figure 3. (b) strategic complements or reciprocating reactions ( ∂Ri ∂α j > 0 ) since a reduction in price by a ﬁrm is an optimal response to its competitor’s price cut.6 Downward and upward-sloping reaction functions compared: strategic substitutes versus complements (a) Strategic substitutes or contrarian reactions ( ∂Ri ∂α j < 0 ). For perfect substitutes (s → 1). ﬁrm i’s reaction function is given by (3.8) above.

Equilibrium outcomes in case of strategic substitutes vs. complements are illustrated as outcomes E and E ′ in ﬁgure 3. the competition between Boeing and Airbus in the aircraft manufacturing industry). A case in point is the automotive sector. beneﬁting from a second-mover advantage. For instance. and GM. By contrast. Porsche. Although duopoly situations exist (e. .g. when reaction functions are downward sloping (involving strategic substitutes or contrarian reactions). in case of strategic complements or reciprocating actions. Toyota. there is often more than two players operating in a given industry. The basic quantity duopoly setup analyzed by Cournot (1838) may be reﬁned to consider more than two competitors. Whether actions are strategic substitutes or complements can greatly affect the optimal decisionmaking in such settings.. 3. Subsequently we discuss the simpler case of oligopoly under cost symmetry (as a special case).6.3 Oligopoly and Perfect Quantity Competition In the previous sections we analyzed industry structure where only two ﬁrms are incumbent. the Stackelberg follower is better off. BMW. Ford. the Cournot oligopoly outcome tends toward the perfect competition benchmark. We conﬁrm that as the number of competitors substantially increases.Market Structure Games: Static 99 to the Bertrand paradox. Following Gal-Or (1985). 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. The slope of the reaction function matters. however. This can lead. under price competition no one has an incentive to set its price ﬁrst if the follower can undercut it later. acting as a Stackelberg leader and enjoying a ﬁrst-mover advantage. each ﬁrm has an incentive to take the lead. where ﬁrms end up waging a ﬁerce price war and make zero economic proﬁts (as in perfect competition). 22.22 This kind of strategic interaction could result in a war of attrition where ﬁrms compete to be the last to make a move. with giants such as Volkswagen (including Audi. Daimler. each ﬁrm doing its utmost not to be considered a coward (chicken game). to situations involving preemption as ﬁrms strive to seize this advantage ahead of competitors. Numerous examples of such industries abound. At ﬁrst we analyze below an oligopoly with cost asymmetry. The economic analysis of such oligopolistic structures can provide interesting insights as well. and Seat). This analysis is useful later in the analysis of option games in both discrete and continuous time.

⎜ ⎝ n + 1⎟ ⎜ b ⎟ ⎠⎝ ⎠ n (3. i = 1... n.1) and marginal production cost ci. In the general Cournot oligopoly with n asymmetric ﬁrms. ⎪ ⎪ C C C ⎪ ⎩a − 2bqn − b (Q − qn ) = cn . Summation leads to a total quantity for the entire market of n ⎞⎛a−c⎞ QC (n) = ⎛ . considering other rivals’ choices as given. . Individual ﬁrm quantities are obtained by substituting the total industry quantity of (3. . Q− i ) . To obtain the Cournot–Nash equilibrium. n. This leads to the ﬁrst-order condition: C MRi ( qiC . where Q− i stands for the quantity produced collectively by all other suppliers except ﬁrm i.23) where c ≡ ∑ j = 1 c j n is the average (variable) production cost in the industry. . Q− i ) = ci . Denote by c− i ≡ ∑ j ≠ i c j (n − 1) the average production cost for all other ﬁrms except i. .. one has to deduce the optimal production strategy proﬁle C (q1C . maximizes proﬁt C p i ( qi . . n.22) In the linear demand case. with Q = qi + Q− i . qn ) such that each ﬁrm i. we must solve the following system of n equations with n unknowns: C C ⎧ a − 2bq1 − b (QC − q1 ) = c1 . .100 Chapter 3 Assume n oligopolist ﬁrms competing in quantity over a homogeneous product. ﬁrms are ranked in cost advantage with ﬁrm 1 having the largest cost advantage or lowest cost c1. . (3.23) into each equation of the system above: . Without loss of generality. i = 1. Each ﬁrm i faces a linear demand function as in equation (3. Q− i ) − ci ] qi . ∂qi i = 1. Q− i ) = a − 2bqi − bQ− i . . . . marginal revenue is MRi (qi . Q− i ) = qiC × ∂p C C C (qi . Firm i’s proﬁt function is given by π i (qi . Q− i ) + p (qiC . ⎪ ⎪ ⎪ C C C ⎨ a − 2bqi − b (Q − qi ) = ci . .. Q− i ) = [ p (qi . .

. the proﬁt for each identical oligopolist ﬁrm is π C (n) = 1 (n + 1)2 ( a − c )2 b .29) 23.. . . .25) Regardless of how many ﬁrms operate in the market.26). n + 1⎝ b ⎠ i = 1.23 The resulting proﬁt for ﬁrm i is p iC ( n) = 1 (n + 1)2 (a − nci + (n − 1) c− i )2 b . si . (3.25). (3. Let si ≡ qiC QC denote ﬁrm i’s (equilibrium) market share and recall the price elasticity of demand e p in equation (3. remains positive. The equilibrium quantity. i = 1.Market Structure Games: Static 101 qiC (n) = 1 ⎛ a − nci + ( n − 1) c− i ⎞ ⎜ ⎟.26) It can be seen that proﬁts are increasing in the cost advantage. resulting from equation (3. . and ε p . is given by pC (n) = c + a−c n+1 ( > c ). . the equilibrium price margin.24 The special case of cost symmetry (with ci = c) has clear-cut insights.22) yields ﬁrm i’s Lerner index: Li ≡ ( pC − ci ) pC = − si ε p . . . and the price elasticity of demand. 24. the most costadvantaged ﬁrm (absolute cost leader) always enjoys a price strictly higher than its variable cost c1.27) The equilibrium price. n. n. . (3.28) The expression above suggests that even for a large oligopoly (n large). n . . (3.. From (3. i = 1. Moreover. ⎠ n + 1⎝ b i = 1.23) as pC ( n) = c + a−c n+1 (> c1 ). This holds as long as the demand intercept exceeds the average unit cost in the industry. . is the same for each symmetric ﬁrm: qC ( n) = 1 ⎛ a − c⎞ ⎜ ⎟. n . (3. a ﬁrm’s proﬁtability depends on its production cost. .24) The equilibrium price obtains from (3. obtained from equation (3.1) and (3. This measure proxies for ﬁrm i’s proﬁt margin and depends on ci . . The ﬁrst-order condition in (3.5). its market share..24). (3. . pC − c.

This assumption might not hold in certain industry settings characterized by information asymmetry.7 depicts this situation. For example. ﬁrm j no longer maximizes its deterministic proﬁt function but instead maximizes its expected proﬁt function.18) in the Cournot game: qiC ( q j .. the market-clearing price approaches marginal production cost. the outcome of its own R&D efforts). as well as its rival’s cost (e. we obtain the symmetric Cournot duopoly results of equations (3.30) 25. and the economic proﬁt of an individual ﬁrm approaches zero. Subscript L stands for low. ⎜ ⎟ ⎝ b ⎠ 2 (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. cL ) = 1 ⎛ a − cL − qj ⎞ . 3. Suppose also that ﬁrm i can perfectly observe what “nature” decided concerning its own cost (e. ﬁrm j has probabilistic beliefs about its rival’s type (cost).17). c. ﬁrm i may have invested in a new innovative process that could alter its cost structure if its R&D efforts succeed (with probability P). ﬁrm i’s reaction function would be similar to equation (3.g.14) to (3.. The rival’s cost can be either low (cL) with probability P or high (cH ) with probability 1 − P (cL < cH). The presence of ﬁxed production or investment costs may affect the number of ﬁrms operating in the sector. Suppose that ﬁrm j does not know for sure ﬁrm i’s cost but that “nature” will reveal it with certain probability.25 That is. the rival uses the prevalent production technology). Figure 3.and H for high-cost type. Firm j knows that if the low-cost outcome (cL) occurs (with probability P). As the number of active ﬁrms is greatly increased (n → ∞). In selecting its optimal quantity. In duopoly (n = 2).4) obtain. the previous monopoly results in equations (3. the quantity produced by any one ﬁrm becomes negligible. the two ﬁrms choose simultaneously their capacity or output. Once ﬁrm i knows its own cost.2) to (3. These outcomes conﬁrm the well-known results in perfect competition: ﬁrms make no excess proﬁts and set prices at marginal cost. Firm j is aware of the information asymmetry in favor of ﬁrm i.g. taking into account the uncertainty it faces concerning ﬁrm i’s type or cost. .102 Chapter 3 In the special case when there is only one ﬁrm operating (n = 1).

⎜ ⎟ ⎠ 2⎝ b (3. . considering its rival’s optimal decision as given. However. It is given by26 π j ( q j .31) Firm j’s expected proﬁt reﬂects its belief (probabilistic distribution) about ﬁrm i’s possible production costs. 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). in case the high-cost outcome (cH ) occurs (with probability 1 − P).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. qH ) . qL . ﬁrm i’s reaction function is instead qiC ( q j . cH ) = 1 ⎛ a − cH − qj ⎞ . qL . qH )] = P × π j ( q j . Firm j’s (Bayesian Nash) equilibrium strategy consists in selecting its output q j so as to maximize its above expected proﬁt in (3. qH ) ≡ E [π j (qi .32) where qL and qH stand for ﬁrm i’s quantity choice as a function of its low or high marginal cost. qL ) + (1 − P ) × π j ( q j . From the ﬁrst-order proﬁt optimization condition (and substitution of equations 26.32). (3. The ﬁrst-order condition is both necessary and sufﬁcient for a maximum to obtain.Market Structure Games: Static 103 Nature cL (low cost) cH (high cost) Firm i qi (cL ) = qL Firm i qi (cH) = qH Firm j Firm j qj qj Figure 3.

cH ) = qL + P (cH − cL ) ⎩ 6b C (≤ qL ) . Firm i’s equilibrium quantities. that is. . except that here we utilize ﬁrm i’s expected cost (ci).34) C where qL = ( a − 2cL + c j ) 3b and qC = ( a − 2cH + c j ) 3b are the asymmetH ric complete-information Cournot quantities for ﬁrm i depending on whether it has low or high cost.31). are obtained by substituting ﬁrm j’s equilibrium quantity from (3. depending on nature’s move.34).104 Chapter 3 (3. the total quantity supplied in the marketplace. 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 .31) in the expression above.30) and (3. is higher under asymmetric information than under complete information. ⎜ ⎠ 2⎝ b Equation (3. Q (cL ). with qi ≡ PqL + (1 − P ) qH . H (3. But ﬁrm j cannot.33) and (3.33) where ci = PcL + (1 − P ) cH is the mean (expected) value of ﬁrm i’s cost. This gives ⎧ q * = qC q *. The difference arises from the fact that ﬁrm j has an informational disadvantage and that ﬁrm i knows it. even though ﬁrm i has the same information as before. (3. it knows both its cost and its rival’s. qC (qi ) = j 1 ⎛ a − cj ⎞ − qi ⎟ . From the ﬁrst-order condition. ( ≥ qC ) .33) obtains from substituting ﬁrm i’s reaction functions (3. Indeed.31) into ﬁrm j’s reaction function) ﬁrm j’s equilibrium quantity is27 qj * ≡ a − 2c j + ci . Firm i faces no information asymmetry and may adapt the quantity it produces to its actual production cost realization (cL or cH ). 3b (3.30) and (3. The equilibrium quantities for ﬁrm i are not the same as the ones derived for the standard Cournot model (under complete information).33) into the reaction functions (3.30) and (3. we have Q (cL ) = q j * + qL* = QC (cL ) + 1− P ( c H − cL ) 6b ( ≥ QC (cL )). c = qC − 1 − P c − c ( H L) i ( j L) L ⎪ L 6b ⎨ C ⎪qH * = qiC ( q j *.35) 27. In the favorable case where ﬁrm i has lower cost cL. from equations (3. This result is similar to the equilibrium outcome in Cournot quantity competition under complete information.

20). believes it has a lower average cost. 29.33) and (3. The market-clearing price is higher.Market Structure Games: Static 105 C where QC (cL ) = qC + qL = ( 2a − c j − cL ) 3b is the total industry output in j the complete-information case obtained by summing the quantities for ﬁrms i and j in equation (3.28 Due to the combined effect of lower price and lower quantity for ﬁrm i.34): Q (cH ) = q j * + qH * = QC (cH ) − P (cH − cL ) 6 (≤ QC (cH )) . Firm i would have been better off if its rival had known its cost.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 realization. and the informed party makes larger excess proﬁt. is obtained H from equation (3. π C = (a − 2cH + c j ) 9b. ﬁrm i will produce less as a best reply to ﬁrm j’s oversupply. Firm i’s equilibrium proﬁt is p L = p i ( cL ) = 1 ⎡ ⎛ a + c j − 2 cL ⎞ 1 − P (cH − cL )⎤ ⎜ ⎟− ⎥ ⎠ 3 6 b ⎢⎝ ⎣ ⎦ 2 C (≤ p L ) . the market-clearing price is lower in the asymmetricinformation case since Q(cL ) ≥ QC (cL ). the effects are reversed. Firm i’s equilibrium proﬁt is obtained from the above and equation (3. . where QC (cH ) = ( 2a − c j − cH ) 3b is the total industry output in the complete-information case.21). Since rivals’ actions are strategic substitutes or contrarian. π L = (a + c j − 2cL ) 9b . Given the linear demand function of equation (3. As the inverse demand function is downward sloping. ﬁrm j. In this case total industry output is obtained from equations (3. 2 C The equilibrium proﬁt in the complete-information Cournot case. one obtains the market-clearing price in the asymmetric-information case: C p (Q (cL )) = pL − 1− P ( c H − cL ) 6 C (≤ pL ).35).21). The equilibrium price in the asymmetric-information case is C p (Q (cL )) = pH + P ( c H − cL ) 6 C (≥ pH ) C with pL = (a + c j + cH ) 3 .1) and the total industry output in (3.19). In the opposite (unfavorable) case where ﬁrm i turns out to have a high production cost (cH ). Firm i produces more than under complete information since its rival. C where pL = ( a + c j + cL ) 3 from equation (3.34) as π H = π i ( cH ) = 1 ⎡ a − 2cH + c j P ⎤ + ( c H − cL ) ⎥ ⎢ 3 6 b⎣ ⎦ 2 (≥ π C ) H 2 where the equilibrium proﬁt of the high-cost ﬁrm. 30. comes from (3. the informed party (i) is worse off as a result of the rival’s information disadvantage in the favorable cost situation (cL).30 This underscores that an informed 28.

106 Chapter 3 Table 3. s is the substitutability parameter in p (Q) = a − b ( qi + sq j ) . c = ∑ n=1 c j n and c− i = ∑ j ≠i c j (n − 1).2 Equilibrium outcomes under various industry structures A: Cost symmetry Industry structure Monopoly Cournot duopoly Stackelberg leadera Stackelberg followera Cournot oligopoly ( n players) Bertrand duopoly (differentiated) Firm i ’s quantity ( qi*) 1 ⎛ a − c⎞ ⎜ ⎟ 2⎝ b ⎠ 1 ⎛ a − c⎞ ⎜ ⎟ 3⎝ b ⎠ 1 ⎛ a − c⎞ ⎜ ⎟ 2⎝ b ⎠ 1 ⎛ a − c⎞ ⎜ ⎟ 4⎝ b ⎠ 1 ⎛ a − c⎞ ⎜ ⎟ n + 1⎝ b ⎠ ⎜ ⎟ (1 + s ) (2 − s) ⎝ b ⎠ 1 ⎛ a − c⎞ Industry quantity (Q*) 1 ⎛ a − c⎞ ⎜ ⎟ 2⎝ b ⎠ 2 ⎛ a − c⎞ ⎜ ⎟ 3⎝ b ⎠ 3 ⎛ a − c⎞ ⎜ ⎟ 4⎝ b ⎠ n ⎛ a − c⎞ ⎜ ⎟ n + 1⎝ b ⎠ ⎜ ⎟ (1 + s ) (2 − s) ⎝ b ⎠ 2 ⎛ a − c⎞ Firm i’s proﬁt 1 (a − c ) 4 b 2 1 (a − c ) 9 b 2 1 (a − c ) 4 b 2 1 (a − c ) 16 b 2 1 ⎛ a − c⎞ ⎜ ⎟ b ⎝ n + 1⎠ 2 ⎛ ⎞ ( a − c )2 1 − s2 ⎜ ⎟ b ⎝ (1 + s )2 ( 2 − s )2 ⎠ B: Cost asymmetry Industry structure Monopoly Cournot duopoly Stackelberg leadera Stackelberg followera Cournot oligopoly ( n players) Firm i ’s quantity ( qi*) 1 ⎛ a − ci ⎞ ⎜ ⎟ 2⎝ b ⎠ 1 ⎛ a − 2ci + c j ⎞ ⎜ ⎟ ⎠ 3⎝ b 1 ⎛ a − 2ci + c j ⎞ ⎜ ⎟ ⎠ 2⎝ b 1 ⎛ a − 2ci + c j ⎞ ⎜ ⎟ ⎠ 4⎝ b 1 a − nci + (n − 1)c− i n+1 b Industry quantity (Q*) 1 ⎛ a − ci ⎞ ⎜ ⎟ 2⎝ b ⎠ 2a − ( ci + c j ) 3b 3 ⎛ a − ci ⎞ ⎜ ⎟ 4⎝ b ⎠ n ⎛a−c⎞ ⎜ ⎟ n + 1⎝ b ⎠ Firm i’s proﬁt 1 (a − ci ) 4 b 2 1 (a − 2ci + c j ) b 9 2 1 (a − 2ci + c j ) b 4 2 1 (a − 2ci + c j ) b 16 2 1 ⎛ a − nci + (n − 1)c− i ⎞ ⎜ ⎟ ⎠ b⎝ n+1 2 Note: p (Q) = a − bQ with Q = qi + q j . The outcomes in case of the Stackelberg game are derived in chapter 4. . j a. the cost function is Ci (qi ) = cqi (symmetry) or Ci (qi ) = ci qi (asymmetry).

concise manual on noncooperative game theory. panels A and B. a competitive stance such as commitment or collaboration may be both value-enhancing for the individual ﬁrms and sustainable as industry equilibrium. The next chapter extends this analysis to dynamic models of oligopoly. as well as potential effects of asymmetric information on the industry structure.2. respectively. Tirole (1988) is considered a key reading on industrial organization. Selected References Osborne (2004) is a good introductory textbook on game theory. and examined how such models motivate certain generic competitive strategies of being a cost leader or differentiating from one another. These tables may be useful for later reference. Averted readers might prefer the rigorous and more advanced treatment of game theory offered by Fudenberg and Tirole (1991). . (2004) provide a good overview of industrial organization issues focusing on the models’ strategic insights. for cost symmetric and cost asymmetric ﬁrms. We ﬁrst discussed the monopoly benchmark. highlighting that. Several equilibrium outcomes discussed in this chapter are summarized in table 3.Market Structure Games: Static 107 party cannot always beneﬁt from its informational advantage when strategic interactions come into play. Conclusion In this chapter we provided an overview of static market structure games. We considered several static models involving price and quantity competition. These inaccurate beliefs can sometimes prove detrimental for the better-informed ﬁrm.or under-react as a result of their informational disadvantage. We then gave applications illustrating how noncooperative game theory can provide powerful insights about real-world problems. We analyzed the impact of the number of players in a given industry on an individual ﬁrm’s proﬁt. in the long term. Tirole’s (1988) appendix provides a short. Besanko et al. Rivals form beliefs about the informed party’s cost type and may over.

Tirole. David Dranove. 1988. Cambridge: MIT Press. Game Theory.108 Chapter 3 Besanko. Jean. Mark Shanley. . New York: Oxford University Press. 1991. Martin J. and Jean Tirole. Drew. Osborne. The Theory of Industrial Organization. New York: Wiley. Fudenberg. Economics of Strategy. David. and Scott Schaefer. 2004. 2004. An Introduction to Game Theory. Cambridge: MIT Press. 3rd ed.

it has to ﬁgure out what is the potential long-term impact of its decision today. Dynamic games make explicit how today’s decisions may affect or induce distinct future strategic situations.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.4 Market Structure Games: Dynamic Approaches In chapter 3 we dealt with benchmark models of market structure from a static perspective. this behavior might induce the rival to act aggressively in the future. When assessing the beneﬁt the ﬁrm could gain from an aggressive stance. The current chapter extends this discussion to dynamic approaches. 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. One way to do this is to “look forward and reason backward” (Dixit and Nalebuff 1991). In section 4. This forms the underlying logic behind backward induction and subgame perfection used in dynamic games under perfect information. we discuss below two streams of models dealing with multiplayer decision-making in multistage settings. we discuss . This dynamic way of thinking consists in ﬁguring out what will be the likely future reaction in the marketplace to today’s ﬁrm actions. Subsequently. 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. in section 4. Based on these notions. These static games allow predicting the short-run impact of a ﬁrm’s actions on its rivals. These allow the inclusion of long-term strategy formulations and discussion of phenomena that require more dynamic thinking such as commitment and collaboration. For example. if one adopts today an aggressive stance toward a rival.2.

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

and ﬁrm j between action c and d .1. 3) (3. As is well known in the industrial organization literature. 1) Firm i b Firm j d (1. Consider the simultaneous game under complete information described in panel a of ﬁgure 4. see Dixit and Pindyck 1994). such as by transforming a simultaneous game into a sequential one.g.1 Concept of Commitment Commitment relates to strategic moves.g. Simultaneous game b. Firm i may choose between action a and b. lack of freedom can have strategic value if it can change the rival’s expectations about one’s future response. Firm i has a dominant strategy to take action a since whatever ﬁrm j decides (c or d ).Market Structure Games: Dynamic 111 c (4. The best response to ﬁrm i’s choosing action a is for ﬁrm j to choose action d (receiving 4 rather than 3). 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. 4. One approach to considering strategic moves is to look at how ﬁrms can be better off by altering the rules of the game. 4)* (1. killing one’s options). 2)* a b (4.1 Payoffs in a simultaneous versus sequential game for strategic commitment The ﬁrst element in (·. 2) a. 4) d (2. 3) a Firm j c Firm i Firm j d (2. while the second denotes the rival’s payoff. the payoff for ﬁrm i is always higher when choosing action a (4 > 3 and 2 > 1).. Given this.. Sequential game Figure 4. . 1) c (3. 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. ·) corresponds to ﬁrm i‘s payoff. turning it to one’s own advantage.1.

ﬁrm i can announce early on it will pursue strategy b.2 An alternative strategy for ﬁrm i is to move ahead of ﬁrm j. with equilibrium payoffs of 2 for ﬁrm i and 4 for ﬁrm j.112 Chapter 4 the Nash equilibrium (*) is the right-top situation. and so ﬁrm i will then receive 3. The appropriate solution concept here is the subgame perfect Nash equilibrium that rules out cheap talk and empty threats by the ﬁrst mover (e..2 summarizes four basic game theory solution concepts. This equilibrium selection relies on very weak assumptions. it must be.. if ﬁrm i chooses action b in the ﬁrst stage.g. d ) consists of strategies that are rationalizable since they survive iterated removal of never-best responses. inﬂuencing its subsequent reaction. But for such a move to have real commitment value. ﬁrm i turns a simultaneous game into a sequential one. namely common knowledge of rationality. Firm i’s equilibrium payoff in the sequential game of ﬁgure 4. Nash’s contribution to game theory and reﬁnements of the Nash equilibrium concept are discussed in box 4. it can change the rules of the game in its favor. whatever the decision of its rival (e. In this ﬁnite-horizon problem (two stages) the solution is obtained by backward induction along the game tree of ﬁgure 4. having the possibility to un-trigger the Doomsday Machine). ﬁrm j will select c (receiving 2 rather than 1). such strategic 2.g. Thus.1b is higher than the equilibrium payoff it would have received in the simultaneous game depicted in ﬁgure 4. In this way. Such strategic commitment makes ﬁrm i better off. If ﬁrm i declares upfront it will pursue action b regardless of its rival’s subsequent action. The Nash equilibrium (a. among other things. 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). we need to reﬁne the Nash equilibrium solution concept to a multistage setting. The discussion above provides an example of how a player can act strategically. Firm i is thus better off choosing action b in the ﬁrst stage. the latter’s optimal action in stage two is to choose action d since its payoff for the strategy proﬁle ( a.1.1b. Once ﬁrm i chooses action a in the ﬁrst stage and ﬁrm j observes this.1a. To be credible. d ) is higher than for (a. receiving 3 rather than 2. no wavering by the Soviet Union following a sneak attack by the United States). if ﬁrm i pursues action a. To acquire this advantage obtained in the sequential game. To deal with the resulting sequential game shown in panel b of ﬁgure 4. receiving 3 rather than 2. . To behave strategically.1. c ) as 4 > 3. Figure 4. changing the ex post subgames with its ex ante strategic decision. ﬁrm i must commit not to follow the static optimal action of the simultaneous game (which was action a). However. credible and observable.

By means of such a strategy each player can guarantee himself a minimum gain. each player tries to maximize his gain in the outcome that is most disadvantageous to him (where the worst outcome is determined by his opponent’s choice of strategy). that is. namely a consistent solution. In a zero-sum game. Nash In his dissertation Nash introduced the distinction between cooperative and noncooperative games. As early as 1928 von Neumann introduced the minimax solution for a two-person zero-sum game. it is not certain that the players’ choices of strategy will be consistent with each other.1 Development of game theory and reﬁned solution concepts As far back as the early nineteenth century. Nash proposed two interpretations of the equilibrium concept: one based on . In a Nash equilibrium all of the players’ expectations are fulﬁlled and their chosen strategies are optimal. and for a long time no overall method existed. and von Neumann had already begun to study mathematical formulations of games. beginning with Auguste Cournot in 1838. the gains of one player are equal to the losses of the other player. In the early 1900s mathematicians such as Zermelo. not solely for two-person zero-sum games. whereby a player is assumed to choose a certain “pure” strategy with some probability. The game-theoretic approach now offers a general toolbox for analyzing strategic interaction. It was not until the economist Oskar Morgenstern met the mathematician John von Neumann in 1939 that a plan originated to develop game theory so that it could be used in economic analysis. Game Theory Whereas mathematical probability theory ensued from the study of pure gambling without strategic interaction. however. The latter are characterized by strategic interaction in the sense that the players are individuals who think rationally. economists have developed methods for studying strategic interaction. that there is always a minimax solution. This solution concept later came to be called Nash equilibrium. But these methods focused on speciﬁc situations. A mixed strategy is a probability distribution of a player’s available strategies. 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. if so-called mixed strategies are introduced. John F. Of course. Borel. The most important ideas set forth by von Neumann and Morgenstern in the present context may be found in their analysis of two-person zerosum games. games such as chess and cards became the basis of game theory. von Neumann was able to show. According to the minimax solution.Market Structure Games: Dynamic 113 Box 4.

but also to avoid equilibria that are unreasonable in economic terms. An example might help to explain this concept. it fulﬁlls Selten’s requirement of subgame perfection. It was precisely these two problems that Selten and Harsanyi undertook to solve in their contributions. Since all players have complete information about each others’ strategic alternatives and preferences.1 (continued) rationality and the other on statistical populations. Moreover Nash showed that for every game with a ﬁnite number of players. The principal idea has been to use stronger conditions not only to reduce the number of possible equilibria. Nash’s second interpretation—in terms of statistical populations—is useful in so-called evolutionary games. however. This may well be a Nash equilibrium—if the competitor takes the threat seriously. which thus implies systematic . According to the rationalistic interpretation the players are perceived as rational. Selten (1965. they can also compute each others’ optimal choice of strategy for each set of expectations. If all the players expect the same Nash equilibrium. A potential competitor who realizes this will establish himself on the market and the monopolist. Imagine a monopoly market where a potential competitor is deterred by threats of a price war. and they have complete information about the structure of the game. 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. 1975) provided the foundation for a systematic endeavor. Reinhard Selten The problem of numerous noncooperative equilibria has generated a research program aimed at eliminating “uninteresting” Nash equilibria. If a game has several Nash equilibria. Another problem is that when interpreted in terms of rationality. But the threat is not credible if the monopolist faces high costs in a price war. confronted with fait accompli.114 Chapter 4 Box 4. By introducing the concept of subgame perfection. the equilibrium criterion cannot be used immediately to predict the outcome of the game. where this information is common knowledge. will not start a price war. This has brought about the development of so-called reﬁnements of the Nash equilibrium concept. Despite its usefulness there are problems associated with the concept of Nash equilibrium. 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. In addition. there exists an equilibrium in mixed strategies. This is also a Nash equilibrium. including all of the players’ preferences regarding possible outcomes. the equilibrium concept presupposes that each player has complete information about the other players’ situation. then there are no incentives for anyone to change his strategy.

including the theory of industrial organization and macroeconomic theory for economic policy. This prompted Selten to introduce a further reﬁnement. In the jargon of game theory. such as sequential equilibrium (Kreps and Wilson 1982). . Under a consistency requirement on the players’ probability distributions. usually called the “trembling-hand” equilibrium. there are situations where not even the requirement of subgame perfection is sufﬁcient. he transformed games with incomplete information into games with imperfect information.” where each type corresponds to a set of possible preferences for the player and a (subjective) probability distribution over the other players’ types. no methods had been available for analyzing games with incomplete information. Harsanyi showed that for every game with incomplete information. or public. have turned out to be very fruitful in several areas.1 (continued) formalization of the requirement that only credible threats should be taken into account. that someone’s hand will tremble. John C. This situation changed radically in 1967–68 when John Harsanyi published three articles entitled Games with Incomplete Information Played by “Bayesian” Players. completely private. The analysis assumes that each player presupposes a small probability that a mistake will occur. Nevertheless. Selten’s subgame perfection has direct signiﬁcance in discussions of credibility in economic policy. whereas they wholly or partially lack this knowledge in games with incomplete information. Since the rationalistic interpretation of Nash equilibrium is based on the assumption that the players know each others’ preferences. It is the most fundamental reﬁnement of Nash equilibrium. A Nash equilibrium in a game is “trembling-hand perfect” if it is robust with respect to small probabilities of such mistakes. despite the fact that such games best reﬂect many strategic interactions in the real world. the economics of information. Harsanyi In games with complete information all of the players know the other players’ preferences. Source: Nobel Prize Committee Website. Harsanyi postulated that every player is one of several “types.Market Structure Games: Dynamic 115 Box 4. the analysis of oligopoly. there is an equivalent game with complete information. Such games can be handled with standard methods. This and closely related concepts. Harsanyi’s approach to games with incomplete information may be viewed as the foundation for nearly all economic analysis involving information. Every player in a game with incomplete information chooses a strategy for each of his types. regardless of whether it is asymmetric. and so forth.

2 Main game theory solution concepts The subgame perfect. players know all moves before t –1 • Imperfect Players have probabilistic beliefs about other players’ type • Imperfect Players have probabilistic beliefs about other players’ type • Select dominant strategies • Go back to the beginning (backward induction) • Avoid profitable one-stage deviations Model use • Eliminate dominated strategies • Determine Nash equilibria at each subgame • Players form expectation about the outcome of the game and act accordingly • Mixed form of perfect and Bayesian equilibrium • Actions are optimal given the beliefs Beliefs are obtained from strategies and observed actions using Bayes’s rule • Determine stable (fixed) points among possible strategy profiles Chapter 4 Figure 4.Nash equilibrium Subgame perfect equilibrium Bayesian equilibrium Perfect Bayesian equilibrium 116 • Simultaneous moves • Dynamic game • Static game • Dynamic game Order of moves • Static game • Players move sequentially • Simultaneous moves • Players move sequentially • Complete information • Incomplete Players do not know other players’ payoffs Each player knows all actions taken previously • Perfect information • Incomplete Players do not know other players’ payoffs Information set • Almost perfect information At date t. and perfect Bayesian equilibria are essentially reﬁnements of Nash equilibrium. Other solution concepts include correlated equilibrium and sequential equilibrium. Bayesian. .

Market Structure Games: Dynamic 117 commitments involve early decisions with a long-term impact that are costly or difﬁcult to reverse (e. Understandable The commitment should affect the incentives of the opponent.. . This typically involves substantial sunk costs for the committing party. it must be hard.3 This is the “whole idea” of the Doomsday Machine that cannot be un-triggered once initiated.6 When ﬁrms commit. for a strategic move to have commitment value it must be: Observable Rivals must be aware of the committing party’s strategic move before making their own decision. Credibility inﬂuences the rival’s estimation whether the committing party is willing to carry through what it has stated regardless of circumstances. Strangelove).g. or impossible to reverse once set in motion. See Dixit and Nalebuff (1991. The automatic Soviet retaliation is suboptimal 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. In the ﬁrst stage. costly. the incumbent can choose excessively high capacity (higher than the second-stage optimal capacity) to deter entry by potential entrants. they do not only anticipate the direct 3.or industry-speciﬁc assets. The Doomsday Machine could not impact on General Ripper’s decision since he was not aware of its existence. 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 announcement will be seen as “cheap talk” and will be of little strategic value. According to Schelling (1960). Such strategic commitments differ from tactical decisions that can be easily reversed. Credible A strategic decision has little commitment value if an announcement is perceived as a bluff. 6.g. Ex ante commitments can signiﬁcantly alter ex post incentives.. The strategic move must be able to change the ex post choices. 1979.1. there is effectively no option to abandon. A classic case is when an incumbent can deter rival entry to protect its own market by building overcapacity (e. 4. This may be the case with relationship. 142–67). see Spence 1977. Dixit and Nalebuff (1991) enumerate eight devices for achieving credibility (coined the “eightfold path to credibility”). Sunk costs are signiﬁcant when the ex post value of the investment outlay is signiﬁcantly lower.4 Credibility is crucial. Costly to reverse For a move to be credible. they involve substantial ﬁxed or sunk costs). altogether affecting the outcome of strategic interactions in dynamic games. In the case of sunk investment with low or no salvage value. or Dixit 1980). 5.5 These are summarized in table 4. pp.

118 Chapter 4 Table 4.e. (7) Develop credibility through teamwork (individual weaknesses can be resolved by forming groups. The terminology “strategic substitutes” and “strategic complements” was not used in the original paper (of 1984). Limit the options to reverse actions Engage in a repeated relationship Build credibility on others Source: Adapted from Dixit and Nalebuff (1991). Geanakoplos. seal off the base as General Ripper did). The following taxonomy is based on Tirole (1988). (6) Move in small steps (build up a reputation of carrying through with your announcement via repeated relationships rather than one-time agreements).g.1.. but it can make the ﬁrm better off due to strategic interactions. 4. effect of the commitment (e. although parts are more directly based on Tirole (1988. direct cost savings from investment) but also what will be the ex post strategic impact on rivals.g. 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). 323–28). provide automatic response to your rivals’ action). This was the “whole idea” behind the Doomsday Machine.2 Taxonomy of Commitment Strategies Fudenberg and Tirole (1984) extend the theory on strategic commitment. reputation is crucial and should be carefully cultivated). The names for the four main business strategies are unchanged. called the strategic effect. (5) Leave the outcome beyond control (i.7 They 7... (3) Cut off communication (e. who complements Fudenberg and Tirole (1984) with elements from Bulow. (2) Make contracts (agree on punishment if the announcement is not followed through). Under uncertainty there is a trade-off between this positive strategic value of early commitment and the ﬂexibility to wait to invest. (4) Burn bridges behind you (deny yourself the opportunity to retreat or to reverse your action). in repeated games. We collectively refer to this work as Fudenberg and Tirole (1984) thereafter.1 Paths to credible commitment Basic concept Make it costly to break your commitment Credibility device (1) Establish and use a reputation (blufﬁng may be costly in terms of reputation if revealed. introducing a new classifying scheme for business strategies. . Strategic commitment kills one’s option to wait. peer pressure) (8) Employ negotiating agents (agents have the permission to negotiate up to a point). pp. and Klemperer (1985).

α i* ( K i ) and α j* ( K i ). In the second stage.. In subgame perfect equilibrium. the outcome will be. by the magnitude of ﬁxed entry costs. deterred. and whether the commitment makes the ﬁrm tough or soft. that of Cournot quantity or Bertrand price competition. puppy dog ploy. Excess proﬁts may be sustainable if there exist signiﬁcant barriers to entry and exit. The authors disregard the case of blockaded entry. For simplicity. π i(⋅. the relevant solution concept is the subgame perfect Nash equilibrium. . since it is an exogenous state that cannot be altered by incumbents. consider two players: ﬁrm i is the incumbent and ﬁrm j a would-be entrant. α i* (⋅) and α j * (⋅) are differentiable in K i . ⋅) are twice continuously differentiable with respect to α i and α j . a j ) depends on the investment commitment Ki and later action choices α i and α j. Entry Strategies Standard competition models (e. must form a Nash equilibrium for commitment choice Ki. the second-stage actions are functions of the ﬁrst-stage investment.Market Structure Games: Dynamic 119 identify four main business strategies: top dog strategy. both ﬁrms compete (deciding simultaneously) over tactical or short-term variables α i and α j (e. Fudenberg and Tirole (1984) build on this framework to examine commitment strategies. If the two ﬁrms choose their actions simultaneously.. speciﬁcally on deterred and accommodated entry. These are closely linked to the type (and sign) of the strategic effect brought about by the strategic commitment. ⋅. ﬁrm i may commit by incurring a sunk investment outlay. Bertrand) assume that the number of ﬁrms in an industry is given exogenously.g. The ﬁrst-stage strategic investment thus affects ex post equilibrium choices. for example. 11. In the ﬁrst stage. 10. π i(⋅. ⋅.” 9. other ﬁrms will contemplate entry to take a slice of the pie. ⋅) is concave in K i . K i.9 Firm i’s proﬁt p i ( K i . and accommodated. for example. and fat cat strategy.g. In reality the number of ﬁrms may be endogenous and driven. ﬁrms’ second-stage actions.10 Under perfect information. that is. and concave in one’s action. ⋅) and π j (⋅. Cournot. ⋅. economic proﬁts will be forced down to zero. lean and hungry look. In such a contestable market. Smit and Trigeorgis (2001) use the terms “aggressive” versus “accommodating” instead of “tough” versus “soft. This strategic effect ultimately depends on whether the (ex post) actions are strategic complements or substitutes.11 Firm i can deter entry (entry 8. They focus instead on entry-barrier erection strategies. a i .8 We discuss next a ﬁrm’s incentive to be tough or soft and present Fudenberg and Tirole’s taxonomy. prices). distinguishing three entry types: blockaded. If there are low or no barriers to entry and exit and incumbents make excess proﬁts. Bain (1956) initiated the study of entry barriers.

=⎜ ⎟ +⎜ ⎟+ ⎝ ⎠ dKi ⎝ ∂Ki ⎠ ⎝ ∂a i dKi ⎠ ⎜ ∂a j dKi ⎟ (4. First. π i. namely dp i ⎛ ∂p i ⎞ ⎛ ∂p i da i * ⎞ ⎛ ∂p i da j * ⎞ . the third term in the total derivative of ﬁrm j’s proﬁt—the symmetric version of equation (4. α j * ( Ki )) > 0. Ki. it has a direct impact on ﬁrm j’s proﬁt value. We must thus consider the total derivative of π j with respect to Ki to determine ﬁrm i’s optimal ﬁrst-stage investment policy. To analyze the strategic impact.2) Firm i’s ﬁrst-period strategic investment. α j * ( Ki )) ≤ 0. In many cases. ⎜ ⎝ ∂Ki ⎟ ⎜ ∂α i dKi ⎟ ⎠ ⎝ ⎠ (direct (strategic effect) effect) (4. despite committing.1) above—drops out. has several value effects. ﬁrm i’s commitment strategy is driven by its rival’s proﬁt (π j). however. Business strategies may differ depending on whether entry is deterred or accommodated. this is a positive direct effect. It results from ﬁrm i’s ex post behavioral change due to its own commitment (dα i* dKi ) and . ∂π j ∂α i × dα i* dKi . The second term. Deterred Entry As noted. Firm i accommodates entry (entry accommodation) if.120 Chapter 4 deterrence) if its investment Ki prevents ﬁrm j from making proﬁts in the second stage: π j ( Ki . α i* ( Ki ) . For instance. if ﬁrm i acquires all scarce resources in the ﬁrst stage. this is the direct effect. we need to consider the total derivative (total effect) of ﬁrm i’s equilibrium proﬁt. represents the strategic effect of the commitment. This leads to dπ j = dKi (total effect) ⎛ ∂π j ⎞ ⎛ ∂π j dα i * ⎞ + . This is the case when ﬁrm i invests in a process innovation that does not improve ﬁrm j’s cost position (no spillover). this effect is negligible. Since in the second stage ﬁrm j will select its action α j optimally (∂π j ∂α j = 0). with respect to the ﬁrststage strategic commitment. Ki. ∂π j ∂Ki . ﬁrm j cannot operate and make any proﬁt. α i* ( Ki ) .1) The total derivative for ﬁrm j’s proﬁt is obtained symmetrically. it allows its rival to make proﬁts: π j ( Ki .

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.2) based on the notion of open-loop and closed-loop strategies. to look tough or aggressive. In this case ﬁrm i should overinvest in the ﬁrst stage to hurt its rival and deter entry. as part of a “lean and hungry look” strategy. meaning if dπ j dKi > 0. If ﬁrm i commits or invests too much in the ﬁrst stage (Ki is high). he could not formulate a closed-loop strategy and act optimally (i. is hurt. . an early investment is a soft commitment if the rival beneﬁts from it. not attack the Russians) given this information. This term fully reﬂects the incentive to under. 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. Firm i should then underinvest to deter entry. we further need to discuss tough as opposed to soft commitment. 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. Open-loop strategies depend only on calendar time but not on the actions previously played in the dynamic game. meaning dπ j dKi < 0. The notion of “overinvestment” (and later of “underinvestment”) is deﬁned with respect to the benchmark case where ﬁrms cannot formulate closed-loop strategies. the existence of the Doomsday Machine has no strategic effect since General Ripper was not aware of it. In this setting. 12. Firm i makes a tough commitment if the rival. that is.2). 132–33) propose an alternative.2) refers to the ﬁrst-order optimality condition in the open-loop strategy case (open-loop equilibrium). 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.Market Structure Games: Dynamic 121 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. We come back to the notions of open-loop versus closed-loop strategies (and the corresponding equilibrium concepts) in later chapters. entry will hardly be deterred since π j will be increased.e. Such an announcement is bad news for the competitor. that is. pp. if they can devise closed-loop strategies. Strangelove. namely where the strategic move is of no commitment value since ﬁrm j does not take its (secondstage) action based on the information conveyed by the commitment. Fudenberg and Tirole (1991. ﬁrm j.12 To determine what commitment strategy to follow. whereas the second term (strategic effect) only exists if ﬁrms observe their rival’s ﬁrst-stage strategic moves. In Dr. 13.” On the contrary.13 Fudenberg and Tirole (1984) coin this approach “top dog” strategy because it consists in “being big or strong. 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).or overinvest. A general recommendation cannot be readily formulated.. The direct effect in equation (4. more technical interpretation of equation (4. Closed-loop strategies allow this since they take account of previous moves as well.

2) for the entrydeterrence case. we set it aside as irrelevant from a strategic viewpoint. This friendlier stance still leaves room for strategic behavior because ﬁrm i can make an early move that enhances its position in the (ex post) product market competition stage. This effect occurs even if the rival does not observe the strategic move. The ﬁrst right-hand term is the strategic effect in (4. captures the effect of a change in ﬁrm i’s action α i on ﬁrm j’s best reply. = ⎝ ⎠ ∂α j dKi ⎜ ∂α j ∂α i ⎟ dKi If the two reaction functions are both downward or both upward sloping. Its sign depends on whether the actions are strategic complements (positive sign) or substitutes (negative). dπ i ⎛ ∂π i ⎞ ⎛ ∂π i dα i * ⎞ ⎛ ∂π i dα j * ⎞ =⎜ . ﬁrm i considers here its own proﬁt function (not its competitor’s) when it devises its business strategy. . ∂π i ∂α i = 0 so the expression above simpliﬁes to ⎛ ∂π dα j * ⎞ dπ i ⎛ ∂π ⎞ . ⎟+ ⎟ +⎜ ⎝ ⎠ 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.3) The ﬁrst (right-hand) term in equation (4.122 Chapter 4 Accommodated Entry If deterring entry is too costly or infeasible. = ⎜ i⎟ + ⎜ i ⎝ ∂K i ⎠ ⎝ ∂α j dKi ⎟ dKi ⎠ (total (direct c (strategic effect) effect) effect) (4. The last term. Contrary to the case of entry deterrence. ﬁrm i should overinvest to increase its total (gross) value. its sign depends on whether the ﬁrm faces tough (negative sign) or soft commitment (positive sign). ⎝ ∂α i ⎠ ⎝ ∂α i dKi ⎟ ⎠ ⎝ ∂α j dKi ⎟ ⎠ The last term. ∂α j * ∂α i . Ignoring the direct effect. the ﬁrm should underinvest instead. is the strategic effect. Thus the strategic effect provides guidance whether to over.3) is the direct effect of the investment on ﬁrm i’s own proﬁt. We thus look at the total derivative of ﬁrm i’s own proﬁt (π i) with respect to its investment Ki. ∂π i ∂Ki . ⎛ ∂ π dα j * ⎞ ⎛ ∂α j * ⎞ ⎛ ∂ π j dα i * ⎞ sign ⎜ i = sign ⎜ × sign ⎜ ⎟. If this strategic effect is negative. Its sign depends on:14 14. ﬁrm i may accommodate entry instead.or underinvest. Note that ∂π i dα j ∗ ⎛ ∂π i ∂α j ∗ ⎞ dα i ∗ . If this is positive. ∂π i ∂α j × dα j * dKi . Since sequential strategic interaction has no impact on the direct effect.

it means . and (2) whether ﬁrms behave in a contrarian (substitutes) or reciprocating (complements) way. we can differentiate among four main business strategies. The four business strategies are discussed next: Top dog strategy Two cases are distinguished. The objective of the ﬁrm in each of the four strategies is to induce the rival to behave less aggressively. Firm i would design its commitment strategy to hurt ﬁrm j. In the entry-deterrence case (ﬁgure 4. This case is equivalent to the entry-deterrence case discussed above. In the accommodated-entry case (ﬁgure 4.4a) and of accommodated entry (ﬁgure 4. 2. dπ j dKi . considering the ﬁrst-order (total) derivative of its rival’s proﬁt.3. These rest on (1) whether the investment is intended to be tough or soft.3 Sign of the strategic effect 1.Market Structure Games: Dynamic 123 Strategic substitutes (∂a * j ∂a i < 0) Strategic complements (∂a * j ∂a i > 0) Tough investment ( dp ( dp j dKi < 0) Positive strategic effect Negative strategic effect Soft investment j dKi > 0) Negative strategic effect Positive strategic effect Figure 4. Consider a different situation involving two incumbents where ﬁrm i would like ﬁrm j to exit the market.4 in case of deterred entry (ﬁgure 4. This analysis can be represented by the two-by-two matrix of ﬁgure 4. Choosing Commitment Strategies Following our previous discussion.4a) this means overinvesting when the investment is tough to ensure that the rival will renounce entering the market (earning zero proﬁt). The four main business strategies are summarized in ﬁgure 4.4b).4b). 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 ). whether ﬁrms react to each other in a reciprocating (strategic complements or ∂ j* ∂ i > 0) or a contrarian (strategic substitutes or ∂ j* ∂ i < 0) manner.

124 Chapter 4 Tough investment Top dog strategy Soft investment Lean and hungry look (a) Strategic substitutes (Cournot quantity competition) Tough investment Top dog strategy Strategic complements (Bertrand price competition) Puppy dog ploy Soft investment Lean and hungry look Fat cat strategy (b) Figure 4. Firm i should then underinvest (stay ﬂexible). cushioning the potentially negative strategic effect (see ﬁgure 4. (b) accommodated entry.3). overinvesting for tough commitment (dπ j dKi < 0) when second-stage actions are strategic substitutes (∂ j* ∂ i < 0) inducing rivals to back down. ensuring that the rival stays out. this means underinvesting to be soft or ﬂexible (dπ j dKi > 0). this business strategy is advisable if second-stage actions are strategic substitutes (∂ j* ∂ i < 0) and the investment makes ﬁrm i soft. Fat cat strategy In the accommodated-entry case (ﬁgure 4. hurting its rival (dπ j dKi < 0). if the investment makes ﬁrm i tough. if second-stage actions are reciprocating or strategic complements .4b). Puppy dog ploy In the accommodated-entry case (ﬁgure 4.4a). the rival will be more aggressive in the second stage as actions are strategic complements (∂ j* ∂ i > 0).4 Four main business strategies (a) Deterred entry. Adapted from Fudenberg and Tirole (1984).4b).4b). In the accommodated-entry case (ﬁgure 4. Lean and hungry look In the deterred-entry case (ﬁgure 4.

(2004) (∂ j* ∂ i > 0).” In the real world some companies sometimes follow suboptimal strategies. Besanko et al.” avoiding the negative effect depicted in ﬁgure 4. summarized in ﬁgure 4. (2004) extend the taxonomy above to include additional business strategies that have a harmful effect on the committing ﬁrm. harmless “puppy dog. ﬁrm i should avoid being aggressive (dπ j dKi < 0).5: Submissive underdog The ﬁrm underinvests to accommodate entry when its commitment is tough (d j dKi < 0) and actions are strategic substitutes (∂ j* ∂ i < 0). becoming a “fat cat. 246–47).5 Suboptimal business strategies observed in practice (accommodated entry) Adapted from Besanko et al. The “weak kitten” is not mature enough to recognize that it should put on more weight (overinvest). instead of underinvesting to keep a “lean and hungry look.15 They identify the following strategies. behaving as a “fat cat.” 15. . It would be better to be a clever. the ﬁrm should be a “top dog” instead (overinvest). pp. See Besanko et al. Suicidal Siberian Here the ﬁrm overinvests in case of strategic substitutes (∂ j* ∂ i < 0) even though its investment makes it soft (dπ j dKi > 0).Market Structure Games: Dynamic 125 Strategic substitutes Tough investment Submissive underdog Strategic complements Mad dog Soft investment Suicidal Siberian Weak kitten Figure 4.” Mad dog The ﬁrm overinvests in case of tough commitment (dπ j dKi < 0) even though actions are strategic complements (∂ j* ∂ i > 0). This strategy is not advisable. 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). (2004.3 (underinvestment).

Should ﬁrm i invest early in a new technology to attain reduced future production costs? Firm i could then commit to a price cut. the rival will be less aggressive in the second stage. The case before (without) investment is indexed “before. For a given level of the rival’s price pj . The optimal business strategy here is to be a nice “puppy dog. Bertrand Price Competition Differentiated Bertrand price competition involves reciprocating actions (strategic complements). This tough commitment by ﬁrm i is detrimental to rival ﬁrm j (as dπ j dKi < 0). For a given level of competitor price pj . Consider ﬁrm i’s reaction function from equation (3. We thus have ∂piB ∂pj ( = s 2 ) ≥ 0. conﬁrming that price choices are strategic complements. .6a. if investment makes ﬁrm i soft (dπ j dKi > 0). If ﬁrm i decides to charge a lower price in the second stage. respectively.16 Firm j is worse off ex post because it is obliged to reduce its own price.” whereas the case after investment commitment as “after. ﬁrm i optimally charges a higher price pi as a result of this 16. with the reaction curve shifting to the left as depicted in ﬁgure 4. ﬁrm i’s price pi will be lower. to avoid entering an intensiﬁed price war. If ﬁrm i decreases its price. ﬁrm j will respond by following suit. maintaining higher prices. and vice versa.3) is negative. following a reciprocating reaction. We illustrate next application of the four main business strategies in the context of these benchmark models. the marketclearing price will spiral downward since the reaction functions are upward sloping. This strategy is not advisable because the strategic move by ﬁrm i will backﬁre as the strategic effect (represented in the top-right in ﬁgure 4. 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). Firm i should instead underinvest.” The case “before” corresponds to the open-loop equilibrium where product-market decisions are taken in ignorance of the rival’s strategic move.8): piB ( pj ) = a (1 − s ) + c s + pj .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. 2 2 where s ∈[0. being more aggressive toward its rival in the later product market stage.” In contrast. 1) is the degree of substitutability.

(b) soft commitment (fat cat srategy) .Market Structure Games: Dynamic 127 pj RiBEFORE(pj) RiAFTER(pj) Rj (pi) pjBEFORE * pjAFTER * E' E piAFTER * (a) piBEFORE * pi pj RiBEFORE(pj) RiBEFORE(pj) Rj (pi) pjAFTER * pjBEFORE * E E' piBEFORE * (b) piAFTER * pi Figure 4.6 Tough versus soft commitment in differentiated Bertrand competition (a) Tough commitment (puppy dog).

ﬁrm j charges a higher price than before.2). 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).128 Chapter 4 commitment with the reaction function shifting to the right. ﬁrm j behaves in a “contrarian” way. To reach the Nash equilibrium. Since quantities are strategic substitutes. The reaction curve now shifts to the left and ﬁrm i produces less after the commitment. The (inverse) market demand function is linear as per equation (3.3) as much as possible. ﬁrm i’s reaction function in Cournot duopoly is qiC (q j ) = 1 ⎛ a − ci − qj ⎞ . producing less in equilibrium than it would have if this investment did not occur. while ﬁrm j produces more.7a. ⎜ ⎟ 2⎝ b ⎠ (4. As seen in ﬁgure 4. We allow for distinct marginal production costs.2. fancy headquarters. pj .2. is not on the reaction curve. This investment has a positive strategic effect and ﬁrm i should overinvest as in a “top dog” strategy. ﬁrm j. By contrast. whereas for a cost decrease (tough commitment) it shifts to the right. this would be the case. By contrast.1). Firm . amplifying the positive strategic effect (bottom-right in ﬁgure 4. implying that for a cost increase (soft commitment) the reaction curve shifts to the left. This is illustrated in ﬁgure 4. a soft commitment would worsen the cost differential in favor of the rival. As seen from equation (3. This would enhance ﬁrm i’s cost advantage in the Cournot duopoly setting (section 3.6b. The cost functions are also linear. An application of “soft” advertising strategy to the German telecom market is discussed in box 4.4) Firm i’s reaction function qiC (⋅) is differentiable and decreasing in its own cost (∂qiC ∂ci = − 1 2b < 0). consider a tough investment commitment such as an R&D investment in process innovation. for instance. if the ﬁrm announces the building up of new. a soft commitment would lead ﬁrm i to produce less than it would otherwise. Cournot Quantity Competition To illustrate the importance of tough versus soft commitment in case of strategic substitutes or contrarian reactions. The original price. In this case ﬁrm i should overinvest becoming fatter (fat cat). however. then no matter what output its rival produces it will produce more output (than it would without the commitment).13). c j < a). if ﬁrm i makes a tough commitment (curve shifts to the right). ci and c j (ci . The two ﬁrms are better off due to this accommodating strategy.

Although liberalization of the telecommunication sector has taken place many years ago. The massive general advertising investment made by Deutsche Telekom is soft (beneﬁts its rivals) and rivals have been less aggressive in second-stage competition. 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. despite liberalization. railway. A case in point is the telephone industry in Germany where Deutsche Telekom. In the last two decades a revolution has occurred in Europe. Deutsche Telekom has not taken full beneﬁt since its advertising campaigns have been quite expensive. 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. and other regional companies. Governments have erected high entry barriers (blockaded entry). Telecom Italia (Alice). In most European countries certain sectors (e. It rather promoted telecommunication services generally. The telecommunication industry is typical of Bertrand price competition. As such.. believing that enhanced competition would result in lower prices and be more beneﬁcial to European consumers. As it is difﬁcult to differentiate among offerings in the telecommunication industry (with the exception of bundling for the iPhone). with an annual turnover of )60 bn a year. faces competitive entry from rival companies such as Vodafone. This may be partly due to Deutsche Telekom’s heavy investment in advertising campaigns.g. . its ad campaigns have been beneﬁcial to rivals as well. 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.Market Structure Games: Dynamic 129 Box 4. once a formidable monopolist. Consequently. the advertising campaign of Deutsche Telekom was not meant to build a differentiation advantage. even though competition is not yet that ﬁerce. Deutsche Telekom has been one of the world’s leading telecommunication and information-technology service providers. “soft advertising” and the persistence of high prices in the German telecom market Fudenberg and Tirole’s (1984) framework can provide powerful insights. Policy makers decided to enforce liberalization of these markets. Still. Every year Deutsche Telekom channels nearly 15 percent of its revenues into ads. Their framework is particularly useful to help explain how an industry evolves once liberalization of the market is enforced.2 European liberalization. prices for telecommunication services have not decreased signiﬁcantly in Germany. post and telecommunications) have long been considered as natural monopolies. electricity. Firms face no serious capacity constraints and the key purchasing criterion for many customers is the price. believing that competitive entry would be socially detrimental.

(b) soft commitment (lean and hungry look strategy) .130 Chapter 4 qj RiBEFORE(qj) RiAFTER(qj) qjBEFORE * qjAFTER * E E' Rj (qi) q iBEFORE * (a) qiAFTER * qi qj RiAFTER(qj) RiBEFORE(qj) qjAFTER * qjBEFORE * E' E Rj (qi) qiAFTER * (b) qiBEFORE * qi Figure 4.7 Tough versus soft commitment in Cournot quantity competition (a) Tough commitment (top dog strategy).

Cost functions are also linear. it is irrevocably committed to its announced capacity decision. Overinvestment in capacity may also result in an alternative model. ﬁnite-horizon game can be obtained by backward induction. The leader has no possibility to revise its production plan and installed capacity ex post (i. The subgame perfect Nash equilibrium of this sequential.3 describes entry accommodation in the Italian electricity market. The follower’s proﬁt function is differentiable and concave in its own strategic variable. the follower chooses output qF (≥ 0) to maximize its own proﬁt.2). The (inverse) demand function is linear as given by equation (3. 17. there is a negative strategic effect and ﬁrm i should refrain from making this kind of investment. There is a positive strategic effect when its strategic investment makes ﬁrm i tough. qF . In the second period. This is what the strategic effect in the case of tough versus soft commitment for strategic substitutes is about. previously dominated by state monopoly Enel. given the leader’s observed quantity choice qL (≥ 0).2.g. . The following section develops the sequential model by Stackelberg and discusses in which circumstances it might be useful.Market Structure Games: Dynamic 131 i’s investment is beneﬁcial to ﬁrm j who is more aggressive in the product market stage.e. due to sunk costs).e. allowing for distinct marginal costs cL and cF .. Firm i should refrain from committing and should thus underinvest. The follower’s optimization problem is to select its output qF (≥ 0) to maximize its proﬁt:17 π F ( qL . 4.1). When its investment makes the ﬁrst-mover soft. also famous in industrial organization. qL). The proﬁt and cost functions are the same as used in Cournot quantity competition (section 3. while the second ﬁrm selects its own quantity in view of the leader’s quantity choice. This may dominate even though the direct effect might be negative (e. It is the duopoly model developed by Stackelberg (1934) where one of the ﬁrms makes an early move selecting its quantity (i. This “lean and hungry look” strategy is depicted in ﬁgure 4... A key assumption is that the follower observes the leader’s choice before selecting its own output.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.1. qF ) = [ p (Q) − cF ] qF . capacity) ﬁrst.7b. Box 4.

having been a protected monopolist in the Italian marketplace for decades. may intervene. Accommodation was likely a preferred strategy. In this industry. capacities are strategic substitutes in that if one ﬁrm adds capacity. the European body responsible for implementing and monitoring adherence to European antitrust law. Given that investing in new capacity was perceived as a tough initiative in this setting. 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 problems. In the current environment. Of course. Even if Enel manages to deter competitive entry (deterred entry). nonstorable product. the optimal reaction of rivals is not to raise capacities or revise their construction plans to accommodate less capacity. 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.132 Chapter 4 Box 4. 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 Commission. traditional frameworks (e. Firms ﬁrst decide on their installed capacity base (a long-term decision) and then compete in the short run in prices under capacity constraints. Enel had the opportunity to make a “ﬁrst-stage” strategic move to alter the “second-stage” competition game. The Italian electric utility Enel is recently facing new challenges. The Italian electricity industry was previously blockaded due to high administrative and other entry barriers. they effectively compete over capacity as in Cournot competition. Fudenberg and Tirole’s (1984) framework of business strategies can be helpful. DG Competition. SWOT.g. Enel may accommodate entry but still behave in a way that makes entry less proﬁtable for potential entrants. Enel has one main choice left.3 Entry accommodation in the Italian electricity market As electric utilities are subject to serious capacity constraints in offering a homogeneous. ﬁve-forces analysis.. Enel had the opportunity to “over-invest” in capacity over the years to discourage potential entrants from building new production units. . Being the sole electricity provider in the Italian market (until July 2007). to accommodate entry.

). qF ( qL )) = [ p (qL + qF (qL )) − cL ] 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.1). ⎩ 4b (4. 4 (4. the above equilibrium proﬁt expressions simplify to ⎧ ⎪ ⎪ ⎨ ⎪ ⎪ ⎩ S L = ( a − c )2 S L S F 8b 2 a − c) 1 ( = = 16b 2 2 (> (< C ).6) The proﬁts for the leader (L) and the follower (F ) in subgame perfect equilibrium are ⎧ S ( a − 2cL + cF )2 . ⎪π L = ⎪ 8b ⎨ 2 ⎪π S = ( a + 2cL − 3cF ) .17).7) In case of cost symmetry between the leader and the follower (cL = cF = c). (4. ⎪ L 2b ⎨ S ⎪qF = a + 2cL − 3cF . The leader will thus choose its quantity qL so as to maximize its proﬁt: S S π L(qL . F ⎪ ⎩ 16b (4. .5) The Stackelberg equilibrium price. is pS = a + 2 c L + cF .Market Structure Games: Dynamic 133 The follower’s reaction function (where superscript S stands for Stackelberg) is 1 a − cF S qF ( qL ) = ⎛ − qL ⎞ . obtained by substituting the equilibrium quantity above in (3. The resulting Stackelberg equilibrium quantities for the leader (L) and the follower (F ) are given by ⎧qS = a − 2cL + cF .8) C where π C = ( a − c ) 9b is the Cournot proﬁt under cost symmetry given in equation (3.

when one gains a competitive advantage by deciding ﬁrst (e. The proﬁt value of being a leader in the sequential Stackelberg game is higher than in the simultaneous wait-and-see case. The sequential Stackelberg model provides an example of ﬁrst-mover advantage.e. Therefore. This may justify an early commitment as a sound strategy for a ﬁrm even if not all information concerning the market development is known or predictable. Since the market price is lower.g. in the case of market entry). with investment costs being fully sunk.. 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. The leader could defer its output decision to the second period but is better off not to do so. Although the leader is better off communicating its output decision to the follower. the leader is actually better off. 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. From a dynamic perspective. the leader) is not necessarily worse off. Conversely. thanks to its commitment to a certain output. the less-informed party (i. . The Stackelberg follower receives a lower proﬁt than the single-period Cournot duopolist S ( F < C ).g. The sequential Stackelberg model is also useful to help assess the importance of information in multiperson games.. even if the price is lower. the follower might have been better off ignoring the quantity chosen by the leader. the Stackelberg follower produces less than under symmetric Cournot competition.. In the sequential Stackelberg setting. the ﬁrm that knows its rival’s quantity decision (the follower) is worse off than a ﬁrm that ignores this information (Cournot case). regarding capacity choice or market entry). 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).134 Chapter 4 The leader in the above sequential Stackelberg game is better off than S a symmetric Cournot duopolist ( L > C). it should be careful not to lose credibility because if the follower suspects “cheap talk. namely à la Cournot. In Stackelberg competition. the Stackelberg follower makes lower proﬁts than in the Cournot case. given the downward-sloping demand. The sequential Stackelberg game should thus be interpreted in light of commitment theory: the leader should follow a “top dog” strategy and overinvest in capacity.” it will choose its quantity as if no communication occurred. By contrast. the market-clearing price is lower in the sequential Stackelberg game.

Antitrust authorities generally prohibit formal collaboration (explicit collusion) but may tolerate other forms (e. One of the two ﬁrms (the bargaining 18. For example. When reasoning backward.2 Bargaining and Cooperation So far we have discussed models where ﬁrms take a noncooperative stance toward their rivals. We here follow the treatment by Shaked and Sutton (1984) and Gibbons (1992). In fact sustainability of cooperative behavior in inﬁnitely repeated games can be established directly by using so-called grim-trigger strategies. Firms often bargain or cooperate with other parties. 19. Ståhl (1972) discusses such a model for ﬁnite horizon.18 4. ignoring the possibility of more complex or repeated relationships based on both competition and collaboration. We do not mean to suggest that the theory of repeated games is built upon bargaining games.Market Structure Games: Dynamic 135 4.. We discuss bargaining and tacit collusion in sequence owing to some similar economic interpretations..g. however. and Rubinstein (1982) extends it to inﬁnite horizon. subgame perfection or perfect Bayesian equilibrium). Consider ﬁrst a simple example of bargaining to help identify the key drivers. customers may ﬁnd it advantageous to be faced with only one technology standard owing to product externalities.g. Such cooperation between rival ﬁrms is not necessarily detrimental to customers. Here we use subgame perfect equilibrium strategy proﬁles under perfect information. Real-world competition calls for analytic models that can better explain this kind of complex strategic interactions observed in the marketplace. Blue ray) may be beneﬁcial both to the cooperating ﬁrms and to the end consumers.1 Bargaining Bargaining problems are treated as dynamic games under complete or incomplete information. In reality. tacit collusion). They are solved using solution concepts suited to a multistage setting (e. We discuss in turn bargaining and (tacit) collusion in repeated games. The “patience” of the bargaining parties is thus a key factor in negotiations. The bargaining process can be limited in time (ﬁnite horizon) or continue indeﬁnitely until parties reach an agreement (inﬁnite horizon). ﬁerce competition is not the only modus vivendi adopted by ﬁrms in the marketplace.2. An agreement on common technological norms (e. one needs to consider the time value of money (discounting) and the trade-off between reaching an agreement today or continuing bargaining. A typical problem is how to split a pie among players.19 Suppose that two ﬁrms “bargain” over market shares in the marketplace..g. including competitors. .

Two time references are considered: the order of the play (decision time) and the real time at which agreements (or settlement) may occur. 1 − s L ) Follower 3 2 Leader 4 (Nature) 5 3 Follower 2 Figure 4. 1 − si. The follower may either accept the proposed deal or refuse it. where k (k > 0) is the appropriate discount rate. the follower (F ) receives the remaining slice. ﬁrms have a certain degree of “impatience” captured by a common discounting factor δ (0 ≤ δ < 1). with the follower (F ) receiving 1 − sL. If F rejects the proposal. Discounting relates to the second dimension. Discounting future payoffs at a higher discount rate gives the players an incentive to reach an agreement earlier. Subsequently the follower (F ) may make a proposal as roles are reversed. respectively. Over the bargaining process. 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. 1 − si ) are the payoffs to the leader and the follower. the leader (L) proposes the following deal to the rival: the leader takes sL (%) of the pie (0 ≤ sL ≤ 1). The leader may accept it or not. it may in turn make a new offer: the leader takes sF and the follower 1 − sF .. Note that δ ≡ 1 (1 + k ). The extensive form of this sequential bargaining game is depicted in ﬁgure 4. 1 − sF ) sL Decision maker Decision time Real time Leader 1 1 ( sL . an exogenously given settlement is applied: the leader receives s (%) and the follower 1 − s (0 ≤ s ≤ 1).g. due to its technological edge or market power). 1 − s ) pt acce t . In the ﬁrst period. We can conjecture that the equilibrium slicing is Follower Follower Leader Leader re t jec t ec rej sF accep (sF .136 Chapter 4 leader L) is allowed ﬁrst to make a proposal to the follower (e. Nature ( s.8 Extensive form of the bargaining game under complete information Here ( si . If no agreement is reached after two negotiation rounds.8.

The follower would then earn 1 − δ s.Market Structure Games: Dynamic 137 affected by the magnitude of the discount rate since a later ( 1) settlement has lower present value. meaning δ(1 − δ s ). ﬁrm F accepts if 1 − sL ≥ δ (1 − δ s ). The leader receives δ s (at real time 2). The follower then proposes a new settlement. As determined above. The optimal deal at decision time 3 is deal A. In this case. The follower would then receive a slice of 1 − sF * = 1 − δ s (at real time 2). For 0 ≤ δ < 1. we have 1 − δ s > δ (1 − s ). or reject it. the subgame perfect equilibrium is found backward. In other words. worth δ (1 − s ) today (at real time 2). receiving the exogenous amount s in the last period. In this case. When selecting between the two alternative deals. L would then receive δ s at real time 2. the follower receives 1 − s at the last stage. This latter settlement is worth δ s today (at real time 2). Deal D The follower refuses the offer. This assumption enhances the model readability but it can be relaxed. receiving sF today. The follower will not accept the offer unless it receives a higher value than otherwise. F then receives 1 − sL. The leader will accept the offer sF if sF ≥ δ s. In such a sequential game with perfect information and a ﬁnite horizon. . 20. where follower F proposes δ s to its rival who accepts it. the leader may design its proposal in a similar manner: Deal C The follower accepts the offer. The leader would optimally retain for itself the maximum acceptable amount. which is worth δ 2 s at real time 1. F receives the present (real time 1) value of 1 − δ s. namely sF * = δ s. One step earlier (at decision time 1). instead of any higher share. Deal B The leader rejects the offer. The follower may construct the offer (at decision time 3) in two alternative ways: Deal A The leader accepts the offer. We assume that if a ﬁrm is indifferent between the present values of the two different deals.20 What is the follower’s best continuation strategy from decision time 3 onward. At decision time 4. the leader may either accept the follower’s proposal. when the leader acts optimally in the subsequent period? The follower (F ) faces this decision if it rejects the offer made by the (bargaining) leader previously. it will select the proposal made ﬁrst. the follower considers the relative value of 1 − δ s (deal A) versus δ (1 − s ) (deal B). the follower is better off offering the minimum acceptable level for the leader.

The owner of the apartment may take advantage of the situation and sell the property at a higher price. 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.2. resulting in a lower δ . hence s* = 1 (1 + δ ). In the subgame perfect Nash equilibrium for the inﬁnitely repeated game.2 Cooperation between Cournot Duopolists in Repeated Games We analyzed in section 3. . Previously the ﬁnal settlement ( s. Moreover the values obtained in equilibrium by the parties decrease with the degree of impatience δ . 4.2 the classic case where Cournot duopolists choose their quantity simultaneously in a noncooperative manner. Instead of ( s. If the follower suffers from delay. 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 *.9) This equilibrium result is related to the ﬁrms’ “patience” via the discount factor δ .21 A case in point is negotiating a short-sale agreement over a real-estate property. In bargaining for the apartment. This ﬁrst-mover advantage increases with higher risk (higher discount rate or lower discount factor). This leads to a situation where even 21. 1+ δ 1+ δ ⎠ (4. They naturally prefer to ﬁnd their ideal apartment early on and avoid paying out rents for a prolonged time.138 Chapter 4 which is sL * ≡ 1 − δ (1 − δ s ) = 1 − δ + δ 2 s (≥ δ 2 s ). The bargaining leader is better off receiving a higher share than its rival. In reality. although decision times are discrete. proposing a less attractive deal. . The three-period model above is rather simplistic and not descriptive of many real-world bargaining situations. they will likely accept to pay a premium due to their higher opportunity cost and impatience. 1 − s ) required the presence of a third party or arbiter in the bargaining process. ﬁrms sometimes bargain over a longer period until an agreement is reached. The simultaneous Cournot competition model rests on the premise that ﬁrms maximize their short-term proﬁt. Suppose that newcomers have decided to acquire a cozy apartment in the city center but stay in a hotel until they ﬁnd the appropriate opportunity. leveraging on the earlier three-period setup. 1 − s ) being exogenously given. Staying in a hotel is costly and increases their opportunity cost of waiting. the split is ( s*. Both parties will thus accept the equilibrium pie sharing ( sL*. 1 − s *) = ⎛ ⎝ δ ⎞ 1 . In such a setting one can truncate the inﬁnitehorizon problem. The leader can take advantage of this. 1 − sL*) at the outset.2.

The Nash equilibrium for a duopolist in the standard symmetric Cournot setup. the desirable cooperative equilibrium (QM 2 . This industry output in Cournot duopoly is higher than in monopoly (QC ≥ QM).4 provides a real-world example of collusion in the German retailing market. The long-term beneﬁts gained from a tacit agreement may offset the short-term gains from behaving selﬁshly.Market Structure Games: Dynamic 139 though the monopoly outcome would have been preferable for both ﬁrms considered individually. and long-run relationships. ch. Even though a ﬁrm would earn a higher short-term proﬁt by deviating from the collusive agreement. is lower. however. This mechanism explains why the collectively optimal outcome is not necessarily reached as a (stable) Nash equilibrium. In this repeated game.14). 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. each player has an incentive to deviate from the collusive quantities (QM 2 . This kind of strategy setting may be captured by repeated games or supergames.22 Box 4. a ﬁrm may have an incentive to cooperate if a (tacit) agreement may create a favorable platform for future higher proﬁts. Clearly. In simultaneous games. ﬁrm actions maximize short-term proﬁts. Growth is here assumed zero. We do not intend to give an advanced account of repeated games here. 23. the two ﬁrms would be better off setting jointly their aggregate production equal to the monopoly quantity (QM). so there is no need to account for the interplay between growth and discounting. obtained in equation (3. in the standard Cournot model. Friedman (1971) considers such a duopoly game where the market is assumed in a steady state. Here we sketch a reﬁnement of the Cournot model to examine how repeated strategic interactions may alter the equilibrium play. QM 2). with total industry output being QC = 2 (a − c ) 3b. is qC = ( a − c ) 3b. Eventually Nash equilibrium quantities (qC . 5). The price. In inﬁnitely repeated games.1) and symmetric production cost. c. Inﬁnitely repeated games can result in collaborative behaviors being sustainable in situations where sufﬁciently patient ﬁrms act in their own interest. ﬁrms frequently compete with one another over an extended period and are faced with recurring competitive situations over multiple stages. it will not be enticed to do so if it values future collaborative proﬁts more. however. QM 2) may be sustainable under certain conditions. . each duopolist makes a tactical decision on the quantity to supply to the market. For a comprehensive treatment of repeated games.24 In each period. A good treatment of repeated games is also given in Fudenberg and Tirole (1991. see Maileth and Samuelson (2006). 24. duopolists end up being better off if they behave as follows: 22. qC ) that are not jointly optimal are chosen. it is never reached as a stable industry equilibrium (prisoner’s dilemma). In real life.23 We again consider duopolist ﬁrms facing linear demand as in equation (3. reputations. However. In multistage games.

” Cartel Ofﬁce spokesman Kay Weidner said. Investigators have evidence that a total of 24 companies may have illegally agreed to price-ﬁxing deals on coffee. Germany’s largest supermarket chains. 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. and the case is expected to go before the higher regional court in Düsseldorf. Ott. there’s a relatively small number of countries that can produce the commodities and the number of producers is limited. . Late last year. but it is illegal to agree . Industry expert Roeb says it’s not surprising that investigations are now focused on makers of sweets following the coffee investigations. There are high ﬂuctuations in commodity prices. is the suspicion that both producers and retailers may have agreed to price ﬁxing. sweets.” he says. They believe millions of consumers may have paid more for these goods than they should have. . Companies are allowed to set recommended prices. and Lidl. Rewe. including Edeka. 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. A total of 56 German Cartel Ofﬁce employees and 62 police ofﬁcers visited the ofﬁces of retail giant Metro. Authorities also visited the ofﬁces of chocolate bar-maker Mars. Amann and F.4 Suspected collusion in the German retailing market German Antitrust Authorities Investigate Mass Retailers S. German antitrust investigators launched a surprise search of the ofﬁces of some of the biggest names in the country’s retail sector. Investigators believe as many as 24 companies set illegal minimum prices on products.140 Chapter 4 Box 4. American food conglomerate Kraft was also involved but avoided penalty because it turned itself in and cooperated with the competition authority during the investigation. the raids were less surprising. as well as the drug store chain Rossmann and pet supply store Fressnapf. however. however. “Certain product groups are particularly prone to price ﬁxing. and pet food. and Tchibo for entering into a secret agreement to coordinate price increases. On Thursday morning. Attractive for All Involved What’s new in the current investigation. For industry observers. “The vertical price ﬁxing is unique in this case. . Dallmayr. the Federal Cartel Ofﬁce imposed )160 million ($233 million) in ﬁnes against coffee producers Melitta. “That makes the market clear and manageable. Both Tchibo and Melitta have contested the ﬁnes.” he says.

8 billion too much for their morning jolt of caffeine from 2000. According to German consumer protection groups. In 2007. of course. . until the three companies were ﬁrst searched in July 2008. Antitrust investigators believe the 24 companies came to a deal on a minimum price for products. 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.” said Cartel Ofﬁce spokesman Weidner. however. If the allegations are true.” said one branch insider .5 million in ﬁnes. 25. thus violating German competition law. This assumes that (QM 2 . Such arrangements are additionally attractive for retailers in that they can boost the sales of their own brands. 2010. . we wanted to make it clear that vertical price ﬁxings are also in violation of antitrust law. that number exploded to )114 million before almost tripling in 2008 to )317 million. coffee drinkers in Germany paid a total of )4. it would mean that both traders and companies adhered to that agreement. 1. Those familiar with the market are convinced that the Cartel Ofﬁce wanted to set an example. Agree to produce half the monopoly quantity if the other player also produces half. following the penalties handed down to the coffee producers. In 2006. Such statistics are good news for those companies not involved in price ﬁxing. Price Fixing Probe: German Antitrust Authorities Investigate Mass Retailers by Susanne Amann and Friederike Ott reprinted with permission from SPIEGEL Online. Publication date: January 15. Deviate from the (tacit) agreement and produce the Cournot–Nash quantity forever if the other player deviates. Such agreements are. “With today’s investigation.. One measure of the Cartel Ofﬁce’s recent success is the value of ﬁnes it has levied from year to year. the Cartel Ofﬁce brought in over )400 million. when the coffee producers began colluding.Market Structure Games: Dynamic 141 Box 4. attractive for all involved as they guarantee both producers and retailers reliable prices and higher proﬁts. QM 2 ) is already the industry state at the outset.4 (continued) to concrete prices.25 2. And for consumers. “Merchants can price their own brands below the agreed-upon prices for name brands without the fear that the name brand prices will follow. This aggressive stance is the (harsh) punishment from having deviated in the ﬁrst place. the antitrust authorities collected just )2. In 2009. .

However. 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 . they each produce QM 2 = (a − c ) 4b. ﬁrm j has an incentive to deviate in the short run. the condition above holds if δ > 9 17 or k < 8 9. ﬁrms earn a proﬁt π C = ( a − c ) 9 b in equilibrium. if the ﬁrm deviates this period and operates in Cournot duopoly forever thereafter. or M ⎛ 1 ⎞ π > π D + ⎛ δ ⎞ πC. If ﬁrm i sticks to the tacit agreement and produces QM 2 while ﬁrm j deviates. 2 earning proﬁt π D = 9 (a − c ) 64b. q j ≥0 ⎝ q j ≥0 ⎣ ⎝ 2 ⎠ ⎠ 2 ⎦ When deviating. If ﬁrms behave cooperatively. ⎝ 1+ k⎠ ⎝ 1−δ ⎠ t =1 t =1 t For tacit cooperation to sustain itself in each period. however. ⎝ 1−δ ⎠ 2 ⎝ 1−δ ⎠ Considering the given proﬁt values π C . The value of cooperating forever is ∞ ⎛ πM ⎞ πM C ≡ ∑δ t ⎜ = ⎝ 2 ⎟ ⎠ 2 t =0 ∑⎛ 1+ k⎞ ⎝ ⎠ 1 t =0 ∞ t = 1 ⎛ πM ⎞ . π M. In the aftermath. a tooth for a tooth. and vice versa. This strategic stance is a translation of the biblical saying “an eye for an eye. Under monopoly. and π D. ﬁrm j would compete forever à la Cournot. So once again we conﬁrm that the degree of impatience or the opportunity cost of waiting (which is exogenous to the ﬁrms’ decisions) affects critically the sustainability of cooperative behavior. ⎝ ⎠ 1−δ ⎜ 2 ⎟ Alternatively. the equilibrium quantity 2 is QM = ( a − c ) 2b and proﬁt equals π M = (a − c ) 4b. Such strategies are also observed in nature. We next analyze this trade-off. Since π D > π M 2 > π C . as discussed in box 4. such as by following a tit-for-tat 2 strategy. receiving Cournot duopoly proﬁt π C each period. ﬁrm j would optimally produce q D = q j* = 3 (a − c ) 8b. In the standard 2 Cournot duopoly game. the following condition must hold: C > D. it must also assess the long-term negative effect of this deviation. In industries characterized by high riskiness (high k . earning π M 2 = (a − c ) 8 b at each stage. it receives the present value: ∞ ∞ δ ⎞ C 1 ⎞ D ≡ π D + ∑ δ tπ C = π D + π C ∑ ⎛ = πD + ⎛ π .142 Chapter 4 Such behavior relates to tit-for-tat or trigger strategies.” It supposes that fair behavior by one player induces fairness by the other.5.

” 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. If both confess.” Trivers’s theory of reciprocal altruism is particularly successful in explaining human behavior because reciprocal altruism is a major part of all human activities . and attempts are made to induce each one to implicate the other. . . However..5 Repeated prisoner’s dilemma and tit for tat in nature Tit for Tat Chris Meredith. cooperation within and between species has generated only one strategy. You Scratch My Back . natural selection discovered the fundamentals of game theory and shaped animal societies according to its rules. . Long before humans started playing games. .. The prisoner’s dilemma is that if they both think rationally. But if one individual implicated the other. and not vice versa. . 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. Within species. individuals adopt alternative competing strategies with frequencies that reﬂect the success of each strategy . If neither one does. each one is imprisoned. as an added incentive. both are set free. and this means that the opportunity to cheat and not return a favor is a very real possibility. Consider how . [it] was an important advance in our understanding of the evolution of cooperation. The two prisoners are held separately. Evolutionary biologists have had considerable trouble explaining the evolution of cooperative behavior. tit for tat .” 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. then the implicated partner receives a harsher sentence than if each had implicated the other. 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.Market Structure Games: Dynamic 143 Box 4. Co-operation involves doing and receiving favors. to a small reward. The concept is summarized in the saying “you scratch my back and I’ll scratch yours. . The problem is that cooperation can always be exploited by selﬁsh individuals who cheat. 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. . It seems that natural selection should always favor the cheats over the cooperators. Australian Broadcasting Co. This is the cooperative strategy available to both prisoners. . but it was a “special theory” rather than a “general theory.

3. low-cost moves and gradually escalates as reciprocation occurs . Robert Axelrod was interested in ﬁnding a winning strategy for repeated prisoner’s dilemma games. Adopt this strategy only if the probability of meeting the same player again exceeds 2/3. unforgiving strategies are likely to produce isolation and end cooperative encounters . defection is the only rational choice. Tit for Tat These results provide a model for the evolution of cooperative behavior. the situation is more complicated than this analysis suggests. Retaliate only after your partner has defected. He conducted a computer tournament. had only two rules..” and “forgiving. . When people know the total number of games of prisoner’s dilemma.” A nice strategy is one that is never ﬁrst to defect. tit for tat would simply be Trivers’s theory of reciprocal altruism restated. he should still “cheat”—since he suffers less than if he trusts his partner. then it may be advantageous to cooperate on the early moves and cheat only toward the end of the game. But if the prisoner’s dilemma is repeated a number of times. At ﬁrst sight it might seem that the model is relevant only to higher animals that can distinguish between their various opponents. The result of the tournament was that the simplest of all strategies submitted attained the highest average score. If his partner fails to implicate him. . If they know that they are destined never to meet again. tit for tat is successful because it is “nice. called tit for tat.5 (continued) one prisoner thinks. However. Never be the ﬁrst to defect.. both do well. It is fairly obvious that the players’ strategic decisions will also depend on their likelihood of future encounters.” “provokable. On the ﬁrst move cooperate. If his partner has implicated him. This strategy. Four features of tit for tat emerged: 1.144 Chapter 4 Box 4. Be prepared to forgive after carrying out just one act of retaliation. [The Slab] Australian Broadcasting Co. . If so. A forgiving strategy is one which readily returns to cooperation if its opponent does so. Both individuals will cheat and both will end up relatively badly off. . 2. . But tit for tat is more than this and can be applied to animals that cannot recognize each other—as long as each individual starts cooperative encounters with very minor. According to Axelrod. 1998. . In a match between two nice strategies. then he should implicate his partner and get the best possible payoff. On each succeeding move do what your opponent did the previous move. Thus tit for tat was a strategy of cooperation based on reciprocity . they do indeed cheat more often in the ﬁnal games. 4.. . A provokable strategy responds by defecting at once in response to defection. Source: Excerpts from Tit for Tat by Chris Meredith.

Fudenberg and Maskin 1986). 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. In itself. tacit collusion between duopolists may not be individually preferable and sustainable as an industry equilibrium. the folk theorem has little to do with collaborative behavior. including the tacit collusion proﬁle. Fudenberg and Tirole (1986) suggest that inﬁnitely repeated games are too “successful” to provide a solid structure for analyzing oligopoly dynamics. and (2) the “focal” equilibrium should be Pareto optimal from the players’ perspective.6 where he also discusses the underlying notion of rationality in game theory. 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. tacit collusion may become self-enforceable as ﬁrms have no incentive to cheat or deviate from the agreed-upon behavior. Harsanyi and Selten (1988) examine such approaches. as part of a trigger strategy. It asserts that if the players are sufﬁciently patient then any “feasible. retaliation is delayed. static perspective can sustain as a perfect industry equilibrium provided that players are sufﬁciently patient or discount factors are large (discount rates are low). The “correctness” of this selection is more a belief than a result relying on solid game-theoretic foundations. 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). Many strategy proﬁles are perfect equilibria for sufﬁciently patient players in such inﬁnitely repeated games. to select among equilibria. This theorem basically asserts that for inﬁnitely repeated games.26 For more on the economic intuition behind repeated games. such as risk-dominance. Tacit collusion is enforced by the threat of retaliation. The folk theorem formalized by Fudenberg and Maskin (1986) is more general than suggested here. . economists often look for an argument that allows selecting one equilibrium among many as being more likely to arise. If ﬁrms cannot immediately react when rivals deviate due to detection lags. Friedman’s (1971) model of tacit collusion among Cournot duopolists is a special case of what is referred to as the folk theorem (e..” “individually rational” payoffs can be enforced by a perfect equilibrium in inﬁnitely repeated games under complete information. This suggests that duopolists would coordinate on half the monopoly output. many strategy proﬁles.g. One should ideally resort to more appropriate selection techniques. that are not optimal from a short-run.Market Structure Games: Dynamic 145 or low δ ). see Friedman 1977. Chamberlin (1933) recognizes other factors that inﬂuence the sustainability of collusive behaviors. see our interview with Robert Aumann in box 4. If the market is more stable or less volatile (high δ or low k ). To improve the models’ prediction power. This makes deviation 26. they instead propose several alternative approaches. for example. such as detection lags and ﬁrm heterogeneity.

6 Interview with Robert J.e. we often follow certain rules or norms of behavior that usually. Thus optimization is over rules that provide repeated guidance over time rather than over individual situation actions (I refer to this as rule. Your work on repeated games is particularly interesting. they do not follow self-interested optimizing behavior in each situation.. Aumann. Rules may lead to optimal behavior in general. lead to broad desirable outcomes for survival or success over many similar decision situations over time. what is the intuitive logic for this? . conﬁrm that our acts are not always rational. act-rationality). such as the ultimatum game. We study both. Such rules may be evolutionary or unconsciously adopted. Rather. i. Nobel Laureate in Economics (2005) 1. Do you believe that cooperation is more descriptive of real-world ﬁrm interactions than classic competition? If so. but not necessarily in every case. or on average.146 Chapter 4 Box 4. 2.vs. rational as well as psychological or behavioral approaches. Economic sciences have been criticized for the presumed rationality of economic agents. or Tversky and Kahneman’s behavioral work. Do you envision a role for a Center for the Study of Irrationality? I belong to the Center for Rationality at Hebrew University. Recent experiments. we eat when we feel hungry. For example. probability matching.

customers. However.” In the repeated prisoner’s dilemma.6 (continued) In repeated games players encounter the same situation over and over again. Cooperation may be harder to attain when there are many players. and sometimes even with competitors. In such games a player has to take into account the impact of his current action on the future actions of other players. i. it is difﬁcult to determine a “focal” choice (e.g. 4.. until recently strategic management frameworks have not adequately addressed this issue.. In such situations cooperation is more likely to be sustainable under certain conditions. The various relationships along the value chain. the presence of a cooperative equilibrium arises because the threat of retaliation is real.. Firms may create win-win relationships with 27.e. ﬁrms cannot at all react to their rivals’ actions over the play of the game. The time element/repetition is important. Porter’s ﬁve-forces framework. may bring about signiﬁcant competitive advantages.2. tends to view other parties (competitors. repeated prisoner’s dilemma). Cooperation is more likely when interaction over time occurs among a few players. but to cooperate and play a socially optimum strategy or follow the “social norm. Intuitively. production quantities) on which ﬁrms are likely to cooperate.3 Co-opetition: Sometimes Compete and Sometimes Cooperate? It is by now well accepted by corporate executives that partnerships with suppliers. In quantity competition. however. reputation or relationship effects.g. cooperation can be sustained if the discount rate is not too high. As noted..Market Structure Games: Dynamic 147 Box 4. involving different ﬁxed or variable production costs). ﬁrms would produce Cournot–Nash equilibrium quantities forever. This is equivalent to a setting where ﬁrms make their decisions simultaneously. i. This case collapses to a situation where ﬁrms formulate open-loop strategies that are adapted to calendar time only. do not necessarily present a threat. for instance. In the extreme case of inﬁnite detection lags. less costly in present-value terms and tacit collusion harder to sustain. if the players are interested enough in future outcomes of the game. since one will play the game again with the same person.. some game-theoretic models can provide economic rationale for this notion. On many occasions the optimal way of playing a repeated game is not to repeat a Nash strategy of the constituent game (e. This further hinders the sustainability of tacit collusion.27 In case of asymmetry among ﬁrms (e.g. or buyers) as threats to a ﬁrm’s proﬁtability. suppliers. .e.

Partnership with suppliers to enhance the beneﬁt to end consumers or improve productive efﬁciency (e. as they involve a mix of cooperation and competition. There are various situations where collaboration with external parties may create value: • • Joint R&D ventures with rivals. The value net includes relationships with external parties presenting threats or opportunities. substitutors..9.g. including activities performed by outside parties. and which can be performed in a relatively generic and low-cost fashion. founded in microeconomics and game theory. They term this kind of strategies co-opetition. • Agreement among competitors to set industry standards (e. The value net consists of four key players: suppliers. With an increasing number of business processes becoming commoditized within and across industries. Porter’s (1980) value chain is based on the premise that everything is done in-house. Blu-ray technology). including outsourcing. executives need to rethink the very basis for competition in their businesses. Co-development with a customer’s R&D team to better tailor endproducts to customer requirements. Substitutors are external parties who act in a contrarian fashion.. Brandenburger and Nalebuff (1995) propose the concept of value net.148 Chapter 4 their suppliers and even their competitors. Strategists have called for a more collaborative model of the value chain based on partnerships. Interactions among ﬁrms are structured along the value net depicted in ﬁgure 4. should be re-considered. Firms need to decide which of their business processes are core or crucial to make their strategies succeed. “Cooperative” strategies nowadays appear on top of corporate agendas. To provide a better framework that takes account of collaborative relationships. 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 . via just-in-time production). As a result of opportunities created by these broader collaborations.g. the entire value chain. and complementors. Today it is possible to redesign the value chain in many industries to better cope with uncertainty and interactive relationships. customers. • • Coordinated lobbying among competitors in the same industry. whereas complementors help create value since their actions beneﬁt both ﬁrms. potentially outsourced to external parties.

players behave cooperatively to increase the value of the total market “pie. A practical approach providing management with state-of-the-art conceptual frameworks would be helpful. The bargaining power wielded in the second stage may stem from competitive advantages. Such a focus is risky as ﬁrms rarely outperform their rivals solely through value redistribution. Once this is accomplished (in cooperation with others). In the ﬁrst stage.28 The value net is helpful to better account for cooperation opportunities that might be beneﬁcial to the ﬁrm. Value redistribution can be accomplished.” Afterward they behave noncooperatively to share the market pie based on their market power. Their approach is characterized by two stages. such as technological leadership. Trigeorgis and Baldi (2010) assess the value of optimal patent leveraging strategies under both demand uncertainty and competitive rivalry using a methodology allowing for a mix between competition and cooperation. 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.9 Value net and co-opetition Adapted from Brandenburger and Nalebuff (1995) favorable terms). Such situations where ﬁrms can either compete or cooperate can be analyzed with tools offered by option games. Yet ﬁrms can cooperate in different ways to increase the size of the pie. . Competition in redistribution is ﬁercer than competition to create new value. created in the ﬁrst stage. through more skillful bargaining with buyers and suppliers. value redistribution can be easier.Market Structure Games: Dynamic 149 Reduce prices Customers Increase prices Dividing up markets Substitutors Price competition COMPETITION Reduce margin Suppliers Company Making markets Complementors Creating new value COOPERATION Increase margin Figure 4. They 28. Such approaches may gain in acceptance over the coming decades. 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. for instance.

under what circumstances should rivals ﬁght and when should they collaborate in using their intellectual property (IP) assets. via cross-licensing to each other or even licensing one’s patented innovation to its rival). ..g.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 volatility of demand and on the size of competitive advantage arising from the patented innovation. The menu of different ﬁght or cooperate strategies is summarized in ﬁgure 4. namely when should two competitors follow a ﬁghting or a cooperating patent strategy? They show that the circumstances under which ﬁrms should ﬁght or cooperate are not trivial.. The key question they consider is. when business conditions are uncertain. The option games approach enables to capture certain features of an adaptive business strategy.150 Chapter 4 Demand Bracketing (asymmetric) Bracketing (symmetric) 1 2 3 H Cross-licensing h Fig t High Patent wall Licensing M 4 Coo ate per 5 6 (monopoly/ abandon) Medium Sleep/ abandon L 7 8 9 Low No (zero) (symmetric) Small Competitive advantage (patent innovation) Large (asymmetric) Figure 4. Under demand uncertainty rivals may sometimes ﬁnd it preferable to compete (e.g. The increasing cone of market and strategic uncertainty makes the value of a dynamic strategy that enables switching among a broader menu of competing or cooperating alternatives key to survival and success in a changing marketplace.10. 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.

Fudenberg and Tirole (1984) discuss the taxonomy of commitment strategies. Review of Economic Studies 38 (1): 1–12. (2004) provide a good overview of industrial organization focusing on the strategic insights of the models. 1971. Dynamic models of complete or incomplete information are more challenging than their simultaneous-move counterparts and give richer insights on how ﬁrms should consider the long-term consequence of their current actions. The results discussed in chapters 3 and 4 serve as building blocks for the option games methodology we deploy later. and Scott Schaefer. 29. New York: Wiley. Chapter 4 considered the time dimension. strategic decisions that appear suboptimal from a short-term.29 Selected References Osborne (2004) offers an accessible account of game theory. James W. Besanko. discussing several dynamic settings. Besanko et al. A non-cooperative equilibrium for supergames. Economics of Strategy. Chapter 3 discussed some static benchmark models involving price and quantity competition. Averted readers might prefer the more advanced treatment offered by Fudenberg and Tirole (1991). Tirole (1988) is a key reference in this area. David Dranove. 3rd ed. Mainstream industrial organization does not explicitly consider the impact of stochastic market uncertainty on the equilibrium results. Friedman (1971) elaborates on the sustainability of tacit collusion in inﬁnitely repeated Cournot games. Dynamic games are useful to understand that committing and killing one’s options may sometimes be advisable as a devise to create competitive advantage in subsequent stages. 2004. . David. Mark Shanley. better explaining optimal decision-making in the face of uncertainty. Merging dynamic games with real options analysis helps bridge this gap. They also provide economic foundations for collaborative behavior in certain markets involving repeated relationships.Market Structure Games: Dynamic 151 Conclusion This chapter and the previous one discussed how industrial organization can be helpful in providing insights about certain competitive situations. static perspective may indeed be optimal in the long term. Rubinstein (1982) examines bargaining over an inﬁnite horizon. Friedman. In such multistage games. Most dynamic models in industrial organization assume either steady state or a deterministic evolution of the underlying parameters.

Game Theory. Econometrica 50 (1): 97–109. 1988. and Jean Tirole. 1982. Cambridge: MIT Press. Rubinstein. the puppy dog ploy and the lean and hungry look. 2004. Cambridge: MIT Press. Jean. Perfect equilibrium in a bargaining model. Osborne. Drew. and Jean Tirole. Martin J.152 Chapter 4 Fudenberg. Ariel. Fudenberg. Drew. American Economic Review 74 (2): 361–66. Tirole. 1991. The Theory of Industrial Organization. New York: Oxford University Press. The fat cat effect. An Introduction to Game Theory. 1984. .

And yet. the analogy between real investment projects and certain traded derivative assets holds conceptual value. Real options analysis involves the application of methods utilized to price ﬁnancial options and other derivatives to real assets. Flexibility. Financial options are ﬁnancial assets (generally traded on the capital market) that give their holders the right—but not the obligation—to buy or sell an underlying asset at a speciﬁed price for a given time period. even when an analogy can be drawn. and Real Options Up to now we have mainly focused on industrial organization models in a certain or deterministic world.5 Uncertainty. 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. For instance. In such a case. Real options draw on an analogy between ﬁnancial options (calls or puts) and real-world contingent cash-ﬂow streams. they may not be traded on the capital market and may simultaneously be held by more than one investors. For example. Option-pricing theory was developed to price this asset class. that is.1 The real options approach to analyzing investment under uncertainty has by now gained standard corporate ﬁnance textbook status. 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. Still. it is an extension of option-pricing theory or contingent-claim analysis to real investment situations. real options are quite different. Real options are now commonly 1. the analogy applies well. Readers familiar with real options analysis may skip this chapter and go directly to the description of option games provided in the subsequent chapter.

Section 5. 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. adaptability to market developments can be of signiﬁcant strategic impact. 5. tackling complex issues such as when or where to invest in generation units is all the more difﬁcult in this highly unpredictable environment. including regulatory. technological trends or rivals’ behavior.154 Chapter 5 accepted as a powerful real asset valuation and management approach. In .3 describes option-pricing theory and illustrates its application in situations involving concrete investment problems from the energy sector. Even though the need to add generation capacities is well recognized in the electric utility sector (see International Energy Agency 2007). Increasing uncertainty casts doubt on current predictions about market developments. we discuss in section 5. The European energy sector exempliﬁes this challenge quite well. In the midst of such uncertainty. 5. Few of these developments could have been predicted. This indicator measures the power adequacy in terms of installed power generation capacity over peak demand in a given geography. To put our examination of real options in a concrete. Several economics and ﬁnance books have been dedicated to this approach. more prominently Dixit and Pindyck (1994) and Trigeorgis (1996). technological breakthrough and demand pattern changes. National markets have opened up to new entrants and energy prices have become increasingly volatile.2 discusses how managers of an electric utility can address such challenges utilizing real options analysis.1 Strategic Investment under Uncertainty—The Electricity Sector Over the past few decades many ﬁrms have experienced new developments in their competitive landscape. Section 5.1.1 Need for New Investment in Europe A key factor monitored by bodies regulating electric utilities is reserve margins. From this industry perspective we examine next the major sources of uncertainty and the business risk exposures implied by the new generation technology choices.1 the investment challenges faced by European electricity suppliers. applied context.

0 0.5 0.5 4.0 3.5 4.1 Growth trends in the European electricity markets From Energy Information Administration Database. consumers face generation inadequacy potentially leading to blackouts. If they fall to low levels.0 0.0 1.5 0..1. Brittany in France) are already approaching critical levels.5 0. by implementing energy-efﬁciency .5 3.” other words. indicating dire investment need in the coming years.5 2. Another means to improve reserve margins is to curb electricity demand.5 2.0 2.0 3.5 3.0 2.0 2.Uncertainty.5 3. In the last decades most European countries have experienced substantial energy demand increases.5 2. In addition.5 1. and Real Options 155 Europe (EU12) CAGR% 4.0 86–91 91–96 96–01 01–06 Electricity consumption Generation capacity Figure 5.0 86–91 91–96 96–01 01–06 Italy CAGR% 4.0 0.0 1.0 1. CAGR stands for “compound annual growth rate.0 86–91 91–96 96–01 01–06 France CAGR% 4. As shown in ﬁgure 5. these increases were hardly met by capacity additions. reserve margins must remain positive. Flexibility. resulting in shrinking reserve margins.5 1. Reserve margins in some European regions (e.5 1.5 4. most power plants built in the 1970s in the aftermath of the oil crisis are expected to be decommissioned or refurbished in the next decade across Europe as they become obsolete or no longer abide by new environmental standards.0 3.g. especially in peak load.

g.156 Chapter 5 measures or other market mechanisms (e. wind. These investments will take place under growing uncertainty and increased environmental constraints with the aim to promote green technologies. customer participation) to induce consumers shift demand from peak load to lower load periods. or ﬁrm speciﬁc.1 Uncertainty factors for electric utilities Idiosyncratic risks Demand uncertainty • Demand growth • Changing demand patterns • Country-speciﬁc prices • Price developments • Effectiveness of energy-efﬁciency measures Regulatory risks • Plant licensing and approval • Regulation of transmission lines Competitive risks • Market power of incumbents • Market entrance Technology-speciﬁc risks Construction risks • Investment cost overruns • Unforeseeable lead time Fuel-related uncertainty • Unsecured supply (e. Poland. however. uranium) Environmental uncertainties • Prices on CO2 and greenhouse gas emissions • Support on green technologies • Waste management and phaseouts (nuclear power) • New environmental standards Firm-speciﬁc risks Capital structure • Bankruptcy risks • Interest payments Cost structure • Economies of scale and scope • Learning-curve effects Company’s portfolio of corporate activities • Internal hedging a. be they idiosyncratic (e. Rapid changes occurring in recent years challenge would-be investors in determining when to invest (optimal investment timing). Such initiatives are. Germany). The 2008 dispute on gas between Russia and Ukraine led to serious supply disruptions in eastern and central Europe (e.g. gas. utilities face a number of uncertainties. not always as effective. so the need for additional generation capacity remains.1..g. 5. Electric utilities across Europe are expected to channel huge ﬁnancial resources into new power generation capacity to ensure system adequacy and reliability going forward.. where to add new generation facilities (network Table 5.. .. electricity demand growth). gas)a • Input price volatility (e. technological. Ukraine. coal.2 Sources of Uncertainty As illustrated in table 5.g.. changing demand patterns.g. Source: Adapted from International Energy Agency (2007).1.

First. We next look at the business risks each company in the sector faces and the risks involved in the generation technology choice.. . and Real Options 157 Electricity price (monthly averages in €/MWh) 100 80 60 40 20 0 2002 2003 2004 2005 2006 2007 2008 Figure 5.2 Idiosyncratic Business Risks Since electricity cannot be effectively stored.g. Flexibility.2 Electricity price ﬂuctuations in Europe from 2002 to 2008 From Powernext design).g. Finally. Energy suppliers for the most part managed to pass this cost through to their customers (given the low price elasticity of demand). This overall price increase can be attributed to three underlying factors.Uncertainty. demand pattern ﬂuctuations. coal) have trended upward. 2. Wholesale electricity prices in many European countries started to skyrocket in 2004 and have remained at a substantial high average level since. Second. leading to higher average generation costs. We do not intend to elaborate on ﬁrm-speciﬁc risk factors but instead adopt the viewpoint of an “average ﬁrm” in the electricity sector. gas. oil. utilities now have to pay for CO2 emissions. plant disruption) and are therefore extremely volatile.2 shows electricity price ﬂuctuations during the period 2002 to 2008. or what mix of technologies to invest in (technology choice). most fuel prices (e. Figure 5. the tightening of reserve margins has resulted in utilizing more expensive generation technologies.. electricity prices are very sensitive to shocks (e.

demand patterns can vary markedly across regions. Other construction-related costs as well might ﬂuctuate depending on general realestate market conditions. enabling customers to be better informed of current electricity prices and alter their consumption patterns accordingly.g. Germany). while others have more tertiary activities (e. in Italy) both for industrial customers and households.. lengthy plant licensing processes for nuclear power plants. especially when lack of process optimization due to limited experience results in substantial cost overruns. The national average market price is likely to be higher owing to the costly national production mix if transmission lines are ineffective. Although governments and regulatory bodies have shown interest at pushing energy-efﬁciency measures.g. The steel price is an important variable in any generation plant investment. Technology-Related Business Risks Capital expenditures may greatly vary from technology to technology and might follow different development paths. it is not clear whether such initiatives will be enforced and will achieve their goals. Various European governments contemplate initiating energy-efﬁciency measures to curb future electricity demand.g. For instance. antitrust regulation or administrative market-entry barriers to protect incumbents. R&D costs can be spread out to a larger number of projects. utilities need to operate more generation units. some being more often subject to huge demand peaks (e. This is critical for nuclear plants. besides achieving environmental objectives. . Some countries have a high share of industrial consumption (e. due to intense use of air-conditioning in southern European geographies). Smart meters have been introduced in some European countries (e.158 Chapter 5 Besides. When demand increases.. including costly ones. temperatures are different across northern and southern Europe and have differential effects. the United Kingdom)..g. The national production mix may also spill over into the electricity prices. New technologies may be characterized by decreasing investment costs over time due to economies of learning.. Local resistance in the form of “not-in-my-backyard” attitudes may also act as a hindrance to ensuring adequate capacity and investment. Governmental intervention may take many forms: subsidies or ﬁscal incentives toward new technological options. Other country-speciﬁc factors might also play a role. Through plant design standardization. to ensure power adequacy.

g. 5. Investment decision-making must be dynamic. which drives cost uncertainty for utilities. with the up and down potential of each underlying factor being seriously considered in adjusting the generation mix. There is no superior power generation technology among the group of mature technological options.g. long-term environmental policy is another source of uncertainty. A practical means to avoid this problem is to internalize the indirect costs (e.g. Depending on whether a ﬁrm is willing to pay large ﬁxed costs (e. coal ﬁred). Certain technologies may possibly put the system at risk as they might not be always available or reliable (e.. and the plant’s lifetime are also important factors. From an individual value-maximizing viewpoint. one might prefer one technology over another. Coal-ﬁred plants are more sensitive to the underlying fuel price volatility than nuclear power. The up-front investment cost is very high for a nuclear or hydro plant and less so for CCGTs. one considers the variable and ﬁxed costs involved in each case. cost overruns. At the end of the day. Each has certain features that make it better suited in certain situations. The ﬁxed cost components are the upfront investment cost. and more reliable than the others. No technology turns out to be cheaper. wind). When selecting among available technological options. but much less than combined-cycle gas turbines (CCGTs).g. Policy makers’ reluctance toward a steady... and the ﬁxed operating and maintenance costs.1. Completion delays. the decommissioning cost. The major variable cost component is the input fuel cost. Supply security may also come into play. damage on the environment) resulting from power generation.. the relative competitiveness of generation technologies varies over time. cleaner. nuclear power) or large variable costs (e. Flexibility. Operating and maintenance costs may differ depending on the technology considered and may undergo distinct development. Cost factors may vary. and Real Options 159 Operating and fuel costs are a major source of uncertainty. This is what the European Union intended when introducing the EU Emission Trading Scheme (EU ETS) in 2005.3 Generation Technologies and Business Risk Exposure A key question is not simply whether to invest but also which available generation technologies to choose.Uncertainty. . The technology choice ultimately determines the project’s sensitivity to certain underlying risk factors and its overall business risk exposure. utilities tend to select the “cheapest” technology regardless of total societal costs.

Fukushima). It is also one of the technologies offering the greatest operational ﬂexibility. EU member countries generally give subsidies to 3. 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). has a high carbon footprint and is signiﬁcantly more expensive if environmental costs are factored in. combined-cycle gas turbines (CCGT). Other technologies such as nuclear. Certain alternative technological options are gradually emerging as mainstream technologies. and nuclear power. Over the past two decades investments in various new generation units have signiﬁcantly altered the generation mix in many European countries. The coal-ﬁred technology involves the lowest (variable) costs under most circumstances. However. This technology. This is offset by current high fuel costs.3 Available sites though are limited and plant standardization is hardly possible..160 Chapter 5 Among the alternative technological options some are considered more conventional. have not yet gained enough acceptance but pave the way for more environmental-friendly power generation. such as coal ﬁred. Other renewable technologies such as biomass. 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. and catastrophic disruptions (e. civil nuclear power has a bad track record of delays. since they can be closed and opened at very little cost. however. CCGT technology. A noticeable trend is the increasing share of natural gas-ﬁred capacity (especially CCGTs) and of renewables technologies (especially onshore wind-power turbines). coal or fuel. Italy. Many countries (e. Reservoirs are very ﬂexible. while a few still invest in this technology with France taking the lead. and solar. however. The CCGT technology has several advantages. Hydro power generation also involves very large (sunk) investment costs. The offshore wind power technology has also gained in acceptance. which may lead to substantial delays and investment cost overruns.g. cost overruns. Recent high natural gas prices and CO2 emission costs have lead certain countries (mainly France) to boost investment in nuclear power plants. Germany) are reluctant to embrace civil nuclear power. .g. This technology is highly sensitive to gas prices since fuel costs represent a signiﬁcant share of total costs. however. Onshore wind power has nearly reached a 10 percent capacity share in Europe (EU12).. small hydro. whose efﬁciency has been signiﬁcantly improved relative to other technological options. has a poor environmental footprint in terms of CO2 emissions. including lower capital investment costs and short construction times.

Despite being environmentally friendly.3 shows the development in terms of generation capacity of various technological options over the recent two decades in Europe. Another alternative for electric utilities is to invest in transmission lines to enable improved integration of electricity systems with neighboring European countries. 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. construction costs and CO2 emission prices signiﬁcantly affect the relative attractiveness of each technology. The presence of interconnection lines between regions is beneﬁcial not only to utilities. Since Table 5. but also to the general public. Transmission lines enable an electric utility to compensate for low reserve margins in one region through imports from another neighboring country. the wind power technology is often challenging for utilities as it can only operate with sufﬁcient wind. Changes in fuel costs.Uncertainty.2. Investment cost Time-tobuild Operating cost Fuel cost Security of supply CO2 emissions . and Real Options 161 increase investment in renewables. 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. Business risk exposure depending on generation technology is summarized in table 5. primarily wind power and hydro.2 Business risk exposure of conventional generation technologies Technology Coal-ﬁred CCGT Hydro Nuclear Wind Low exposure Medium exposure High exposure Note: The table excludes idiosyncratic uncertainty (which is the same whatever the technology) as well as ﬁrm-speciﬁc risk. which have the option to supply the market under better economic conditions. Figure 5. Flexibility.

162 Chapter 5 Generation capacity by technology type in EU12 (in million kW) 600 Total CAGR% (1987–2007) 1. conversion.2 300 200 Thermal 1. For nuclear plants.2 100 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Figure 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.5 Renewables 17. 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. In contrast.2 400 Hydro 0. Because natural gas prices are very volatile. CCGTs are very sensitive to fuel costs. and fabrication. Wind power needs no fuel as such.3 Generation capacity by technology type in Europe From Energy Information Administration Database investment in generation capacity is largely sunk. They can beneﬁt from an improved understanding and guidance concerning the risk factors. Unexpected events may make other technological alternatives more suitable under speciﬁc future market conditions.7 500 Nuclear 1. this brings substantial fuel-sensitivity for CCGTs. 2007 0 . 5. fuel costs (mainly uranium) represent a small share of total operating and investment costs (most being dedicated to enrichment. particularly when formulating investment decisions to enhance their generation capacity and future economic proﬁts. ﬁrms face high business risks when deciding at the outset which technology to select. being therefore quasiﬁxed).

resolves to operate such a plant in Brittany if it is deemed worthwhile.. real-estate development. R&D. management can beneﬁt from different types of real options. real-estate development. and Real Options 163 Table 5. mining). capitalintensive industries.. strategic acquisitions. The necessary tools to quantify the values of such real options are discussed in the subsequent section. Relevant industries Resource extraction industries. When a managerial decision takes time or is done in stages. the ﬁrst project can be valued in view of the future growth options it creates. management can spend more to expand the project scale or it can extend the project’s useful life. outputs or locations. If the market prospects are worse than expected. Staging or time-to-build option Expand or extend option Contract or abandon option Capital-intensive industries (e. Technology-based ﬁrms (R&D). If investment takes place in stages. Suppose that French utility EDF has identiﬁed that in the Brittany region reserve margins are falling to such low levels that they may jeopardize power supply security. industries with multiple product generations. management can default if market prospects prove worse than expected. Multinational ﬁrms with production facilities in different currencies. Switching option Compound option As summarized in table 5.3. new product introductions. under the prevalent market conditions. managers can contract or abandon it for salvage. Since the involved capital investment cost I is large and cannot be recouped.Uncertainty.g.g. platform strategy in the automotive sector. startup ventures. If the project turns out better than expected. Management can select among the best of several alternatives.3 Common real options Real option type Deferral or waiting option Description Management can wait before making the investment to see how the market unfolds. management wishes to decide on solid ground when more sure that the need for new generation capacity in this . longdevelopment capitalintensive industries (e. being authorized to open up nuclear power plants in France. High-tech. Natural-resource industries (e. Often it might have the ﬂexibility to time its investment decision after observing how events unfold. EDF. electric utilities). e. Flexibility.. Deferral or timing option Management is not always confronted with a now-or-never investment decision.g.. inputs. We here discuss common types of real options in the context of an electric utility.g. airplane manufacturers).

The value of the initial wind farm is Vt at time t ( ≤ T ). electric utilities are increasingly investing in renewables technologies. At time t ( ≤ T ). Suppose that EDF may exercise its option to invest only once. The investment opportunity can be valued similarly to compound options (options on options). namely Vt + max {eVt − I e . Let VT indicate the time. may pay off under certain conditions and help avoid costly premature investment. Typically large construction projects are staged. though it may come at the cost of forgoing early cash ﬂows. management can choose to forego any future planned capital outlays. Vt }. Vt. management can expand the number of turbines or the scale of production (by e percent) by making an additional cash outlay I e. Option to stage or default during construction (time-to-build option) Cash ﬂows are not generated overnight once managers make an investment decision. meaning at maturity the option is worth max {VT − I . 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 . EDF in effect holds an investment timing or “waitand-see” option to beneﬁt from the resolution of uncertainty about electricity prices (reﬂective of the regional imbalance between demand and supply).164 Chapter 5 region is here to stay. such as wind power. with the possibility to expand. If future electricity prices or governmental subsidies are higher than expected. plus a call option on future (expanded) investment. 0} = max {(1 + e ) Vt − I e . VT − I . Waiting. The initial wind farm thus enables the ﬁrm to capitalize on future expansion opportunities. 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. at maturity (year T ). The actual investment staging consists of a series of capital outlays. if market conditions deteriorate. or 0. 0}. Just before expiration the option will pay off the greater of the net value created.T value of the investment’s expected operating cash ﬂows. Option to expand or extend Given the raised public awareness of environmental challenges ahead and the enforcement of more stringent environmental legislation. scalable wind farms with a limited number of turbines. During power plant construction. This . 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) investment cost outlay I t required to proceed to the next stage. A possible plan design for the utility is to start up small. the entire project can be viewed as the base-scale wind farm.

can make the basic small. especially if the costs of switching between the operating and idle modes are relatively small.. exploiting the tremendous volatility in local electricity prices. In this case the utility might be better off not operating temporarily. management can operate below total power generation capacity or even reduce the scale of operations (by c percent). The contingent payoff at time t (≤ T ) is π t = max {Pt − Ct . This case with no switching cost has been analyzed by McDonald and Siegel (1985) along the Black–Scholes lines. with present ˆ (option) value π 0(t ) ≡ e − rt E0[π t ]. allowing decision-making to be path independent. which will be exercised only if future electricity prices or subsidies turn out more favorable. scalable wind farm project worth undertaking. Enron allegedly made huge proﬁts in California operating such peak power plants only a few days or weeks in the year when prices peaked. Flexibility. paying off max {I c − cVT .5 Option to switch use (e. 0} at maturity.4 In peak-demand periods. the total plant value is V0 = ∑ t =0 π 0( t ) provided switching costs are small or negligible..g. This ﬂexibility to mitigate loss is analogous to a European put option on part (c percent) of the base-scale project.Uncertainty. Because the plant embeds such shutdown and restart options at each (discrete) time period t until maturity T T . It may be proﬁtable to operate ﬂexible (e. . Option to shut down (and re-start) operations A power plant does not necessarily have to operate in each and every period. 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. 5. 0}. Option to scale down or contract If market conditions turn out weaker than originally expected. 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. operation can start up again and be quite proﬁtable. and Real Options 165 expansion option. 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. as market electricity prices rise to peak levels. For simplicity. with exercise price equal to the potential cost savings (I c). thereby saving part of the planned cash outﬂows or ﬁxed costs (I c). We discuss below two types 4.g. It may sometimes be preferable to build a plant with lower initial construction 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. we assume henceforth that switching costs are negligible.

Generally. the payoff at the following node will be max {Bt . selecting the most proﬁtable output once price uncertainty gets resolved. At − I ( At −1 → Bt )} . especially liqueﬁed natural gas (LNG). 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 generation units in view of the actual energy prices (gas vs. or to 6. Inversely.g. Over the past years natural gas has been under increasing competitive pressure owing to the introduction of substitute products. . If the correlation between the two fuels is lower. the ﬁrm may switch from natural gas to LNG by incurring the switching cost I ( At −1 → Bt ) . 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. A case in point is the merger of the French gas utility GDF with Suez. max { At . This move partly resulted from the synergies arising from the increasingly growing share of gas-ﬁred power generation (CCGTs) in Europe. Recently there has been a consolidation trend in the energy industry toward the merging of electric and gas utilities. building a ﬂexible generation facility that can switch among alternative fuel inputs) but also by maintaining relationships with a variety of suppliers. Let At be the value (as of time t) of utilizing natural gas and Bt of using LNG as input. compared to the (best of the) rigid alternatives that confer no or less choice (either natural gas or LNG). the switching option will be even more valuable. The cost of switching from one input to the other may differ depending on which fuel was previously in use. process ﬂexibility can be achieved not only through an adequate technology choice (e. electricity).166 Chapter 5 of switching options. if the LNG fuel was initially used. The utility would be willing to pay a certain premium to acquire such a ﬂexible technology. Should market conditions prove currently better for LNG over natural gas. An effective strategy is to invest in ﬂexible gas-ﬁred generation technologies (especially CCGT) that can use either of these fuels. 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.6 Naturally the correlation between natural gas and LNG is fairly high since the products are close substitutes. Such interconnection lines enable the Italian electric utility Enel buy cheap nuclear power from France. relating to inputs or outputs.. changing the mix as their relative prices change. Bt − I ( At −1 → Bt )} . Another example of the option to switch outputs relates to the integration of European electricity markets due to the introduction of merchant transmission lines. Another form of switching option relates to the optionality to design operations such as to produce alternative outputs. The prices for natural gas and LNG are positively correlated. The utility can select the best of the two operating modes. exhibiting some form of path dependency.

Myers and Majd (1990) examine a similar problem. The prospect to forgo negative cash ﬂows when shutting down a plant can provide a sufﬁcient incentive and make the abandonment option valuable. Because of more stringent environmental constraints and demand for higher energy efﬁciency. The investment in the ﬁrst EPR plant is a prerequisite in a chain of interrelated projects. Vt. . 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.7 Corporate (compound) growth options An early investment may set the path for future opportunities to follow. plants with higher variable costs). decommissioning the less performing generation units (e. It may ﬁnd it better to shut down operations. 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). 0} or max {Vt . and building the ﬁrst EPR plant. and Siemens as the new generation of pressurized water nuclear reactors. Future nuclear power plants could leverage on the experience gained from developing. A case in point is the evolutionary pressurized reactor (EPR) technology developed by Areva. with exercise price the “salvage value. management does not have to sustain operations forever. This option is analogous to an American put option on current project value. several new generation technologies are being developed (while older ones are being substantially researched on and improved). Such growth options are particularly valuable when learning-curve effects are involved. entitling management to receive Vt + max {St − Vt . 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.” St.. It could be of interest. The salvage value for which the plant can be sold or exchanged. the resale price of production facilities is limited. to build one as an operating prototype. St } before option expiration in year T . EDF.Uncertainty. however. and Real Options 167 sell electricity in France should the price there be higher than the Italian market price.g. may ﬂuctuate over time as does the project’s value Vt. designing. Flexibility. Option to abandon for salvage value If electricity prices suffer a longstanding decline. Since most assets in the electricity sector are dedicated to generate power with no possibility to produce other goods. Management has a valuable option to abandon a project permanently and stop paying the production costs. St.

There are noticeable “unbalanced” mixes in France (large share of nuclear power) or the Netherlands (almost 70 percent gas ﬁred). Portfolios of real options A well-diversiﬁed power generation portfolio includes several affordable technologies that hedge exposure to various technology-speciﬁc business risks while achieving power adequacy. CO2 emissions prices) can alter the relative attractiveness of alternative generation technologies. R&D-intensive. pharmaceuticals) as well as in industries where having a global footprint is key. it is not necessarily the case at the national level. 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. For general option interactions.4. Diversiﬁcation in terms of technologies is a sensible strategy for an electric utility to help manage risks. subsequent generations would not even be feasible. Such growth options are found in many other industries especially in industries which are infrastructure-based. . ch. nuclear plants) should be committed to base-load demand in 8.8 Even though the installed generation capacity is well-diversiﬁed on the overall European level. computers. 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). The technology portfolios in the European Union compared to individual member countries are shown in ﬁgure 5. see Trigeorgis (1996. better performing nuclear power plants. 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.. Portfolios of options may also involve negative interactions or positive synergies.168 Chapter 5 of a chain of new. Unless the ﬁrm decides to commit and initiate the ﬁrst EPR investment. it is an interproject compound option. In such coupled systems. As part of their risk management strategies. fuel costs. investment costs. 7).g. the experience generated during the development of the ﬁrst-generation EPR plant may serve as a springboard for developing future enhanced-efﬁciency nuclear power generation units.g. utilities can consider investing in other technology types or setting up transmission lines.. Fluctuations in the key cost factors (e..g. in semiconductors. Even if the initial stand-alone project does not generate positive net value on its own. Transmission lines make it possible to leverage on the Europe-wide welldiversiﬁed generation mix and reduce exposures in a given geography to certain technology-speciﬁc business risks. Plants involving high ﬁxed costs (e. A well-diversiﬁed portfolio of generation capacities allows utilizing technologies better suited to changing market conditions. that is. or involving multiple product generations or applications (e.

and Real Options 169 Total capacity 100% Renewables Nuclear 80% Hydro 60% 40% Thermal 20% 0% BE 15 DK 13 FR 112 DE 127 GR 13 IE 6 IT 82 LU 1 NL 23 PT 14 ES 77 UK EU12 80 562 Total capacity (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. CCGTs) characterized by large variable costs should operate during peak hours when load is higher and electricity prices sufﬁciently high to cover these costs.3 Basic Option Valuation Should electricity prices or other market factors evolve differently than initially expected. cannot be properly valued using the classical discounted cash-ﬂow (DCF) approach. Flexibility..Uncertainty. however. G. Flexible power plants (e.g.1 discusses how to think about managing portfolios of options via a gardening metaphor. Marco A. The marginal costs are hardly stable over time. A precise rigid recommendation for the generation mix is unwarranted since the optimal mix changes continuously over time. Figure 5. 5. Real options analysis is a more useful tool to analyze managerial ﬂexibility since it . The aforementioned real options. so the graph changes dynamically. the utility’s management has several options to adapt to enhance the future cash ﬂow stream or limit losses. Box 5.5 shows a static version of the recommended generation mix as a function of electricity demand and marginal costs.2. Días from Petrobras discusses some real options applications in Brazil in box 5.

These cases at the extremes—now or never—are easy decisions for the gardener to make. However. Harvard Business Review Managing a portfolio of strategic options is like growing a garden of tomatoes in an unpredictable climate. Some are edible and could be picked now but would beneﬁt from more time on the vine. and there is enough time left in the season. wind) Electricity demand (in MW) Figure 5. Other tomatoes are not yet edible. hydro Must run (e. Walk into the garden on a given day in August. and you will ﬁnd that some tomatoes are ripe and perfect.1 Managing portfolios of options: A gardening metaphor Strategy as a Portfolio of Real Options T. Luehrman. they are sufﬁciently far along. no gardener would ever bother to pick them. even if squirrels do get them.. Any gardener would know to pick and eat those immediately. Other tomatoes are rotten. In between are tomatoes with varying prospects.170 Chapter 5 Marginal costs (in €/MWh) Demand-off peak Demand peak Extreme demand Old plants Gas-fired Coal-fired Nuclear. 127) Box 5. and there’s no point in picking them now. p. that .g. The experienced gardener picks them early only if squirrels or other competitors are likely to get them.5 Technology use as a function of demand level Adapted from International Energy Agency (2007.

trying to get more of those in-between tomatoes to grow and ripen before time runs out. Flexibility. In option terminology. Source: Reprinted with permission of Harvard Business Review from “Strategy as a Portfolio of Real Options. By the last day. it can suggest what to do to help those in-between tomatoes ripen before the season ends. fertilizing. Luehrmann. They are monitoring the options and looking for ways to inﬂuence the underlying variables that determine option value and. outcomes. there are small green tomatoes and late blossoms that have little likelihood of growing and ripening before the season ends. and goes home. Still others look less promising and may not ripen before the season ends. however.1 (continued) many will ripen unharmed and eventually be picked.Uncertainty. 89–99. and they might just as well be left on the vine. none of the fruit falls into the “now” or “never” categories. Early in the season. The weekend gardener visits frequently and picks ripe fruit before it rots or the squirrels get it. but based on what they see. There is no value in picking them. Of course. active gardeners are doing more than merely making exercise decisions (pick or not to pick). The interesting question is: What can the gardener do during the season. Finally. Not only do they watch the garden. September– October 1998. we would expect the active gardener to enjoy a higher yield in most years than the passive gardener. pp. the weather is always a question. picks the ripe tomatoes. they also cultivate it: watering. and Real Options 171 Box 5. Active gardeners do much more. good gardeners also understand how the garden changes over time. 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. while things are changing week to week? A purely passive gardener visits the garden the last day of the season. active gardeners in several ways.” by T. and not all the tomatoes will make it. Still. Copyright © 1998 by the Harvard Business Review School Publishing Corporation. Option pricing can help us become more effective. and weeding. 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. ultimately. Finally. fewer weeds. Beyond that. . But with more sun or water. all rights reserved. even some of these tomatoes may make it. or just good luck. Most experienced gardeners are able to classify the tomatoes in their garden at any given time. all of it falls into one or the other because time has run out.

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. Here RO started as the villain and ended up as a hero! Due to the oil price shocks in the 1970s. Días. But in the 2000s a new technology appeared in Brazil: the ﬂex-fuel car using either gasoline or ethanol. The ﬂex-car was an immediate success. 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. One example is the ﬂex-fuel car. leaving everybody better off: ethanol producers. Some of these applications are listed below. 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.172 Chapter 5 Box 5. How. and to what extent. Brazil initiated the ethanol-fuel automobile production in the 1980s. Brazil is likely the most popular user of real options analysis in the world. In the last years almost all automobiles sold in the Brazilian market are ﬂex-fuel. We say that in Brazil even the past is uncertain! So ﬂexibility is more valuable here than elsewhere. But with low petroleum prices the owners of sugar mills preferred to make sugar instead of ethanol (switch output option). offsetting the fear of the producer switch-output (sugar-ethanol) option. The ﬂex-fuel car provided switch-input options for the consumer. Ethanol car production practically disappeared with the fall of consumer conﬁdence in the ethanol automobile.2 Interview with Marco A. leaving the service stations without ethanol for customers. G. Petrobras 1. Besides the United States. The history of instability and uncertainty obligates both people and businesses to be more ﬂexible to adapt to the frequently changing environment. and consumers. including several public cases where . A real options success story! 2. automobile producers.

castorbean. deﬁnitely. but separate from courses on real options.Uncertainty. In the future. We conducted analysis using real options. i. cotton. 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. Do you see a role for using game theory in conjunction with real options analysis? Yes. RO thus contributed in the public debate with a lot of success! ii. This course. We demonstrated to ANP that this ﬂexibility has value so that the tariff must be higher for BG compared with “take-or-pay” tariffs. Petrobras thus had more time to discover and appraise new oilﬁelds. . suggesting between 8 and 10 years. suggesting only 5 years for deepwater blocks exploration.” Using RO. 3. we showed the importance to stay in Africa offshore. In 2003. iv. The study recommended the project (though the 2008 crisis and other priorities. We studied GTL (gas-to-liquid) technology using RO (switch-input and switch-output options) in 2006 to 2008. The petroleum sector was opened up in Brazil in the late 1990s. motivated three real-life applications already. In 2005. while paying the same tariff as other companies without this ﬂexibility (“takeor-pay” contracts). enlarged the duration to 9 years. The RO value was decisive for the project to get approved by the board of directors. a biodiesel project was analyzed with real options because of the “ﬂex” technology for the inputs. namely ﬂexibility to use vegetable oils from soybean. ANP presented for public debate a proposal for the duration of the exploratory phase. Flexibility. v. Subsequently ANP. BG and Enersil wanted free access to the pipeline with ﬂexibility to use it or not. once it became aware of the results. iii. In 1998. Petrobras International solicited another real options project named “Strategic Valuation of E&P International at West Africa Offshore. put the project in wait mode). and Real Options 173 Box 5. In 2000 to 2001. and nowadays the African production is very signiﬁcant for Petrobras’s international operations.2 (continued) the decision of the petroleum regulatory agency (ANP) was often favorable to Petrobras. the recent large pre–salt discoveries needed more than 6 years to be discovered after the auction. I think option games courses will be offered at Petrobras also and related applications will follow. Petrobras kept its business there. etc. such as large discoveries in pre-salt. The decision of ANP was to permit free access to the pipeline but require paying a higher price for the tariff. At Petrobras game theory is being taught since 2007. although recent.

. The Black–Scholes model is also often referred to as the Black–Scholes–Merton model to pay tribute to Robert C. An alternative approach. option-pricing theory. The discrete-time CRR model converges to the continuous-time Black–Scholes model for small time increments or large number of inbetween steps. Merton discusses the development and impact of continuous-time ﬁnance. and the relevance of real options in box 5.174 Chapter 5 can allow future decisions to be adapted to future market conditions. Discrete-time models are generally better suited when one needs to handle practical or complex valuation problems (e.10 Originally these models were designed to price ﬁnancial options but have since been extended to valuing real options. Discrete-time models are easier to implement. is to make the adjustment 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 ). portfolios of real options). The two setups are closely related. as if the utility could not alter its operational or investment decisions over time. while the discrete-time multiplicative binomial model of Cox–Ross–Rubinstein (CRR) offers a more intuitive introduction to option pricing.. 10.9 The Black–Scholes (BS) or Black–Scholes–Merton model involves advanced mathematics and notions of ﬁnancial theory in continuous time. 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.3. that is core to option pricing. The continuous-time approach assumes instantaneous decisionmaking. Static NPV represents an extreme case where the management commits at the outset (at t = 0) to a stringent plan of action. We ﬁrst present the basic valuation idea in discrete time and later extend it brieﬂy to the continuous-time context. 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. The valuation approaches underlying the net-present-value (NPV) paradigm and real options analysis involve similar assumptions but alternative versions of risk adjustment. though continuous-time models have an appeal as they help better identify the theoretical value drivers and examine the underlying trade-offs. The two most known option-pricing models are attributed to Black and Scholes (1973) and Cox. 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. Ross. Merton for developing much of the foundation work in Merton (1973). 9. Discrete-time and continuoustime models offer alternative ways to characterize these certainty equivalents. and Rubinstein (1979). Robert C.g.

Paul A. he generated the Kolmogorov equations for warrant pricing and with H.Uncertainty. 2. P. convertibles. I traded warrants. Samuelson recently passed away. 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. Nobel Laureate in Economics (1997) 1. At MIT I worked with Paul Samuelson in 1968 on warrant pricing. Did you envision the widespread use or application of options thinking and tools when you ﬁrst worked on options and stochastic-calculus applications? 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. including ﬁnance. 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.3 Interview with Robert C. McKean derived . such as using it to develop a uniﬁed theory for pricing the capital structure of the ﬁrm. Merton. and Real Options 175 Box 5. and OTC options before I ever studied economics. Paul Samuelson introduced geometric Brownian motion for underlying stock prices. 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 replicate the payoffs to any derivative via dynamic portfolio trading in the underlying asset. Can you comment on his early contribution to continuous-time ﬁnance? In his 1965 rational theory of warrant pricing. His seminal work spans many economic ﬁelds. Flexibility.

and given that the portfolio tracking error (following a portfolio strategy that minimizes that error) is uncorrelated with all traded asset returns. 3. 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. a.6 depicts the underlying asset’s value dynamics in a one-period binomial lattice. 5. such as NPV. I provided the connection between his warrant pricing model and the Black–Scholes model. Since in all equilibrium asset-pricing models (e. 4. Conceptually the model can be adapted to nontrading of the underlying asset and even to nonobservable interim prices (see Merton 1998. the CAPM or arbitrage pricing theory) assets that have only nonsystematic or diversiﬁable risk are priced to yield an expected return equal to the riskless interest rate. Assume further that this asset is traded in capital markets or that there . In an attached appendix to Samuelson’s published 12th von Neumann Lecture.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). respectively. my Nobel Lecture (Merton 1998) includes a list of various applications of the model methodology. etc. Figure 5. Real options valuation is no more handicapped than any of the other tools of valuation. 326–36). where you need data on an equally risky asset to estimate beta. including real options.176 Chapter 5 Box 5. the option pricing formula would apply even in those applications in which the underlying asset is not traded. pp..a This was the ﬁrst time that the Black–Scholes model appeared in published print. 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. This lecture resulted in the article by Samuelson (1973).3.3 (continued) pricing for the early exercise provision of American-style warrants. 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. Paul Samuelson was John von Neumann Lecturer at the SIAM Annual Meeting in 1971. In one period.g.

1+ k 1+ k (5. We assume that the market is complete so that the replication argument holds. . 12.11 Real options involve cash ﬂows that are asymmetric on the downside versus the upside and are contingent on future uncertain events. The standard (NPV) approach. they must sell for the same current value to avoid risk-free arbitrage proﬁt opportunities. Risk. we could create a riskless replicating portfolio and discount the payoffs from this portfolio at the 11. is unable to properly value projects involving operational ﬂexibility. may vary in a complex way over time and across various future states. 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. Investing immediately would result in project NPV = V − I .12 Since the option and its equivalent portfolio would provide the same future returns in all states. the future values of the power plant (V + and V − ) are related to its present value (V ) as a discounted expectation: V= E [V1 ] qV + + (1 − q) V − = . one can capture a form of timing ﬂexibility and act optimally by choosing the alternative with the highest NPV. however. 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.1) Suppose that investing in the plant involves capital cost I . Flexibility. When we consider a project with differing starting dates as mutually exclusive alternatives. and Real Options 177 V+ 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. Optionality can be properly valued using option-pricing theory. Under traditional NPV analysis. and therefore discount rates. such as the option to delay the investment for a year. This approach based on mutually exclusive alternatives extends the standard “NPV rule” asserting to invest in positive NPV projects. Equivalently.Uncertainty.

investors’ risk attitudes do not matter in valuing the option and need not be explicitly considered.3) 13. in a risk-neutral world is V= ˆ E [V1 ] pV + + (1 − p) V − = . The position. the present value of any contingent claim can be obtained from its expected certainty-equivalent value discounted at the risk-free rate r. and so risk-neutral expected cash ﬂows can be appropriately discounted at the risk-free rate. (5. C+ − C− V+ −V− and B= C (1 − ) . Through the ability to construct a riskless portfolio. it yields in each state of the world a return equal to 1 plus the risk-free return r. This system of two equations with two unknowns gives the following values for N and B N= with ⎛ C+ −C− ⎞⎛ V ⎞ =⎜ + ⎟ − ⎟⎜ ⎝ V − V ⎠⎝ C ⎠ being a discrete measure of the elasticity of the option with respect to the underlying asset value. C + = N × V + − (1 + r ) B and C − = N × V − − (1 + r ) B. 1+ r 1+ r (5. that is. The risk-neutral probability of an up move is then p≡ (1 + r ) V − V − V+ −V− . Option-pricing theory bypasses risk-aversion by valuing options as if investors were in a risk-neutral world. Holding B bonds at time t is worth B (1 + r ) in one period. 14. In such a world all assets would earn the risk-free return (r).13 To value the project as if in a risk-neutral world. 1+ r . 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. this portfolio must sell for the same price as the option it replicates.178 Chapter 5 risk-free rate. Therefore.14 Alternatively. The present value of the underlying asset. invested in the asset to replicate the option payoff is the option’s hedge ratio (or option’s delta). The NPV approach factors investors’ risk-aversion in the risk-adjusted discount rate k . such as the power plant. Since the bond is risk-free.2) ˆ where E [⋅] denotes the risk-neutral expectation. Let p denote the risk-neutral probability of an upward move (and 1 − p the probability of a downward move). To avoid arbitrage opportunities in the capital market. N . In discrete time. Consider a portfolio that replicates the payoffs of the option in each state. r. we can equivalently—and more conveniently— obtain the option value as if we were in a risk-neutral world. it is obtained as the difference (spread) of the option prices divided by the spread of asset prices. one needs to utilize the so-called risk-neutral probabilities. Consider a portfolio made of N shares of the underlying asset Vt and B risk-free bond(s) that pay €1 next period.

the expected return of this option must also equal the risk-free rate r. If the plant is built immediately. In the up case. q. net of the capital investment cost I = C80 m. In a risk-neutral world. (5. in one period. it is R − ≡ V − V − 1 = d − 1. with each outcome equally likely (q = 0. EDF will receive gross project value V = C100 million (m) . Effectively. The risk-neutral probability. EDF has no fear of preemption and. Flexibility.4) can be obtained by considering returns. since p accounts for investors’ risk-aversion. By waiting. 16. respectively. giving lower weight to upside events.8) or down by 40 percent (d = 0. and Real Options 179 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). In the down case. the return is R + ≡ V + V − 1 = u − 1. Suppose that this real option has value C + or C −.5) Example 5. EDF will forgo one period of proﬁt but can beneﬁt from the resolution of political uncertainty. p is the value probability q would have in equilibrium if investors were risk neutral. the plant will have an expected value (from subsequent cash ﬂows) of V + = C180 m if the 15.1 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.5). Probability p is lower than the real probability of an upward move. formula (5.Uncertainty. A year later.4) Consider now a deferral option on the underlying power plant’s value. the risk-neutral probability above is given by15 p≡ (1 + r ) − d u−d . as a function of V + or V − . or p≡ (1 + r ) − d u−d . In the electricity case we can derive the risk-neutral probability p from the price dynamics of electricity prices using forward prices for electricity.5) provides a formula for the value of the option in terms of V . 1+ r 1+ r (5. This results in the following fundamental option-pricing formula:16 C= ˆ E [C1 ] pC + + (1 − p)C − = . . p. Alternatively. may gain political support through subsidies. this results in an NPV of C20 m. 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: pR + + (1 − p) R − = r.6) depending on the outcome of next year’s elections. Suppose that the plant’s value in one period will move up by 80 percent (or u = 1. Note that d < 1 < 1 + r < u for the no-arbitrage argument to hold. Equation (5. depending on the party chosen. u is the discrete-time equivalent of the continuoustime volatility parameter eσ h (which is a function of the volatility of the asset σ and the time step h). r and the asset volatility (u and d ).

In year 1. EDF may install new turbines in one of its wind farms in Brittany.20 = C100 m. Example 5. 0} = 100 in the event of a positive election outcome. .6 = 0. 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. The option to defer the investment can be quite valuable. expanding production scale by making a complementary investment if the newly elected regional government gives support to renewable energies.4 × 100 + 0. based on equation (5.6 × 0 ≈ C 37 m. 1. is C= 0.6 If there are no options creating asymmetry in the payoff proﬁle. since the ﬁrm would invest only if prices and project value rise sufﬁciently. is p= (1 + r ) − d u−d = 1.4 ( < 0. Suppose that the expected rate of return or discount rate is k = 20 percent and the risk-free interest rate is r = 8 percent. however.5) . The original investment opportunity can be seen as the base-scale project plus a call option on future growth.8 − 0.2) would yield the same value for the plant as traditional DCF valuation based on (5.4). while it has no obligation to invest under unfavorable developments.2 Option to Expand Alternatively.08 − 0.08 EDF thus has a very valuable option to defer the investment for a year (37 > 20).5).50) by adding capacity at extra cost I e = 40. The risk-neutral probability.180 Chapter 5 outcome is favorable or V − = C60 m in the adverse case. 0} = 0 in the event of a negative outcome. obtained from equation (5.4 ) 60 1. or C − = max {60 − 80.4 × 180 + (1 − 0. The value of the option to invest next year.1): V= 0. 1. waiting until further information about the outcome of political elections and the electricity prices in Brittany is revealed. The value of the plant launched one year from now is C + = max {180 − 80. 0} = max {(1 + e ) V + − I e .5 × 180 + (1 − 0.08 0. the riskneutral valuation formula of equation (5. providing C + = V + + max {eV + − I e .5) 60 = 1. V + } after an up move.

it will obtain the guaranteed (French nuclear) price P − = max {0. receiving PI+ = 1. PF }. The average (next-year) price in Italy would have been E [ PI ] = qPI+ + (1 − q) PI− = 0.5) each year.1.5 × 60 − 40. will move up by 50 percent to PI+ = 1. obtaining C + = max {1. Suppose that the electricity price in France is constant at PF = 1 due to reliable nuclear power technology. Flexibility. Without the transmission line. 1. This is analogous to the previous option to expand with payoff max {PI+ − PF .5. if Italian prices drop to PI− = 0.5 × 180 − 40.Uncertainty. PF } or P − = max {PI− . 0} = 0. The expanded NPV (including the value of the option to expand if the market grows) based on equation (5. If local prices move up next year. being exposed to the full price ﬂuctuation risk.5 m . but it will maintain the base scale in the adverse case earning C − = max {1. Enel could only sell at local prices. If they move down.67. 1} = 1. 60} = 60.5 or PI− ≈ 0. and another limiting the downside risk to Enel by selling in France rather than in Italy if local prices drop (a put option). and Real Options 181 or C − = max {(1 + e ) V − − I e .5. With the transmission . The price received by Enel will be P + = max {PI+ . In the case at hand.67. 180} = 230. 1} = 1. 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 (1.5 (u = 1. In the adverse case. EDF will choose to expand in the up case.67 next year. 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). V − } in the adverse case.6 × 60 ≈ C118.5) is C= 0.67.08 Example 5. being PI = 1 today. 0} = 0.33.67 (d = 2 3) with equal probability (q = 0.67 ) ≈ 1. The Italian electricity price.4 × 230 + 0. Enel will charge P + = max {1.5 + 0.5.5.3 Interconnection Line The Italian electric utility Enel is considering installing an interconnection line with France that would enable it to beneﬁt from electricity price differentials between the two countries.5) or down by 33 percent to PI− = 0. If the Italian electricity price rises next year. Enel can export electricity to France receiving the higher French price PF = 1. 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. the option payoff is then max {PF − PI− .

1. the risk-neutral probability of an up move (with risk-free rate r = 0. however.05 Outside Europe. downscaling its own production.4).” 18. max {E [ PI ].5 + 0. Savage (2009) applies Jensen’s inequality to challenge certain managerial practices based on the “ﬂaw of averages. We can characterize this value difference by applying Jensen’s inequality to convex or concave functions.05) is p ≡ (1.1. We thank Marcel Boyer for suggesting this example.”17 What is the correct “average” price discounting for the value of the transmission line? From equation (5. follows a binomial process with an upward multiplicative factor u = 1. From equation (5.46. The payoff function f (⋅) of the call option is convex in the underlying factor X .4 below for two steps. Thus the transmission line allows to sell at higher prices on average. makes it possible to circumvent this “ﬂaw of averages. where Enel of Italy has the option to enter the Russian electricity market in two years’ time.05 − 0.46 × 1. Example 5.182 Chapter 5 line. Hydro reservoirs are very ﬂexible resources. In contrast. the average price is E [ PI ] = 0.67) = 0.5) the value of the merchant interconnection line per unit of output is 0. This is discussed in appendix 5A and illustrated brieﬂy in example 5.54 × 1 ≈ 1. On the converse. so that the opposite inequality holds. During the day.25 ( > 1. . The transmission line would be mispriced if managers ignore the embedded switching ﬂexibility value and base their investment decision on the future average price. Hydro-Québec. it raises own production and sells them back electricity at high prices (high local demand).4 Option to Invest or Defer (Two Steps) Consider a situation analogous to example 5. PF } = 1. so that Hydro-Québec can increase or decrease output at very low cost almost overnight. Suppose again that the market value. by considering the optimal switching decision at each period in each state. Ontario and the northeastern states of the United States rely mainly on nonﬂexible thermal power plants that virtually have a constant output. 1. such that E [ f ( X )] ≥ f ( E [ X ]). a state-owned corporation in Canada with large production capacity in hydro (95 percent).5 + 1) = 1. is proﬁtably exploiting such transmission lines.18 One can extend the above one-period binomial analysis to a larger number of steps though a repetitive process.67) (1.5 (1.17 .1).5 − 0. a put has a concave payoff function. At night. Real options analysis. Hydro-Québec buys electricity from Ontario and the NE-US at very low prices (due to low local demand).5 and 17. explaining why prices there are very sensitive to changes in demand patterns. currently C150 m (V = 150).

The current investment option value is assessed by a backward process using risk-neutral valuation along the two-step binomial tree. In the intermediary state (that occurs after a downward move following an up move or inversely). the gross market value. and Real Options 183 downward factor d = 1 u ≈ 0.4). Figure 5. Enel will then enter the market.04. determined from equation (5. 0} = C 258 m. The risk-free interest rate is r = 0.5 × 0.Uncertainty.45. after two consecutive down moves.7 Binomial tree evolution and payoff for the option to defer (2 steps) . in the up state the investment option value is given by equation (5. V ++ = uuV = 1. receiving C +− = C70 m. receiving a net (forward) investment opportunity value of C + + = max {338 − 80. receiving C − − = 0.67 × 0. The riskneutral probability of an up move.5 × 150 ≈ C 338 m. In the down state. it receives V +− − I = 150 − 80 = C 70 m. In the scenario following two consecutive up moves.67 in each period.5 × 1. the gross market value is V − − = ddV = 0.67 × 150 = C150 m. exceeds the investment cost. the gross market value is V +− = udV = 1. Flexibility. is p = 0. If Enel invests.67 × 150 ≈ C 67 m. It will thus again exercise its investment option at maturity. Enel must incur an infrastructure investment cost of I = C80 m to enter this geography at T = 2 years. Enel will not invest I = C80 m for a negative NPV (67 − 80 = −13). I = C80 m.7 shows the market value evolution and the investment option’s payoffs at maturity.5) as Binomial tree representing market value evolution Option payoff Option tree 338 C ++ = 338 − 80 = 258 C + = 148 p C ++ = 258 225 p 150 150 100 C +– = 70 C = 80 1−p C – = 30 1−p p C +– = 70 1−p 67 C –– =0 C –– = 0 t=0 1 2 t=0 1 2 Figure 5. Going backward to t = 1. It will instead abandon the investment option.

one step earlier. Each approach has its own merits. 1.45 × 70 + 0.552 × 0 1. . The continuous-time approach is more helpful to derive basic investment principles.04 In the down state. 2 That is. the current value of the investment opportunity for Enel to enter the Russian market in two years is &80 m. 20.45 × 0. 1+ r 1. The net present value of entering the market immediately (at t = 0) is NPV = V − I = 150 − 80 = C 70 m. which is more that the value to enter it today. σ 2 its variance and z is a standard Brownian motion.55 × 70 + 0. See the appendix of the book for detail on the GBM. Vt.04 2 ≈ C 80 m. follows a multiplicative binomial process. 5. 1+ r 1. the option has (time-1) value C− = 0. Continuous-time models are useful when model assumptions enable the derivation of analytical solutions. In continuous time this corresponds to assuming that the underlying asset follows the geometric Brownian motion (GBM) dV = ( gV ) dt + σ V dz.6) where g denotes the actual growth trend of the process.55 × 70 = ≈ C148 m.04 Alternatively.184 Chapter 5 C+ = pC ++ + (1 − p)C +− 0. the present value (t = 0) of the investment option for Enel is C= pC + + (1 − p)C − 0.45 × 258 + 0.45 × 148 + 0.2 Continuous-Time Options Analysis Real options analysis can be either dealt with in discrete or in continuous time.04 Finally.20 19.19 The CRR discrete-time analysis rested on the assumption that the underlying asset. using the t = 2 expectation. based on applying the equation from appendix 5A for the binomial distribution with n = 2 steps: C= = p2C + + + 2 p (1 − p) C + − + (1 − p) C −− 2 (1 + r )2 0.45 × 258 + 2 × 0.55 × 0 = C 30 m.3.55 × 30 = ≈ C 80 m. (5.

For a given maturity. Our derivation of BS in note 21 rests on probabilistic properties of the European call option and of geometric Brownian motion. This portfolio consists of N shares of the underlying asset and a short position. the hedge ratio (position in the underlying asset) used in the replicating portfolio is N = CV (Vt ) = N( d1 ) . N = CV (V ) and B = e − rtC (1 − ε ) . Flexibility. instead of g. Under risk-neutral valuation.6). equal to r in the Black and Scholes model. with ε ≡ CV (V ) × V C . we obtain C = e − rT ∫ max {VT − I . the asset price does not exactly follow ˆ the GBM of equation (5.19) in the appendix of the book. 22. T . a European call option pays off the greater of the net value VT − I or zero.Uncertainty. At maturity T . respectively. As noted. as the time 21. . d1 = ln (V I ) + [ r + (σ 2 2)]T .16) and (A. The replicating-portfolio approach generalizes to a larger family of processes (Itô processes) and can accommodate other payoff functions. in a risk-free bond. it is possible to create a portfolio replicating the payoff to a call option. 0} p(VT ) dVT 0 ∞ = e − rT ∫ (VT − I )p(VT ) dVT I ∞ = e − rT × ξ − e − rT I × θ . meaning CT = max {VT − I . θ = N ( d2 ) and ξ = Ve rT N ( d1 ) . the probability that the option ends up “in the money” and gets exercised at maturity. One can obtain it based on the replicating portfolio argument as in Black and Scholes (1973) and Merton (1973). Under the risk-neutral probability measure. (5. ˆ where θ ≡ Pr (VT ≥ I ) and ξ ≡ E [VT | VT ≥ I ] are. In the BS case involving geometric Brownian motion. here.22 Parameters d1 and d2 are given by σ T d2 = d1 − σ T . and the expected value of the asset when it does.7) where N (⋅) is the cumulative standard normal distribution. they view the same problem from different mathematical angles.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. and Real Options 185 Black and Scholes (1973) use this process to derive their famous formula for pricing European call options. We employ the risk-neutral drift term r. 0}. under mild conditions. 23. In continuous time. where r is the continuously compounded risk-free interest rate. B. the call option at ˆ time t = 0 is worth C = e − rT E [CT ]. By decomposing C . The multistep Cox–Ross–Rubinstein (CRR) option-pricing formula is derived in appendix 5A.8) This formula is a cornerstone in option-pricing theory. From equations (A. Let p (·) denote the probability density under the risk-neutral measure.” g .23 The discrete-time and continuous-time approaches are not really competing paradigms. but an adjusted GBM involving a “risk-neutral drift.

From the Black–Scholes formula of equation (5.94 − 80 × e −0. ˆ ˆ 25. d1 = ln (150 80 ) + [ 0.97. Underlying project value is V = 150.186 Chapter 5 step.7).84 ≈ C 79 m.4 2 ≈ 1. Cox. as given by u = eσ h . ˆ where α ′ ≡ ln r − (σ 2 2) . N (d1 ) ≈ 0.5 Option to Invest (Black–Scholes) Let us revisit example 5.25 Example 5.54 − 0. converges to the BS formula in (5.54. and Rubinstein (1979) show that.04 + ( 0. and d2 ≈ 1.26 The risk-free interest rate is r = 4%. 24.5 in example 5. Enel may delay investment in the Russian electricity market for two years until the true market development is revealed. the investment option value is C = 150 × 0.4. Suppose that this value ﬂuctuates continuously over time (driven by global energy supply and demand factors) with volatility σ = 40%. The investment outlay for the power plant is I = 80. 26. Ross. in the limit. h ≡ T n. becomes increasingly smaller (as h approaches 0 or the partition of the time interval becomes ﬁner with n going to inﬁnity). This is close to the value obtained in example 5. The CRR formula converges to the BS formula if h ≤ σ 2 α 2 .4 above using the CRR binomial model (C80 m) with only two steps (n = 2). d .9) Under these conditions the multistep CRR binomial option-pricing formula. The probability of an up move is given by p= 1 2 + ˆ 1 α′ 2 σ h.04 × 2 × 0. and p are consistent with their continuoustime counterparts if 24 u = eσ h 1 and d = . with α ≡ r − (σ 2 2). σ = 40 percent. From the cumulative standard normal distribution. From equation (5. This volatility value. is close to u = 1.4 above.7). u (5.94 and N (d2 ) ≈ 0.8).84. In the binomial model the parameters u.4 2 2)] 2 0. . the complementary binomial distribution function B used in appendix 5A converges to the cumulative standard normal distribution function N(⋅). continuous replication is approximated and the multiplicative binomial process converges to the geometric Brownian motion.4 2 ≈ 0. discussed in appendix 5A.

One way to simplify the problem is to deﬁne project value.7) deals with a relatively simple situation where a single risk factor evolves stochastically. we obtain from Black–Scholes formula (5. I ) = X N ( d1′ ) − 1e −0 T N ( d2 ′ ) . ˆ i. We want to value a European call option giving the right to receive at maturity uncertain project value VT by paying uncertain investment cost IT . I . I ) = e − rT E [max {VT − IT . with relative (instantaneous) variance given by σ X 2 = σ V 2 + σ I 2 − 2 ρσ V σ I . (5.. I . with two needed adjustments: (1) r = 0 and (2) σ 2 becomes σ X 2 as given by equation (5. follow correlated geometric Brownian motions dV = ( gV V ) dt + σ V Vdz. V .e.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. Suppose that both project value. and investment cost.11) (5. Vt.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 ′ ).10).7) that C (V . where 1 ln (V I ) + σ X 2T 2 d1 ′ = . several risk factors may affect ﬁrm value. Margrabe (1978) examines a more general situation where a ﬁrm can exchange one (nondividend-paying) stochastic asset (I) for another (V). In reality.Uncertainty. I t.6′) These factors are assumed correlated with correlation coefﬁcient ρ. and Real Options 187 The Black–Scholes formula of equation (5. C (V . Given these adjustments and the homogeneity of the option value function. σX T d2 ′ = d1 ′ − σ X T . in units of investment outlay. For example. 0}]. Let X ≡ V I be this composite (relative) stochastic factor. thereby reducing the problem dimensionality by one dimension (from two to one). dI = ( g I I ) dt + σ I I dz′. (5. (5.12) 27. the capital investment cost as well as the project value may evolve stochastically. Flexibility. The Black–Scholes formula still applies.

0}. The parameters d1’ and d2’. where the generation cost. the general solution in McDonald and Siegel (1985) obtains as Margrabe’s (1978) formula for the option to trade one risky asset for another.2 2 − 2 × 0. P0G ) = P0E N( d1′ ) − H × P0G N( d2 ′ ). PtG. is driven by two factors: the input gas price. 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. For a two-year horizon (t = 2) we have 28.10). (5. and technological efﬁciency.08.11) the expected present value of π 0( t ) = C( P0E . ch. The generation cost.11′) where H × P0G is the present value of the (time-t) exercise price.6 Option to Temporarily Shut Down Operations28 The Italian electric utility is equipped with CCGT technology. Assuming that the two assets pay no dividends.11) with maturity t.188 Chapter 5 Example 5.32 + 12 × 0. Ct = H × PtG. From equation (5. Suppose that the current prices of electricity and gas are P0E = C12 and P0G = C10.3 × 0. Ct .10). From equation (5.12). The electric utility is not compelled to operate the CCGT plant at any time t if variable costs are not covered. with correlation coefﬁcient ρ = 0. are given by ln ( P0E ( H × P0G )) + σ X t 2 1 d1′ = σX t (5. 30. with efﬁciency coefﬁcient H = 1. is the exercise price of this European call option. .29 The output electricity price. dPt E = (rPt E ) dt + σ E Pt E dzt. 2 σ X = 0. The present example is adapted from McDonald (2006. obtained from equation (5. 17). which evolves stochastically according to dPtG = (rPtG ) dt + σ G PtG dzt. The heat rate H corresponds to the number of British thermal units necessary for the generation of one MWh of electricity. Electricity and gas prices are correlated with coefﬁcient ρ .2 ≈ 0. Pt E. follows the geometric Brownian motion. P0G ) is C( P0E . McDonald and Siegel (1985) derive the closed-form solution for this problem.40. where H is the efﬁciency coefﬁcient. Electricity and gas prices have volatility σ E = 30 percent and σ G = 20 percent. measured by a constant heat rate H. 29. The contingent proﬁt stream at time t is thus π t ≡ max {Pt E − Ct .4 × 1 × 0.12′) 2 2 2 and d2 ′ = d1′ − σ X t with σ X = σ E + H 2 × σ G − 2ρHσ E σ G following 30 (5.

94.0.67 − 0.08 2 ≈ 1. Scholes. options to defer or expand).95 − 1 × 10 × 0. providing a consistent and uniﬁed approach toward incorporating the value of real options associated with the investment decisions of the ﬁrm. . the power plant that embeds such operational ﬂexibility in each year t has total T value ∑ t = 0 π 0( t ). switch use. Cox. based on equation (5.g. Black and Scholes (1973) and Merton (1973) derive the key properties and formula for valuing European call options.11). This valuation approach serves as foundation for the option games approach developed later in the book. Black. Journal of Political Economy 81 (3): 637–54. and Real Options 189 d1′ = ln (12 (1 × 10)) + (0. so N (d1′ ) ≈ 0.55. The pricing of options and corporate liabilities. Conclusion We discussed multiple sources of risk affecting companies in the energy sector and the breakthrough innovation of real options analysis.g. d2 ′ = 1. and Rubinstein’s (1979) binomial model is widely used for pricing options in discrete time.95 and N (d2 ′ ) ≈ 0. Assuming the CCGT plant will be decommissioned in T years. Fischer. of π 0 ( 2 ) = C(12. 1973. and Myron S. Optionbased valuation is a useful tool to corporate managers and strategists..67 . 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. Ross. while others reduce downside risk (e.94 ≈ 2. interconnect or default on staged planned outlays).08 2 ≈ 1. Having ﬂexible operations with the possibility to shut down operations in two years results in a value. options to contract. Flexibility.08 2 2) × 2 0. Dixit and Pindyck (1994) discuss various real options in continuous time.. Trigeorgis (1996) offers a broad overview on real options. 10 ) = 12 × 0. 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.Uncertainty. Some of these options enhance the upside potential (e.

Pindyck. The risk-neutral probability of an up move. 2007. T ⎢∑ ⎜ ⎟ (1 + r ) ⎣ j = 0 ⎝ j ⎠ ⎦ 1 (5A. in equation (5. Suppose that the time to maturity T is divided into n time steps. or CT = max {VT − I . and let j be the number of up moves in n time steps. John C. Tackling Investment Challenges in Power Generation. Ross. Avinash K. At maturity in the last period n.4). International Energy Agency.31 We can generalize equation (5. Rubinstein. and Mark E. Trigeorgis. 0}⎥. Journal of Financial Economics 7 (3): 229–63. Appendix 5A: Multistep Cox–Ross–Rubinstein (CRR) Option Pricing Consider a European call option that gives the right—but not the obligation—to receive at maturity the underlying asset value VT by paying the exercise price or investment cost I . Theory of rational option pricing. each jump occurring with risk-neutral 31. Investment under Uncertainty. and Robert S. over an interval is given in equation (5. 1994. Lenos. Princeton: Princeton University Press. 0}. Bell Journal of Economics and Management Science 4 (1): 141–83. Option pricing: A simpliﬁed approach.190 Chapter 5 Cox. Dixit. after j up moves. Robert C. each of equal length h ≡ T / n. 1996. Cambridge: MIT Press. 1979. . p. Paris: IEA Publications. for consistency the value of parameters u and d should be related to the time increment. As discussed elsewhere.5) to obtain a binomial option pricing formula for n periods C= (1 + r )T ˆ E [CT ] = ⎡ n ⎛ n⎞ j ⎤ n− j p (1 − p) max {u j d n − j V − I . Real Options: Managerial Flexibility and Strategy in Resource Allocation.. 1973.9). the call option pays off C n = max { u j d n− jV − I . Merton. 0}. h. This call option pays off at maturity (T ) the greatest of VT − I and 0.1) where n! ⎛ n⎞ ⎛ n⎞ j n− j ⎜ j ⎟ ≡ (n − j )! j ! and ⎜ j ⎟ p (1 − p) ⎝ ⎠ ⎝ ⎠ denotes the binomial distribution giving the probability that the asset will take j upward jumps in n steps. Stephen A..

p). multiplied by the state probability that each scenario will occur. n. E [C ]. n. If we let m be the minimum number of up moves (over n periods) “triggering” call option exercise (above which V > I ). n. (5A. p′ ) − I (1 + r )n B (m. Flexibility.2) where B( ) is the complementary binomial distribution function that gives the probability of at least m up moves in n periods n ⎛ n⎞ n− j B ( m. The summation of all possible (from j = 0 to n) option values at expiration.Uncertainty. p) ≡ ∑ ⎜ ⎟ p j (1 − p) . 1+ r . is discounted at the risk-free rate r over the n time periods. ⎝ j⎠ j=m with p′ ≡ u p. This ˆ expected option value. the binomial option-pricing formula in (5A.1) becomes C = VB ( m. and Real Options 191 probability p. gives the expected option value at maturity T ( n) .

.

First. at maturity. In part II of the book.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. dealing concomitantly with both market and strategic uncertainties. thereby precluding preemption or war of attrition effects. Our belief is that these separate approaches should be combined. starting ﬁrst with a simple “equilibrium selection procedure” and building up in terms of complexity over subsequent chapters. we put these perspectives together. it enables us to have investment triggers that are independent of the time or stage considered. discrete-time analysis. In what follows we introduce concepts and tools gradually in terms of increasing complexity. circumventing the issue of optimal timing under rivalry. for discrete-time analysis with ﬁnite horizons. we start with the simpler case of European options that give the option holder only one investment exercise possibility. 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 rational option holders.II OPTION GAMES: DISCRETE-TIME ANALYSIS In the ﬁrst part of the book. We illustrate the simple idea behind option games via illustrative examples in chapter 6. To simplify. Using European options has two main advantages. Here the investment trigger is ﬁxed and prescribes the investment decision at the end period (maturity). 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. . and discussed how an industrial organization perspective may provide useful insights to managers about how to behave vis-à-vis rivals under certain business conditions. we introduced basic principles of strategic management and real options. leveraging the strengths of each discipline to provide enhanced managerial guidance. Second. discussing some useful models at the interface between game theory and real options as part of a uniﬁed. it allows circumventing the problem of optimal timing in multiplayer settings.

Whether the ﬁrststage 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). and patent strategies. spillover effects. providing new insights about R&D investment. as in Cox. 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.194 Part II of Fudenberg and Tirole’s (1984) framework for analyzing business strategies under uncertainty in light of whether ﬁrms react in a reciprocating or contrarian manner. and Rubinstein (1979). In chapter 7 we discuss how the above principles can be applied in the context of Cournot quantity and Bertrand price competition.. Ross. An extension and application in case of two-stage R&D investment games is also provided. Exogenous demand uncertainty is modeled via discrete-time multiplicative binomial models. . goodwill building. In chapter 8 we describe how commitment and early investment in two-stage games (e. both in the context of a proprietary R&D investment and when there are spillover effects (shared beneﬁts). in R&D or advertising campaigns) may alter the strategic value of an investment opportunity.g. The cases of Cournot quantity and Bertrand price competition are analyzed in discrete time. The analysis is extended to derive optimal investment strategies under uncertainty.

These two issues are not really that distinct. standing at the intersection between the theory of investment under uncertainty (real option analysis) and the game-theoretic analysis of strategic investments. while suitable to account for stochastic uncertainty. Each approach can separately bring about useful insights in analyzing business situations.2 provides a simple illustration to help ﬁgure out the logic behind option games. Thereby the ﬁrm kills the option to delay further. In section 6. industrial organization. Strategic management has a lot to beneﬁt by more explicitly incorporating the trade-off between the value of ﬂexibility and commitment. This is what “option games” is all about.6 An Integrative Approach to Strategy: Option Games In part I we discussed basic approaches providing insights about how to behave in an uncertain competitive environment. each discipline. Real options analysis.3 and 6. We reviewed strategic management. and real options as separate.1 We elaborate on these issues further in upcoming chapters. Standard game theory has not dealt so far with stochastic dynamics. while dynamic games are mostly cast in a steady or deterministically evolving environment. which is a form of commitment. Optimal timing is concerned with the choice of the right moment at which to incur a sunk investment cost. Sections 6. We discuss two prominent issues here: optimal investment timing.4 go deeper and discuss applications to R&D and the mining/chemicals industry. standalone disciplines. and the trade-off between ﬂexibility and commitment. . often makes the simplifying assumption that strategic interactions do not materially affect the investment decisions or project values of ﬁrms. Nonetheless.1 we discuss how option games can provide useful insights to management faced with conﬂicting strategic choices. 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. Section 6. taken separately. respectively. losing valuable ﬂexibility. static games by their very nature do not involve such a problem. 1. also has drawbacks.

as the result of a multiplayer problem. rivals may prefer to wage a war of attrition in the hope that their rival will retreat sooner. In other situations. Deutsche Bank took into account the risk of international rival banks preempting it. In their decision-making. such as Deutsche Bank. acquiring several local banks such as Harrest Fund Management and Huaxia Bank. In these settings the optimal timing decisions. 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. Rivals may preempt.2 A good understanding of investment timing requires a simultaneous assessment of both market uncertainty and the anticipated reactions of competitors eager to seize their slice of the pie. especially when investment costs are sunk. eroding the incentive to defer the decision.1 Key Managerial Issues: Optimal Timing and Flexibility versus Commitment 6. Investing when the project NPV is positive is inferior to selecting optimally the time at which the project value is maximal. contemplating investing in China where proﬁts have been growing and prices escalating. the optimal timing policy may differ substantially from that of a monopolist. Many international organizations face such a dilemma. In competitive settings. Optimal investment timing under uncertainty is a key challenge. 2. But if the market ﬂops. investing can prove quite valuable. with due accounting for the time value of money. 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. Deutsche Bank actually decided not to wait. 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. The market in China is not fully liberalized and administrative barriers have long blockaded entry by foreign ﬁnancial institutions. Real options analysis can provide valuable insights concerning the optimal timing decisions of ﬁrms under uncertainty. Should the ﬁrm invest now? Invest later? Abandon the project altogether? If the market develops favorably. investing prematurely may prove a regrettable mistake.196 Chapter 6 6.1 Optimal Investment Timing under Uncertainty Consider the example of a multinational ﬁnancial institution. .1.

Smit and Ankum (1993).2 An Illustration of Option Games Viewed in discrete time. as the one shown in ﬁgure 6.1. any company considering a capital-intensive decision. or input costs may restrain a ﬁrm from committing early. Smit and Trigeorgis (2001. and Trigeorgis (2009) discuss option games in discrete time. 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. The value of commitment as discussed in industrial organization challenges the belief that ﬂexibility is always valuable. using binomial trees depicting the evolution of the demand state. and how the current value of an investment option can be determined using the backward risk-neutral valuation principle. 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. This trade-off can be addressed by combining real options analysis and game theory. and (2) in the face of competitive threat or pressure.An Integrative Approach to Strategy 197 must form an industry equilibrium. Kar.1. In boxes 6. prices.2 The Trade-off between Flexibility and Commitment In an uncertain competitive environment. In real options analysis. This approach enables deriving key insights by use of simple numerical examples. 2004). . using stochastic processes to model the underlying variables. 6. while chapter 5 focused on the ﬂexibility value via real options analysis. a ﬁrm might be better off to build ﬁrst-mover competitive advantage. providing a balancing act between the two. an option game is an overlay of a binomial tree onto a payoff matrix. and (2) the continuous-time approach. The reader may recall that chapter 4 dealt with the value of early commitment (industrial organization).4 A binomial tree. like whether to invest in a new technological process to develop a new product.3 One thus needs to weight the relative merits of commitment versus ﬂexibility.1 and 6. In chapter 5 we described how project value dynamics can be modeled based on a binomial tree lattice. and Ferreira.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. how risk-neutral probabilities are derived. is 3. two approaches are commonly used: (1) the discrete-time approach. 4. 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.

by deﬁnition. such as ﬂexibility to change trajectory. enabling to actively realize value which is above and beyond the sheer . especially in environments that are complex and exposed to many sources of uncertainty. Boston Consulting Group 1. or accelerate. this typically can be achieved with much precision by an in-depth DCF and scenario analysis. in settings where signiﬁcant uncertainty and managerial ﬂexibility is involved. 2. However. The approach provides structural elements and a “vocabulary” that can be very valuable in strategy discussions that.1 Interview with Rainer Brosch and Peter Damisch. 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. options. 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. and contingent decisions. Looking at a company as a portfolio of businesses opens up an important perspective. 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 development in a very powerful way: it helps to analytically support strategic decision-making. abandon. 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. In many contexts a detailed valuation of business cases or strategies is an important element of our work. center around managerial ﬂexibility. 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.198 Chapter 6 Box 6.

An Integrative Approach to Strategy 199 Box 6. and to what extent do you believe real options analysis offers better guidance to your clients than traditional capital budgeting techniques? . Over the years we have continued to develop strategy and portfolio analysis in many directions. Option games thus make a very important and directional contribution to strategy. In your corporate ﬁnance and risk management practice with clients at McKinsey & Company. capable of providing awareness and tremendous insight. dynamic paths and trajectories. including among these strategic ﬁt.1 (continued) sum of the parts.2 Interview with Eric Lamarre. Admittedly. such as by integrating additional parameters. consolidating various views which are inseparably connected to options thinking and competitive analysis. This is exactly what option games is about. it is always a challenge to highlight competitive interaction and even more so when options are involved. namely to tackle portfolio effects and synergies that are the basis of the portfolio perspective. options. tying together game theory and options thinking into a joint. this lens requires to actively address trade-offs within the portfolio. At the same time. The BCG Portfolio Matrix is one well-known example. Box 6. analytically rigorous framework. Today’s portfolio manager can rely on very advanced approaches. and competitive interaction. how. role-based views. value creation potential. McKinsey & Company 1. From its ﬁrst days BCG has pioneered strategy through portfolio analysis.

How useful have you found real options analysis in your consulting practice? Have your clients shown interest in this approach? Despite its compelling beneﬁts. even more so when integrated within the organizational and strategy processes.2 (continued) There is no doubt that real options analysis generates a more insightful dialogue among senior managers. more important. RO techniques place much greater emphasis on these risks. 2. Second. First. How did you ﬁrst come up with or run into the option games concept? We ﬁrst came across this concept in the mining industry. Managers intuitively understand this dynamics. It helps uncover additional value not fully recognized by traditional NPV techniques and. Option games are particularly helpful for a special class of strategy problems where uncertainty is high and a company’s actions or those of competitors can shape industry dynamics. Finally. While a typical investment business case merely lists potential risks.200 Chapter 6 Box 6. but must also take on more risk because future demand is uncertain. clients have been slow to adopt the RO approach for three reasons. If properly used. . poor execution during ﬁrst experimentations often leads to disappointing results. 3. senior managers often revert to familiar methods despite the shortcomings these methods present in certain situations. There is sometimes too much focus on computer simulations and not enough on structuring the risk problem properly. creates a structured conversation around the sources of risk and how a company plans to respond to these risks. This is sometimes the case in mining when major capacity expansions can materially impact the supply/demand balance. but they may ﬁnd that quantifying the value is difﬁcult with standard DCF methodologies. as well as on the managerial ﬂexibility to react. having received little training on RO techniques. The ﬁrst mover in adding capacity will hold an advantage. often too much focus is placed on analytics and not enough on the organizational changes required to generate broad adoption inside a corporation. this new methodology can be a real source of competitive advantage.

The analysis reveals the beneﬁts to each player from . Firms i and j can both invest now. If none invests now. Once the binomial tree charts the evolution of potential demand scenarios until maturity (year 2).04). C* ).2. 2 p (1 − p) 2 for the intermediary demand state. At maturity both ﬁrms can invest. The annual risk-free interest rate is 4 percent (r = 0. 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). or let the option expire. working the tree backward enables the ﬁrm to assess the value each strategy creates under rivalry. Suppose that p is the risk-neutral probability of an up move per period. C* . Consider a duopoly consisting of ﬁrms i and j sharing a European option to invest in an emerging market within two years. To each scenario at the end node in the binomial tree of ﬁgure 6. The basic structure of this option game in discrete-time is depicted in ﬁgure 6. and (1 − p) for the low demand state.1 Binomial tree representing evolution of market uncertainty and associated probabilities used to model the stochastic evolution of project value V . in each end node a two-by-two payoff matrix depicts the resulting competitive interaction. wait and invest later (at maturity in year 2). Once the equilibrium (*) strategic ++ +− −− option values are obtained in each end state (C* .An Integrative Approach to Strategy 201 State value Cumulative probability p p V ++ pp V+ 1− p p V 1− p V +− = V −+ 2 p (1 − p ) V− 1− p V −− (1 − p ) 2 Figure 6. both can abandon. The resulting equilibrium outcome (*) and corresponding player payoffs can be anticipated for each of the three payoff matrices. while two-bytwo matrices are used to capture the competitive interactions among players.1 corresponds the cumulative risk-neutral probability shown in the right column after two steps: pp for the high demand state. or only one invests (potentially involving a coordination problem).

If both utilities invest at t = 2. 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). Suppose that the market is currently worth C150 m (V = 150) and evolves with an upward multiplicative factor u = 1. Such a problem might have a different answer. Suppose the Russian government is selling two options to invest. that ﬁrm would seize the entire market pie (in effect will be a monopolist). would change. If only one ﬁrm invests when the market is mature in year 2. Let us put this in a concrete context from the electricity sector (see example 5. such as growth or volatility.5 and downward factor d = 1 u ≈ 0.4). Suppose that the Italian utility Enel and EDF of France both possess the option to enter the Russian electricity market in two years’ time. Suppose that the Italian 5.5 This investment option is analogous to a shared European call option with maturity two years. Abandon V −− C*−− .67 in each period. A different issue might be of interest as well.202 Chapter 6 Binomial tree representing market uncertainty Payoff matrix for Strategic option strategic uncertainty value Firm j Invest Abandon V+ Abandon Abandon V Firm i High demand ++ Invest C*++ Invest Abandon V V− Invest V +− C*+ − Invest Abandon Invest t=0 Low demand 1 2 Figure 6. The intent here is to value. the option to invest in this market as incorporated in the ﬁrm market value. with Enel and EDF as bidders. for each ﬁrm. we assume that the market will be divided among the two ﬁrms relative to their market power. with the underlying market value following a multiplicative binomial tree process.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.

An Integrative Approach to Strategy 203 utility (Enel) has a comparative advantage enabling it to acquire a higher slice of the market pie (s = 0. 70) (0. each of the tree end nodes of demand has a corresponding two-by-two matrix.3 that occurs after two consecutive demand up moves. with its French rival obtaining the remainder (40 percent). . Each ﬁrm must incur an infrastructure investment outlay of I = C80 m to enter the Russian market. each ﬁrm will either invest (receiving the net project value at that time) or abandon the investment (receiving nothing). 0) Invest Abandon Invest Low demand Abandon 67 (–40. –13) (0. 0) t=0 1 2 Figure 6. 55) (258. 0) C*++ = (123. In this case.3 Binomial tree and equilibrium end-node payoff values in the Enel versus EDF rivalry over the Russian market The ﬁrst element in (·. 0) (0. the gross market value is V ++ = uuV = 1. If the ﬁrm does not enter the market.5 × 1. ·) represents ﬁrm i ’s (Enel’s) net value or payoff. 0) C*−− = (0. Consider ﬁrst the upper demand state in ﬁgure 6.60). –53) (–13. The values obtained by each ﬁrm in each competitive scenario are presented in two-by-two matrices. If both ﬁrms invest at maturity (invest. 55) (0. 258) (0. 0) 225 Invest Invest Abandon (10. receiving a net (forward) value of V ++ − I = 338 − 80 = C 258 m. 0) (0. while the second entry denotes the net value or payoff to ﬁrm j (EDF). At maturity in year 2. Binomial tree representing market uncertainty Payoff matrix for Strategic option strategic uncertainty value Firm j Invest Abandon Abandon 338 Firm i High demand Invest (123. it gets the full gross market value V ++ incurring the entry cost of I = C80 m. letting its investment option expire. 0) 150 100 Abandon 150 C*+− = (70. –20) (70. In the event where only one ﬁrm (Enel or EDF) enters the market.5 × 150 ≈ C 338 m. it receives nothing (0). invest). they split the market as follows: Enel obtains 60 percent of the gross market value (338) at the cost of I = C80 m.

while the second entry denotes the net value or payoff to ﬁrm j (EDF). if EDF abandons the option. 0) (0. The equilibrium payoffs. Again. If both ﬁrms invest.4 × 150 − 80 = − C 20 m. Enel thus has a dominant strategy to invest. it receives V − + − I = 150 − 80 = C 70 m. and the second to EDF (ﬁrm j). EDF also has a dominant strategy to invest.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). ·) represents ﬁrm i’s (Enel’s) net value or payoff. Enel is better off investing obtaining net value C258 m rather than 0. with Enel receiving C123 m and EDF !55 m.4 × 338 − 80 = C 55 m. If Enel or EDF ends up in a monopoly. it receives nothing (0). Given that . Here the gross market value is V − + = udV = 1. earning !55 m if Enel invests or C258 m if Enel lets its option expire. Whatever EDF chooses. 55). Given that Enel has a dominant strategy to invest. If the ﬁrm abandons.4 Two-by-two matrix in the upper demand node The ﬁrst element in (·. We next determine which competitive outcome is more likely to occur as a stable solution. Enel receives s × V − + − I = 0. The ﬁrst number in each pair of payoff values (in parenthesis) represents the payoff to Enel (ﬁrm i). The resulting Nash equilibrium in the upper end node is for both ﬁrms to invest. receiving 0 rather than a negative payoff (−C20 m). These competitive situations are summarized in the two-by-two matrix of ﬁgure 6. receiving a positive value in both situations. receiving net (forward) value: s × V ++ − I = 0. applying the Nash equilibrium concept.6 × 150 − 80 = C10 m. The case arising in the medium demand state (occurring after a downward move following an up move or inversely) can be analyzed similarly. the best response of EDF is to abandon the market. ++ C* = (123. Enel has a dominant strategy to invest.6 × 338 − 80 = C123 m. 258) (0. while EDF obtains 0. EDF gets 0. 0) Figure 6. are shaded or shown with *.4. Enel earns a higher payoff by investing than by abandoning the project: if EDF invests. Enel receives C123 m when investing and 0 otherwise.204 Chapter 6 Firm j (EDF) Invest Abandon Firm i (Enel) Invest Abandon (123. 55) (258.

Going backward along the binomial tree at t = 1. we need to assess the risk-neutral probabilities of each end node that will allow determining the present value of the strategic option. 1+ r 1.67 × 150 ≈ C 67 m. Neither ﬁrm therefore has an incentive to invest. the risk-neutral probability of an up move is p= (1 + 0.67 = 0. 1+ r 1. receiving 0.45) × 70 = ≈ C 90 m.67 1.04 The (time-1) value for Enel in the down state is C− = 0. The binomial tree and resulting Nash equilibria (highlighted) in each of the three demand states are shown in ﬁgure 6. in the up state the investment option for Enel is worth C+ = pC ++ + (1 − p)C +− 0. In the present case with r = 0. one step earlier. The resulting Nash equilibrium payoff is C*−− = ( 0. 0 ).An Integrative Approach to Strategy 205 each ﬁrm plays its best response to its rival’s actions.04 Finally. since whatever the resulting competitive outcome. In the down state (after two consecutive down moves). . 1. is C55 m. the current value of the investment opportunity for Enel to enter the Russian market in two years. the risk-neutral probability of an up move is given by equation (5.67 × 0.55 × 0 ≈ C 30 m.67.55 × 30 = ≈ C 55 m. the Nash equilibrium payoff in the intermediate demand state is C*+− = ( 70. accounting for strategic interactions with European rival EDF in each possible state of market demand evolution. u = 1. and determine for each ﬁrm the investment option value by backward valuation along the binomial tree.45 × 123 + (1 − 0. the ﬁrm would incur losses.04) − 0. the present value (t = 0) of the strategic investment option for Enel is C= pC + + (1 − p)C − 0.5 − 0.4). Following the discussion in chapter 5. For this.45 × 70 + 0. which is lower than the needed investment outlay of I = C80 m.3. The next step is to substitute these equilibrium payoff or strategic option values in the end nodes of the binomial tree. 0 ). Both ﬁrms thus have a dominant strategy to abandon the project.45 × 90 + 0.5. and d ≈ 0.45.04 That is.04. the gross market value is V − − = ddV = 0.

–1) Sleeping Wall Invest t= 0 1 Stage I Low demand C *–– = (9. 0) (3.45 × 24 + 0. The next section provides an illustration of option games in the case of patentleveraging strategies. The setup of their problem together with the payoff matrices at maturity are depicted in ﬁgure 6. Trigeorgis and Baldi (2010) consider different patent-leveraging strategies among two patent-holding ﬁrms in a duopoly. 6.04 = C 24 m. 0) (–14.45 × 55 + 0. 0) (–20. 33) Sleeping Wall 108 Invest C *+– = (34. Binomial tree representing market uncertainty Payoff matrix for Strategic option strategic uncertainty value Firm j Sleep Invest 324 Firm i High demand Sleep (98.206 Chapter 6 The value of the investment opportunity for EDF is similarly obtained to be 10 m. 152) Sleeping Wall Invest C *++ = (92. 31) (220.5. 8) (92. It will be used again in the examples in the rest of this chapter and in subsequent chapters. 0) 2 (–5. EDF will receive 55 m in the up state or 0 in down state.6 This basic valuation procedure is a cornerstone for the discrete-time analysis of option games. Section 6. 33) (68. 0) (34. Going back one step earlier. –7) Wall Bracketing Stage II Choice of patent fighting strategy Patent acquisition for firm i (old technology for firm j ) Figure 6. At t = 1 in the down state. –17) Wall Bracketing Sleep Invest Sleep 36 (9. worth C + = (0.55 × 0 ) 1. EDF’s investment opportunity is worth zero.4 provides a case application in the context of mine investments. .04 = C10 m. the current ( t = 0 ) value of EDF is C = (0.5 Binomial tree and equilibrium end-node payoffs for patent ﬁghting strategies where ﬁrm i has a strong patent advantage 6. 3) (–29.3 Patent-Fight Strategies As another illustration of the usefulness of simple option games.55 × 0 ) 1. 31) Wall Bracketing 180 Sleep Sleep Invest 100 60 (9. At time t = 1 in the up node.

each ﬁrm decides on its best patent-leveraging strategy. intermediate. ﬁrm i has an advantage (capturing more of the option value according to its higher market power). or low demand. may go on the offensive to identify and exploit gaps around ﬁrm i’s core patent. At time t = 2 (or at the beginning of stage II). ending up in a bracketing war with ++ bottom-right payoffs C* = ( 92. different types of ﬁghting equilibria may result: Under high demand.7 Last. whether to ﬁght. it captures full monopoly NPV. The weaker rival. depending on ﬁrm i’s cost advantage and the state of demand (high. The rival will be inclined to ﬁght (even attack) if demand or volatility is high. The resulting equilibrium strategies are for both ﬁrms to invest. ﬁrm j. Firm i may pursue a similar offensive strategy. 31). When one ﬁrm invests while the rival waits.” When both ﬁrms sleep (wait) and postpone their ﬁghting decision. ﬁrm i can solidify its large advantage building a defensive patent wall around its core patent in the hope of driving the rival out. depending on realized demand. believing it has a ﬁghting chance. intermediate. Alternatively.5 focuses on the case where ﬁrm i has a strong advantage resulting from the innovation. Under asymmetric reciprocating competition with high demand. each ﬁrm should invest regardless of the opponent’s decision (for ﬁrm i. Firm i has an incentive to fortify and exploit its large cost advantage to drive the rival out of the market. Figure 6. Entering a reciprocating ﬁght is costly and erodes proﬁt margins for both ﬁrms. ﬁrm i innovates and acquires a new core patent that is superior to the old patented technology used by rival ﬁrm j. for ﬁrm j. Absence of such advantage is likely to induce symmetric rivals to cooperate. or low). . 152 > 33 and 31 > 8). while a large cost advantage by ﬁrm i will favor a ﬁght mode instead.” virtually putting its patent in a “sleep mode. they share a reduced market value reﬂective of their respective market power. reducing total market pie (to 70 percent)—except when one ﬁrm ignores its ﬁghting rival and lets its patent sleep. both ﬁrms feel induced to ﬁght via • 7. The type of competition depends in part on the size of the cost advantage resulting from the patented innovation. resulting in a patent-bracketing war. This situation will result in patent ﬁghting. 220 > 98 and 92 > 68.An Integrative Approach to Strategy 207 At time t = 0 (or at the beginning of stage I). In case of a large cost advantage. When both ﬁrms attack each other via patent bracketing. In the two-by-two matrices under high. cooperate. each ﬁrm can “wait and see. Invest is a dominant strategy for both. or wait. different types of ﬁght mode may result.

(1. respectively. for ﬁrm j.” Firm i lets its superior patent sleep. Given that the equilibrium investment option values at maturity (t = 2) ++ +− −− for ﬁrm i are C* = 92.8 • Under intermediate demand.08)2 . Given the low level of demand.36 × 0 = C 4 m. 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. 0 > −1 and 0 > −7). both ﬁrms would actually lose value by ﬁghting each other. This amounts to the disadvantaged ﬁrm abandoning the market. • In the problem above the risk-free interest rate is r = 0. ﬁrm i should invest.48. with associated probabilities pp = 0. C* = 34. C* = 0 . with ﬁrm j waiting (sleeping). 0).4 and 1 − p = 0. and C* = 9.48 × 0 + 0.48 × 34 + 0. Firm j’s value of the investment opportunity obtains similarly as C4 m. and C* = 0 . The Nash equilibrium for the upper-left game payoff is C*−− = ( 9. 9 > −5 and −14 > −20. medium. and (1 − p) = 0. respectively.208 Chapter 6 reciprocal patent bracketing—even though they would be better off to let their patents sleep. 0 ). obtaining ( 98. ﬁrm j prefers to wait (sleep) rather than engage in a costly bracketing ﬁght (0 > −17). each ﬁrm has a strictly dominant strategy to let its patent sleep (for ﬁrm i.6 . 33). the current (t = 0) value of the strategic investment opportunity for ﬁrm i is C= ++ +− p2C* + 2 p (1 − p)C* + (1 − p) C*−− ( 1 + r )2 0.36. 2 2 p (1 − p) = 0. Firm j’s investment opportunity is worth C= 0.08)2 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.16 × 92 + 0. (1. a situation analogous to the prisoner’s dilemma.08 and the riskneutral probabilities for an up or down move are p = 0. regardless of its rival’s decision (34 > 9 and 3 > −29). resulting in patent walls with Nash equilibrium payoffs C*+− = ( 34.16. The equilibrium strategy is for both ﬁrms to “sleep. Knowing that ﬁrm i will invest and ﬁght. in the high. a dominant strategy. and low demand states.36 × 9 = = 29.16 × 31 + 0. Firm i will invest building a defensive patent wall around it. Firm j obtains in each demand state C* = 31.9 8. maintaining its option to become a monopolist should the market recover in the future (with continuation value 9). Under low demand. ++ +− −− 9.

To get around this problem. It is reprinted by permission of Harvard Business School Publishing. Between 1995 and 2001 annual revenues for the US commodity chemicals industry fell from $20 bn to $12 bn. 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.4 An Application in the Mining/Chemicals Industry Ferreira. . Jayanti Kar. will invest in a similar project ﬁrst. strategic investments to prevent rivals from gaining ground. which compares your payoffs with those of your competitor under different scenarios. It’s a story that regularly plays out in many industries.An Integrative Approach to Strategy 209 6. March 2009. which has varied in recent years with shifts in the country’s political economy. while companies’ operating proﬁts fell on average by 26 percent a year. if demand exceeds local supply. This approach involves American-type real options and games and is solved backward by use of numerical analysis. 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. managers can incorporate the collective effect on market-clearing prices of other companies that are expanding their capacity at the same time. the standard calculation of payoffs does not allow managers to factor in uncertainty for key market variables such as prices and demand. its largest competitor. it must avoid tying up too much cash in risky projects. This section is an excerpt from “Option games: The key to competing in capitalintensive industries” by Nelson Ferreira. Typically the way to do this is to create a payoff matrix. From MineCo’s perspective there are two key sources of uncertainty: the growth rate of local demand. Kar. and Trigeorgis (2009) present an actual application of option games in the mining/ chemicals industry. Indeed any company making big-budget investment decisions faces the same basic dilemma. Unfortunately. we use a hybrid model that overlays real options binomial trees onto game theory payoff matrices. it must make timely. customers will import from foreign sources. nor does it assign any value to ﬂexible investment strategy. . . and the risk that CompCo. Using game theory models. . and Lenos Trigeorgis. which effectively sets a cap on prices. especially during times of market uncertainty.10 Deciding when to add capacity in the face of rivals is a challenging problem for any industry. On the one hand. In this market. On the other. 10. Harvard Business Review.

a 70 percent probability of a downward shift in each period).6).000 tons. Y1. Y1. The MineCo project involves adding 250. and Y2. and a capex of $150 per ton. and Y5 and production starting in Y6). 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 probabilities at each node in the demand tree (see ﬁgure 6. Using historical data and surveys of the company’s managers. If demand rises and MineCo or its competitor adds capacity at a higher marginal operating cost. and both new mines have a lifespan of 17 years. projected capacity of 320. 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. . The price at each node is determined by demand and supply. and Y2 and production starting in Y3) or in Y3 (with capex to be invested in Y3.000 tons and the current price (set by imports) is $1. We assume that demand will go up or down by a ﬁxed multiple in each period (in this case the period is a year). and both projects will start producing in Y3. we can model how evolution in demand and capacity will affect prices and thereby revenues and proﬁts for each of the two companies. also spread over three years. For the purposes of simplicity. we predict demand will move up or down by about 5 percent in each period. spread over three years. Given this.210 Chapter 6 The current demand is 2. We estimate the risk-adjusted probability of an upward shift in each period at 30 percent (therefore. The Comp Co project faces cash operating costs of $740 per ton annually. 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. We will refer to this tree throughout the analysis in this section. local prices will rise.200. we assume that each ﬁrm can decide to invest in Y0 (with capex in Y0. 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).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.7).000 per ton. The investments take three years to complete. First. Scenario 1: Both Companies Invest Now If both ﬁrms decide to invest now. Y4. they will incur capital expenditures in Y0. we create a binomial tree showing how market prices might evolve (see ﬁgure 6.

which is an estimated present value of cash ﬂows for the remaining 14 years of the mine’s useful life. estimated over the remaining life of the project.000 tons) is shown in the lower panel of ﬁgure 6. To calculate this. $78.000). To illustrate. discounted annual operating proﬁts at each node plus the terminal value—and subtract from that sum the . 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.000.0% 1713 16.6 Demand evolution and probability tree To calculate the annual operating proﬁts at each node for each ﬁrm.7.569. In Y6 nodes.An Integrative Approach to Strategy 211 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 2200 100% 2313 30% 2093 70% 2431 9% 2200 42% 1991 49% 2556 3% 2313 19% 2093 44% 1894 34% 2687 1% 2431 8% 2200 26% 1991 41% 1801 24% 2825 0. which gives us a terminal value of $774.2% 2093 30.250. 000 tons of added capacity represents $78. we have to add in the terminal value. Our ﬁnal step is to weight the numbers at each node by the corresponding 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.8% 2313 13. MineCo gets a margin of 313 (the 1.2% 2556 2.4% 1801 30.000.8% 2970 0.0% 2431 6. The resulting tree for MineCo (with the added capacity of 250.9% 1894 36. we assume that price and demand remain constant subsequently and apply the standard discounting formula.000 price less its cost of 687) per ton.000.250. at the upper demand node in Y5. 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.819. and get a total value for the upper node in Y6 of $852.5% 1991 32.1% 2687 1. We then sum up these numbers—the weighted. We add that to the Y6 annual operating proﬁt (again. which for 250.3% 1630 11.0% 2200 18.8% Figure 6.

250 3. if not.833) 78. CompCo enters in Y3. −$195 m.000 740 700 687 685 1. While CompCo Waits In this scenario MineCo invests ﬁrst.833) (20.000 1. There are four possible Y3 scenarios.250 3. Scenario 2: MineCo Invests Now. and terminal value for each ﬁrm .407 35.250 3. we calculate how prices will evolve from Y3 through Y6.000 1. for CompCo. giving it the advantage of being the sole producer from Y3 to Y6.250 78. we determine the market-clearing prices.449) (19.833) (20. operating proﬁts. If demand evolves favorably.212 Chapter 6 Market-clearing prices (in US$/ton) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 1. each with an associated probability of occurrence (see demand tree in ﬁgure 6.000 1000 700 700 685 685 1.000 1.833) (20.000 1.833) (20.250 13. Next.250 0 (500) 78.000 1.7 Scenario 1: Both companies invest now present value of the annual capex investments made by each company.819 852.8).819 144.000 1. At each of the nodes.421 0 (5.000 1. using the demand tree and given the fact that MineCo has invested in extra capacity and CompCo so far has not. or ﬁnal payoff value. This gives us the net current payoff value.833) (20. it abandons the project.250 (500) (500) Figure 6.000 740 700 687 685 680 Payoffs for MineCo (in US$ thousands) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 852.250 3.073) (20. If both ﬁrms invest now. for each company under scenario 1: For MineCo the expected payoff in Y0 is −$36 m. while CompCo waits until Y3 to decide whether to invest.000 700 700 685 1.250 (500) 78. We begin the valuation by calculating the market-clearing prices from Y0 through Y3. both lose money.250 3.

CompCo will abandon the project.An Integrative Approach to Strategy 213 Evolution of demand till year 3 Y0 Y1 Y2 Y3 Probability of reaching node (Y3) Competitor’s decision (Y3) Expected value of payoffs (in US$ million) 3% • CompCo decides to invest Up Up • MineCo = 328 • CompCo = 71 wn Do 19% Up • MineCo = 263 • CompCo = ∅ wn Do wn Do Up wn Do Up Figure 6. At all the other demand nodes. As a rational investor. and Y6) showing what the annual operating proﬁts plus terminal value would look like at each node if CompCo were to invest then. and –$185 m for the other three nodes. These expected net Y0 payoffs for MineCo and CompCo (taking into account the investment costs incurred in Y0 wn Do 44% CompCo abandons project • MineCo = -6 • CompCo = ∅ wn Do 34% • MineCo = -64 • CompCo = ∅ . Next for each Y3 scenario we weight the node values by the demand probabilities for Y4. Y5. In other words. –$169 m. and Y6 and discount the values back to Y0. preferring a payoff of zero to losing money. Y5. we create a three-year binomial tree (Y4. which is only the case in the top node where demand evolution from Y3 is high enough to accommodate a second entrant. CompCo will not invest in Y3 unless its payoff value is positive. the other waits assuming that CompCo does invest in Y3. based on the assumption that CompCo will not invest in any but the top demand node. and –$114 m. We thus recalculate the operating proﬁts plus terminal value for both companies.8 Scenarios 2 and 3: One company invests. 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. for each of the four scenarios.

the expected ﬁnal payoff at Y0 is ($328 m × 3%) + ($263 m × 19%) + (−$6 m × 44%) + (−$64 m × 34%). We arrive at the ﬁnal payoff for each company by summing up the four weighted. For each. 0) 34% Dominant strategy • MineCo = ∅ • CompCo = ∅ . 0) (0. While MineCo Waits This is estimated in the same way as scenario 2. Scenario 4: Both Companies Wait In the last scenario. We ﬁnally weight these four pairs of Y0 payoff values according to the probabilities associated with the Y3 demand nodes. –114) (87. 0) (0. 0) 44% Dominant strategy • MineCo = ∅ • CompCo = ∅ wn Do CompCo Invest Abandon (–57. 0) (0. –169) (0. 405) (0. For MineCo.9). where both ﬁrms wait until Y3 to decide whether to invest.5 wn Do CompCo Abandon Invest Invest Abandon wn Do MineCo Up Abandon Invest MineCo Figure 6. we need to consider four subscenarios: both ﬁrms Probability of reaching node 3% Expected value of payoffs (in US$ million) Dominant strategy • MineCo = 143 • CompCo = 71 CompCo Abandon Invest MineCo Evolution of demand till Y3 Y0 Y1 Y2 Y3 Invest Abandon (143. 71) (0. 0) 19% Up Mixed strategy (average) • MineCo = 43. we start by looking at the four possible demand nodes in Y3 (see ﬁgure 6. which yields $35 m. discounted payoff numbers. but with MineCo as the follower. –158) (–55. Scenario 3: CompCo Invests Now. the expected ﬁnal payoff at Y0 is ($71 m × 3%) + ($0 × 19%) + ($0 × 44%) + ($0 × 34%). –102) (–11. The ﬁnal payoffs are $4 m for MineCo and −$83 m for CompCo.9 Both companies wait to decide wn Do wn Do (–45. 71) (410. 0) (0. –185) (0. which yields about $2 m.5 • CompCo = 35.214 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. For CompCo. 0) Up CompCo Abandon Invest Up Invest Abandon MineCo Up wn Do (–2.

and subtracting net present capex costs. we weight these four pairs of net Y0 payoff values according to the probabilities associated with the Y3 demand nodes. for example. We arrive at . We thus have 16 subscenarios. the expected net Y0 payoff for the node is (0. which is when decisions are made. In the ﬁrst subscenario. only CompCo investing in Y3.5 × $0). Let’s take the upper demand node in Y3 as an example. both ﬁrms invest from Y3 to Y5 and enter in Y6. but suppose here that the companies are roughly symmetrical such that there is an equal chance that either equilibrium will prevail. which varies depending on the Y3 investment decisions of MineCo and CompCo. weighting annual operating proﬁt plus terminal value. We calculate the expected net Y0 payoffs in the same way we did in scenario 1 but with a three-year tree. is based on the demand evolution (captured by the demand tree) and on total industry capacity. We perform similar exercises to calculate the expected net Y0 payoffs in the remaining three subscenarios. The price at each node. this results in Y0 net expected payoffs of $143 m for MineCo and $71 m for Comp Co. The resulting expected payoffs from the two mixed equilibria therefore are simply the average of the payoffs associated with each equilibrium for each player.5 × $87 m) + (0. each with its own three-year market-clearing price evolution tree. Finally. The remaining three two-by-two matrices are similarly analyzed to ﬁnd Nash equilibria. we have two. in other words. We present all expected net Y0 payoffs in a series of two-by-two game matrices.5 m. We then identify the Nash equilibria—outcomes from which neither player has an incentive to deviate. with the ﬁrm not investing receiving a zero payoff and the ﬁrm investing receiving payoffs determined by demand evolution and industry capacity. At three nodes (the top and the lower two) there is a single (pure) equilibrium. For MineCo. In the top demand node. only MineCo investing in Y3. which yields $43. For the upper demand node. CompCo reaches the same conclusion. There are theories about how to determine which of two equilibria one should favor. MineCo cannot do better since the alternative (abandoning) would entail a lower (zero) payoff whatever CompCo does. as ever. respectively). we see that both MineCo and CompCo will ﬁnd it optimal to invest in that year (receiving $143 m and $71 m. one for each demand node in Y3.An Integrative Approach to Strategy 215 investing in Y3. each player will choose one strategy 50 percent of the time and the other the remaining 50 percent. discounting back to Y0. This exercise is then repeated for the remaining three sets of subscenarios. In one (the second). and both abandoning.

10 Comparing strategic scenario payoffs for a ﬁnal time-0 decision . as no player has an incentive to deviate from the associated strategy choices. as shown in ﬁgure 6. A conventional real options calculation using the same data would have indicated that delaying the project would add $8.216 Chapter 6 the ﬁnal payoff for each company by summing up the four weighted. The optimal decision for MineCo therefore is to invest at once. How does this recommendation compare with the traditional valuation methods? Given the data. 2) MineCo Scenario 3 Wait (4. MineCo cannot do better (if it decides to wait as well. 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. discounted payoff numbers. We see that scenario 2 (MineCo invests now and CompCo waits) is a Nash equilibrium scenario. –195) Wait Scenario 2 (35. How Do the Results Stack Up? Having analyzed the four different strategic scenarios one at a time.5 m in ﬂexibility value to the NPV number for MineCo CompCo Invest Scenario 1 Invest (–36. This yields an expected net Y0 payoff value for MineCo of $12 m [($143 m × 3%) + ($43. we now put them together into a time-zero payoff matrix for a ﬁnal decision.5 m × 19%) + ($0 × 44%) + ($0 × 34%)]. with disastrous results.10. it will get $12 m instead of $35 m). moving to scenario 4. 8) Note: Current value of payoffs in each strategic scenario (in US$ million) Figure 6. This would suggest that both companies should invest immediately. –83) Scenario 4 (12. For CompCo the payoff is $8 m.

whereas CompCo is better off waiting. Trigeorgis and Baldi (2010) discuss an application of the aforementioned methodology in the context of patent games. In the next two chapters we elaborate further on option games in discrete-time settings. Ferreira. In MineCo’s case. actual application and discuss the insights offered by option games. considering models of quantity or price competition. deriving fruitful insights into when and how ﬁrms should invest in uncertain environments when they also face strategic interaction. examining when early commitment might be worthwhile in an uncertain environment in the context of R&D and advertising strategies. Conclusion In this chapter we illustrated via simple numerical examples the beneﬁts of an integrative approach to strategy. Harvard Business Review 87 (3): 101–107. would still misrepresent value for both players. Smit and Trigeorgis (2004) develop the option games approach in discrete time and give a number of case applications. and Trigeorgis (2009) present a concrete. highlighting their relevance for strategic management practice. which.An Integrative Approach to Strategy 217 and $5 m for CompCo. 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. Selected References Smit and Ankum (1993) and Trigeorgis (1996) discuss related issues of market structure under uncertainty. Jayanti Kar. Chapter 7 discusses this investment option. we extend our tool kit to quantify the trade-off between ﬂexibility and commitment. Ferreira. the ﬂexibility value from delaying is more than outweighed by the commitment value created by investing now. Option games: The key to competing in capital-intensive industries. This would suggest that both should delay. In Chapter 8. . and Lenos Trigeorgis. With the beneﬁt of an option games analysis. although not disastrous. Kar. We ﬁrst consider the option to invest in a new market in different competitive situations. each player can see how the ﬂexibility and commitment tradeoff works out for it. Nelson. 2009.

A real options and game-theoretic approach to corporate investment strategy under competition. 1993. J. and L. Ankum. Han T. Patent leveraging strategies: Fight or cooperate? Working paper. 2010. Strategic Investment: Real Options and Games. and Lenos Trigeorgis.218 Chapter 6 Smit. and Francesco Baldi. 2004. Han T. Princeton: Princeton University Press. Cambridge: MIT Press. A. Lenos. Real Options: Managerial Flexibility and Strategy in Resource Allocation. Trigeorgis.. University of Cyprus. Smit. . 1996. Trigeorgis. Financial Management 22 (3): 241–50. Lenos. J..

In section 7. upon market entry. Q) = aX t − bQ. The chapter is organized as follows. Throughout part II we assume a linear market demand function. we present a benchmark model for later analysis. Most of the results and insights from the models developed here would carry over to other types of inverse demand curves.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. 7. and Q is the total output (capacity) offered in the marketplace. the inverse (stochastic) demand function is given by p ( X t . In section 7. In section 7. Chapter 8 then builds upon these two benchmark duopoly models and puts them in dynamic perspective in light of earlier-stage commitment decisions.1) follows a multiplicative binomial process. a and b are constant parameters.1) where X t follows a multiplicative binomial process. .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.1 The binomial stochastic process followed by X t is shown in 1. (7.3. focusing on a monopolist’s option to invest.2. we discuss quantity competition models and examine the importance of having a cost advantage from a dynamic perspective. we analyze investment settings in which. ﬁrms compete in price. The simple models presented herein offer pedagogical value and make easier the understanding of subsequent chapters. Encompassing more aspects of reality would involve more complications to the modeling of option games. That is.

220 Chapter 7 X2++ ~ X1+ ~ X0 X1− ~ X2+ − ~ X2−− Figure 7. but these models are more demanding mathematically. 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).3 At each end state or node in the binomial tree. while part III discusses perpetual American options in continuous time that may admit closed-form solutions. 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. it chooses its strategic variable (output) to maximize its payoff. the monopolist can choose at maturity between investing or abandoning the investment. As seen in chapter 3.1 Multiplicative binomial process followed by demand (intercept) X t is the underlying asset (stochastic market demand) at time t. We could also consider American-type options. . equation (3. ~ ﬁgure 7.1 for two periods: after each up move. Under market demand uncertainty the ﬁrm has an option to invest but can wait until new information is revealed. is meant as a discrete-time equivalent of the geometric Brownian motion. These assumptions used in the discrete-time and continuous-time parts are compatible. Many of the models used in the continuous-time part assume that X t follows a geometric Brownian motion.4). 2. The binomial lattice. that is. the equilibrium proﬁt for a monopolist in the deterministic case (if X t were constant over time and equal to 1) is πM = (a − c )2 4b . for example. Ross. deferring the investment decision until maturity. as in Smit and Trigeorgis (2004). we would need to resort to numerical analysis. Part II focuses on European options in discrete time due to their relative simplicity. X t is multiplied by u. 3. it selects the monopoly proﬁt-maximizing output QM ( XT ). To solve this problem. developed by Cox. and Rubinstein (1979). When the monopolist decides to invest. 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 ).

provided that aXT ≥ c. The ﬁrm will not invest if aXT < c since demand would not cover marginal production costs. The perpetuity formula above (used as the present value) is often referred to as the Gordon formula. If the monopolist ﬁrm invests. X M . The appropriate risk-adjusted discount rate is k (k > g ).4 Suppose the monopolist ﬁrm invests amount I at time t = T . . 5.Option to Invest 221 Given the stochastic uncertainty about the demand parameter X t . The monopolist’s net project value at the end node (at maturity T ) is given by NPV M ( XT ) = π M ( XT ) δ − I. This occurs when the random demand reaches or exceeds a speciﬁed trigger X M . It equals the inﬁnite sum of subsequent cash ﬂows beginning with π M ( XT ) starting in one period (end of the year) and growing in perpetuity at a rate g per year. The monopolist’s investment trigger. In this sense the classical NPV rule holds at maturity because the monopolist is then faced with a now-or-never decision. At maturity it must decide either to invest or abandon. (7. or XT ≥ X M . receiving at the end of the year the equilibrium proﬁt π M ( XT ) that grows thereafter in perpetuity at an average annual growth rate g . is given by 4. it becomes committed to the project and receives the NPV of the investment as given in equation (7. and π M ( XT ) = 0 otherwise. The ﬁrm cannot delay the investment decision beyond maturity. namely M t 1 ⎡∞ M ⎛ 1 + g ⎞ ⎤ π ( XT ) . The ﬁrm will decide to invest at maturity T if and only if NPV M ( XT ) ≥ 0.2) provided that the ﬁrm invests. ⎢ ∑ π ( XT ) ⎜ 1 + k ⎟ ⎥ = ⎝ ⎠ ⎦ δ 1 + k ⎣ t =0 provided that δ ≡ k − g > 0. (7.3) 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 NPV M ( XT ) = π M ( XT ) k − I. the equilibrium proﬁt for the monopolist at maturity T now is π M ( XT ) = (aX T − c) 2 4b .3).

10 × 250 + 15 = 5. At the time the unit variable cost for the monopolist was c = 15.10 − 0 = 0.10. The appropriate discount rate for the ﬁrm was 10 percent or k = 0.1 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. the optimal investment decision of the monopolist depends solely on whether the value of XT at maturity exceeds the ﬁxed investment trigger X M . XM ≡ 2 bδ I + c . and I ) determining the investment trigger of the monopolist X M are constant and known at the outset.222 Chapter 7 Binomial tree evolution Threshold Investment decision Payoff value High XT ≥ X M ~ ~ Invest ~ NPVM XT ≥ 0 ( ) X0 XT XT < X M Low XM ~ Do not invest (abandon) 0 Figure 7.2 illustrates the payoff and investment decision of the monopolist at maturity. The market growth ( g ) was 0 percent p. a (7. T . a. The demand parameter X t evolved stochastically with a = 5 and b constant and equal to 1. c.a.4). is XM = 2 1 × 0. b. Note that δ = k − g = 0. Example 7. g . 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). depending on the random value of XT exceeding or being below the speciﬁed ﬁxed critical threshold X M . The investment trigger for the monopolist. Figure 7.2 Critical threshold.10. based on equation (7. 5 .4) Since all parameters (k .

10 .4). p= (1 + r ) − d u−d . and g = 0 .2) is a quadratic function of the demand shock XT . we can work out the present value of the investment by backward induction using risk-neutral valuation along the binomial tree. The monopolist’s proﬁt function in equation (7. When moving back along the binomial tree. we use the risk-neutral probability from equation (5. The payoff function for the monopolist option holder at maturity. the resulting payoff values at maturity T can be easily derived based on equations (7. is shown in ﬁgure 7. NPV M ( XT ).3). The maximal value of the investment must be determined simultaneously with the monopolist’s optimal investment behavior or exercise strategy.4). . Unit variable cost is c = 15. The payoff at maturity (as a function of end-node value XT ) increases at an increasing pace beyond the trigger point X M = 5. Once the end-node project values are determined.Option to Invest 223 NPVM at maturity (in thousands) 30 20 10 0 0 5 10 15 20 25 XM End-node value XT ~ Figure 7.6 Once the optimal investment trigger level X M has been determined as per equation (7. to calculate the expected option values and discount the resulting certainty-equivalent values at the risk-free rate r.2) and (7. I = 250.3. 6. k = 0.3 Payoff value ( NPV M) at maturity for the monopolist’s option to invest We assume linear demand with a = 5 and b = 1.

involving uncertainty about the future industry structure as a result of both market demand uncertainty and (endogenous) multiplayer strategic interactions. (7.1 Cournot Duopoly To value the option to invest under both demand and strategic uncertainties in the case of a duopoly. the expanded NPV of the investment for the monopolist ﬁrm is obtained recursively as E−NPV = where ∑ n j =0 ⎛ n⎞ j n− j M j n− j ⎜ j ⎟ p (1 − p) NPV (u d X 0 ) ⎝ ⎠ ( 1 + r )n .224 Chapter 7 If the time to maturity T is subdivided into n equal subintervals of length h = T n as in appendix 5A.2. We next look at the situation when several ﬁrms may enter the market. We assume complete information concerning the cost structure of the players and the level of demand reached at maturity (time T ). Game theory models strategic interactions in terms of decision time. whereas in real-world decisions real time matters in the evolution of exogenous demand . 7.5) 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. 7.2 Quantity Competition under Uncertainty In the previous section we developed an investment option model characterizing the optimal behavior of a monopolist ﬁrm having an exclusive right to enter the market. 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. each with (riskneutral) probability p. One way to illustrate the time elements of the problem is to look at decision time versus real time.

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 . Firm j’s ⎣ ⎦ cost and proﬁt functions are given similarly. It drives the evolution of the underlying asset in the binomial tree. 9b Under market uncertainty (with XT being random).6) To be entitled to these proﬁts. each ﬁrm must incur investment cost I i (I j.7 Firm i’s (linear) cost function is given by Ci (qi ) = ci qi. Real time is essential in ﬁnancial theory. We subsequently analyze Cournot quantity competition under uncertainty.” .4 Cournot model involving demand (real-time) and strategic (decision-time) uncertainties uncertainty. Figure 7.Option to Invest 225 firm i qi Decision time 1 2 firm j qj Strategic uncertainty (2 decisions) Real time 1 2 3 T–2 T–1 T Demand uncertainty (T periods) Figure 7. c j ≥ 0. 8. The ﬁxed costs are not explicitly considered or alternatively are included into the market-entry cost. (7. respectively). Suppose two ﬁrms compete over a homogeneous product but differ in their cost structure. q j . Let k be the appropriate risk-adjusted discount rate. The superscript C stands for “Cournot. considering in turn the case of (1) cost symmetry and (2) asymmetry. X t ) − ci ⎤ qi. The variable (marginal) cost of ﬁrm i is ci and of ﬁrm j is c j. X t ) = ⎡ p (Q. and its proﬁt by π i ( qi . this becomes π iC ( XT ) = (aX T − 2ci + c j ) 2 9b .4 illustrates the binomial tree approach to time and uncertainty evolution. with ci . 7.

226 Chapter 7 Table 7. g . the advantaged one. We show there that depending on the magnitude of the cost asymmetry.7) If both ﬁrms decide to invest at maturity. The ﬁrst term is again the value of a perpetuity starting at the end of year T or equivalently in year T + 1. the industry structure then becoming a monopoly. namely ﬁrms chose whether or not to enter the market. This statement has common-sense appeal. ViC ( XT ) = (aXT − 2ci + c j ) 9bδ . it is. . the optimal investment strategies in Cournot duopoly are based on whether the demand parameter XT at maturity T exceeds or is below certain threshold levels. We here consider pure strategies. b. For “small” cost difference. the (asymmetric) Cournot duopoly game payoffs obtain. If the cost asymmetry among the players is sufﬁciently large. the equilibrium strategies in the 9. ci. The Cournot–Nash equilibrium value of this investment generating the above annual proﬁts in perpetuity (from the end of year T ) is given by9 NPViC ( XT ) = π iC ( XT ) δ − I i. At this early stage of discussion. As stated here. 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. These optimal investment triggers depend on the (exogenously given) values of k . the disadvantaged ﬁrm may accept its role as follower. two situations may emerge. whereby the advantaged ﬁrm enters peacefully as leader with no risk of preemption. and on the level of demand reached at maturity.1 Comparison of project value payoffs in monopoly and Cournot (quantity) competition Monopoly (only ﬁrm i) Cournot duopoly 2 NPVi M ( XT ) = Vi M ( XT ) − I i NPViC ( XT ) = ViC ( XT ) − I i 2 Note: Vi M ( XT ) = ( aXT − ci ) 4bδ . When a speciﬁed threshold demand level is reached. In chapter 12 we analyze the coordination problem arising in the intermediary region in a context involving perpetual American investment options.1 compares the value functions in monopoly and in Cournot duopoly. ﬁrm i (ﬁrm j) will invest. (7. enters at an intermediary demand level. no one enters (both ﬁrms make zero proﬁts). However. however. 10. the disadvantaged ﬁrm may try to enter ﬁrst as well. For large cost asymmetry. XT .10 If demand is low. c j. based on weak game-theoretic foundations. a. This decision is driven by the ﬁrms’ respective optimal exercise or trigger policies. Analogous to the monopoly case. Table 7. leading to preemption effects. we assume that only one ﬁrm.

Therefore the condition XT ≥ c a becomes redundant. If XT < X C.8) where δ ≡ k − g. each ﬁrm decides whether to enter (à la Cournot) or not.5. condition XT ≥ c a is satisﬁed. 12. Both ﬁrms have the same investment 11. The Cournot investment trigger for both symmetric ﬁrms in a duopoly is XC ≡ 3 bδ I + c . In the case of the investment opportunity being analogous to a European call option the ﬁrms decide to invest only at the end nodes. The Cournot investment trigger strategies discussed above are shown in ﬁgure 7. Investment outlays are the same. Cournot under Cost Symmetry Suppose that ﬁrms i and j share a European investment option in a duopoly. 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.” Consequently investment thresholds are identical and. If XT ≥ X C . Costs are identical between the two ﬁrms. Firm i will invest at the end node at maturity if realized demand XT is high enough such that the forward investment NPV is positive. 13. The discrete-time analysis of the investment dynamics under quantity competition that follows reveals more intuitively the role of these investment thresholds. meaning if NPV C ( XT ) ≥ 0. both ﬁrms will invest. the industry structure will be either “both invest” or “neither invests. . provided they are reached at maturity ( XT ≥ X C ).11 At maturity. At maturity there is no further option to defer the investment. each facing variable unit cost c. so the NPV rule holds. The optimal investment policy of each ﬁrm depends on the actual level reached by the underlying random variable compared to the investment thresholds. then the project end node value is zero since the option is not exercised. These thresholds are crucially important in the analysis of investment strategies under endogenous competition as they help induce ﬁrms’ optimal investment strategies.12 The investment condition is therefore13 XT ≥ X C (provided that XT ≥ c a). the option is exercised since the project has positive NPV.Option to Invest 227 duopoly case differ depending on whether the industry consists of symmetric or asymmetric-cost ﬁrms. Firms compete over quantity (capacity) when they both operate. I (≥ 0). a (7. For symmetric ﬁrms we might assume symmetric investment (exercise) policies. When XT ≥ X C .

The payoff function in the symmetric cost case looks like the payoff function of a call option with exercise price X C = 6.3) are higher. Figure 7. Thus each duopolist will invest at maturity provided the demand parameter XT exceeds X C = 6.7).6) to obtain the net project value from equation (7. . the (common) investment trigger for the Cournot duopolists obtained from equation (7. Once the investment decisions at maturity are determined. Since monopoly proﬁts are higher than individual proﬁts of Cournot duopolists the payoff (NPV) values at maturity in the monopoly case (see in ﬁgure 7.228 Chapter 7 Binomial tree evolution Threshold Investment decision Payoff (firm i.6 depicts the Cournot duopoly end-node payoffs (NPV) as a function of the stochastic demand level at maturity. One difference compared with the monopoly case lies in the relevant proﬁt function once investment is made. facing symmetric variable costs of c = 15.8) is X C = (3 1 × 0. We can derive the present value of the investment by backward induction working back through the binomial tree. if demand is high and both ﬁrms enter.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. j) High XT ≥ X C ~ Invest NPV C (XT) NPV C ~ (X ) T ~ X0 XT XT < X C Do not invest (abandon) ~ XC 0 0 Low t=0 T Figure 7. facing the same risk-adjusted discount rate k = 10 percent and investment outlay I = 250 to enter the market. we utilize the Cournot equilibrium proﬁt of equation (7. XT .2 Investment Trigger for Symmetric Cournot Duopolists Two symmetric ﬁrms compete in quantity.10 × 250 + 15) 5 = 6. Given these parameters. trigger. After maturity T steady state is reached. The demand parameter X t evolves stochastically. Firms are identical. Example 7. with a = 5 and b = 1.

since ﬁrms are less likely to follow symmetric strategies. At the end nodes (at maturity). they choose the appropriate output given knowledge of the prevalent number of active ﬁrms.. In the case of cost asymmetry. Once the ﬁrms enter. Under cost asymmetry an investment game results with industry structure (monopoly or duopoly) depending on the speciﬁc trigger policies of the two ﬁrms. we assume a cost leader with comparative cost advantage (subscript L) and a high-cost ﬁrm (subscript H) as follower. consider the strategic (normal) form of the simultaneous game shown in table 7. We next look closely at the resulting payoffs in the strategic form to deduce under which conditions each ﬁrm invests. the investment triggers for Cournot quantity competition are determined similarly but require taking a closer look at the strategic interactions. If only one ﬁrm invests. If both ﬁrms invest (e.Option to Invest 229 NPV C at maturity (in thousands) 25 20 15 10 5 0 0 5 XC 10 15 20 25 End-node value XT ~ Figure 7. H ) will decide to invest (enter) or not. each ﬁrm (i = L. Once they have invested. ﬁrms select their output optimally. . it results in a monopoly.6 Payoff ( NPV C ) at maturity for option to invest in (symmetric) Cournot duopoly Cost Asymmetry In case of cost asymmetry. under high demand).g. To help determine the investment strategies.2. and if none invests no one turns a proﬁt (0). the resulting industry structure is an asymmetric Cournot duopoly.

230 Chapter 7 Table 7. meaning if XT < X iM with X iM ≡ (2 bδ I i + ci ) a. meaning if X iM ≤ XT < X iC . If XT ≥ X C . If ﬁrm j invests. The ﬁrm is always better off (its investment has positive NPV) because its value as a monopolist exceeds the value as Cournot duopolist (at least for the low-cost ﬁrm). if ﬁrm i invests. ﬁrm j has a dominant strategy not to invest. but ﬁrm i should invest since NPVi M ( XT ) ≥ 0.7). The two pure-strategy Nash equilibria are (Invest. If ﬁrm i chooses not to invest. 2. If ﬁrm j does not invest. If NPViC ( XT ) ≥ 0. ﬁrm i has no dominant strategy. Firm i has no dominant strategy (if X iM ≤ XT < X iC ).3) and (7. a (7. The same arguments apply for ﬁrm j. ﬁrm j should invest. If NPVi M ( XT ) < 0. the optimal response of ﬁrm i is to invest.2 Strategic form of end-node investment game in asymmetric Cournot duopoly Firm j (high cost) Invest Firm i (low cost) Invest Do not invest (abandon) ⎛ NPViC ( XT )⎞ ⎜ ⎟ C ⎝ NPVj ( XT )⎠ 0 ⎛ ⎞ ⎜ NPV M X ⎟ ⎝ j ( T )⎠ Do not invest (abandon) ⎛ NPVi M ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 ⎛ 0⎞ ⎜ ⎟ ⎝ 0⎠ Note: NPVi M ( XT ) and NPViC ( XT ) are given in equations (7. Symmetrically. Deriving the outcome of strategic interactions is more involved in the absence of dominant strategies. If XT < X jM . Abandon) and . Two cases can be distinguished to facilitate further analysis: 1. the optimal (re)action of ﬁrm i is not to invest. In this case there are two pure-strategy Nash equilibria. Neither ﬁrm i (if X iM ≤ XT < X iC ) nor ﬁrm j (if X jM ≤ XT < X C ) has a j dominant strategy.9) ﬁrm i has a dominant strategy to invest at maturity regardless of the decision of its rival. ﬁrm i has a dominant strategy not to invest at maturity. but ﬁrm j has a dominant strategy ( XT ≥ X C or XT < X jM ). If realized demand XT is such that NPViC ( XT ) < 0 and NPVi M ( XT ) ≥ 0. meaning if XT ≥ X iC . ﬁrm j has a j j dominant strategy to invest whereas ﬁrm i should not invest since NPViC ( XT ) < 0. where X iC ≡ 3 bδ I i + ( 2ci − c j ) . the best reply for ﬁrm j is not to invest.

• Consequently the low-cost ﬁrm would choose not to invest. Schelling (1960) introduced the notion of “focal point” to support the use of Nash equilibrium as a solution concept. The end-node equilibrium payoffs (NPVT) can again be determined as a function of the demand parameter XT. Monopoly Only one ﬁrm (the cost leader) invests. Invest). . When this cost asymmetry is taken into account. as discussed later. depending 14. The above are summarized in table 7. choosing their individually rational output à la Cournot. if XT < X L .15 The optimal investment strategies again depend on the level of demand XT reached at maturity T. A third Nash equilibrium in mixed strategies also exists. denoting the cost subscript accordingly (cL < cH ). 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. Cournot competition Both ﬁrms invest simultaneously. while the rival has no incentive to invest and compete with the low-cost ﬁrm. These explicit investment trigger restrictions enable deducing the optimal investment policies for the duopolist option holders. we employ a focal-point argument. This outcome may be the most likely since it Pareto dominates other strategy proﬁles. This case occurs when C C M XT ≥ X H ( > X L > X L ). three industry structures may result at maturity (T ): • • M M No one invests if XT < X L (< X H ). Let’s now consider explicitly that ﬁrm i is the low-cost ﬁrm (L) and ﬁrm j the high-cost ﬁrm (H). X iM ≤ XT < X iC .3.14 To solve this problem. being M M C C M mutually exclusive given that X L < X H and X L < X H. the M C C case where XT ≥ X H is not possible. we can deduce the equilibrium value payoffs at maturity depending on the level of demand reached at time T . The low-cost M C ﬁrm (L) becomes a monopolist if X L ≤ XT < X H. Similarly. become a monopolist. Depending on the future evolution of the underlying demand. j j The discussion so far applies for the general case. X jM ≤ XT < X C. Three regions or demand zones can be distinguished for ﬁrm i: XT < X iM . The “focal point” here is that the low-cost ﬁrm invests and the high-cost ﬁrm does not. some cases sort themselves out. or become a cost-advantaged Cournot duopolist. The focal-point argument suggests that among multiple equilibria some are more likely to occur due to common sense or psychological reasons. XT ≥ X H does not hold. Some use this approach to select among several purestrategy Nash equilibria. The focal-point argument has questionable mathematical foundations so that one might prefer to rely on alternative equilibrium selection procedures. 15. and XT ≥ X C. Similarly there are three demand regions for ﬁrm j: XT < X jM . Once the investment policies are determined. and XT ≥ X iC .Option to Invest 231 (Abandon. In other words. Such an alternative is alluded to later and discussed in detail in chapter 12. If XT < X L .

3 Investment triggers and equilibrium payoffs (NPV) at maturity for Cournot quantity competition High-cost ﬁrm (H) Low demand M XT < X H M C X H ≤ XT < X H C XT ≥ X H Intermediate demand High demand Low-cost ﬁrm (L) Monopoly Monopoly Focal point Monopoly 2 High demand Monopoly No investment ⎛ 0⎞ ⎜ 0⎟ ⎝ ⎠ 0 ⎛ ⎞ ⎜ NPV M X ⎟ ⎝ H ( T )⎠ C XT ≥ X L Cournot Monopoly Monopoly 2 Intermediate demand M C X L ≤ XT < X L M ⎛ NPVL ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVL ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVL ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVL ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 Low demand M XT < X L Note: X iM ≡ 2 bδ I i + ci a. for i = L. X iC ≡ 3 bδ I i + 2ci − c j a. NPViC ( XT ) ≡ ⎡( aXT − 2ci + c j ) 9bδ ⎤ − I i . ⎣ ⎦ ⎣ ⎦ ( ) ( ) C ⎛ NPVL ( XT )⎞ ⎜ ⎟ C ⎝ NPVH ( XT )⎠ 0 ⎛ ⎞ ⎜ NPV M X ⎟ ⎝ H ( T )⎠ 0 ⎛ ⎞ ⎜ NPV M X ⎟ ⎝ H ( T )⎠ Chapter 7 .232 Table 7. NPVi M ( XT ) ≡ ⎡(aXT − ci ) 4bδ ⎤ − I i . H.

for i = L. in M C the intermediary demand zone. At intermediate levels of demand. when XT ≥ X H = 7). the industry becomes an (asymmetric) Cournot duopoly.7. One can discern three demand regions: for realized demand M XT lower than the lower investment trigger X L . H .4) and (7. industry structure and payoffs (NPV) at maturity in asymmetric Cournot duopoly X iM = (2 bδ I i + ci ) a. on demand realization XT . only the low-cost C ﬁrm (L) invests. The high-cost ﬁrm does not invest or becomes a Cournot duopolist (it cannot become a monopolist). X L ≤ XT < X H. given its cost advantage.e. ( ) ( ) . The resulting industry structures are summarized in ﬁgure 7.3 Investment Triggers in Asymmetric Cournot Duopoly To help understand industry dynamics under cost asymmetry. The investment triggers under asymmetry are now M given from (7. Example 7.8 shows the ﬁrm payoffs at maturity (NPV) when costs are asymmetric. no one invests. Both face an identical capital investment cost I = 250. assuming now that there is a low-cost ﬁrm with cost cL = 10 and a high-cost ﬁrm with cH = 15. the low-cost ﬁrm is the only one to enter the market and chooses its quantity accordingly to enjoy temporary monopoly proﬁts. X iC = (3 bδ I i + 2ci − c j ) a . Figure 7. let us revisit the example used previously (in the case of cost symmetry). 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 C the rival at X H. However.7 Investment decisions. at high demand (i.10 × 250 + 2 × 15 − 10 5 = 7.9) by X L = 2 1 × 0..Option to Invest 233 Binomial tree Threshold Investment decision/ industry structure Payoff function High C XT ≥ XH ~ Both invest (asymmetric Cournot) C NPVH (XT) C NPVL (XT) ~ ~ X0 Intermediate M C XL ≤ XT < XH ~ Low-cost firm invests (monopoly) High-cost firm does not (0) M NPVL (XT) ~ 0 Low M XT < XL ~ None invests (0) 0 0 t=0 T Figure 7.10 × 250 + 10 5 = 4 and C X H = 3 1 × 0.

The low-cost ﬁrm produces more than the high-cost ﬁrm due to its cost advantage. The equilibrium investment probability for ﬁrm i is thus16 16. 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 particular the equilibrium investment “intensity” or probability used to solve the coordination problem by use of continuous-time mixed strategies.8 Payoffs at maturity for option to invest in asymmetric Cournot duopoly ~ as demand ( XT ) rises. still earning higher proﬁts. The discontinuity occurs at this point. . receiving zero. however. This logic is close to notions used later in chapter 12. In the present context. The situation above rests on the resolution of the coordination problem (who enters ﬁrst) in the intermediate demand region by use of the focalpoint argument. the low-cost ﬁrm recognizes that the high-cost ﬁrm is also able to enter and make a proﬁt. In this case ﬁrm i chooses its (equilibrium) investment probability qi* such as to make its competitor (ﬁrm j) indifferent between investing. the follower’s value is equal to zero since we consider the problem at ﬁnite maturity (T ). and abandoning. receiving qi* NPVjC + (1 − qi* ) NPVjM. namely that the low-cost ﬁrm (L) naturally invests ﬁrst or is the only entrant. and thus adjusts its optimal quantity à la Cournot.234 Chapter 7 NPV at maturity (in thousands) 15 10 5 Low-cost firm (L) High-cost firm (H) 0 0 M XL 5 C XH 10 15 End-node value XT Figure 7.

that a “coordination failure” where both ﬁrms invest in the market. (2) monopoly. We assume that this strategy proﬁle is the most likely based on a focal-point argument. although only one can enter proﬁtably. 4. Let the transcript i = 1. ﬁrm 2 has a relative cost advantage compared to ﬁrms 3. NPVjM − NPVjC (7. 7. In this region each ﬁrm will invest with a positive probability (nondegenerate mixed strategy) as per equation (7. . however. when there are n active . . we do not allow for mixed strategies (this approach is less analytically tractable). We here generalize this approach to an asymmetric oligopolistic industry where n ﬁrms share an (European) investment option.Option to Invest 235 qi* = NPVjM . once it has invested. three market structures may result: (1) no investment. n.2 Asymmetric Cournot Oligopoly In the previous section on Cournot duopoly. 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. This point is addressed in chapter 12. We also recognize that the low-cost ﬁrm (L) will enter the market even if the investment is unproﬁtable for the high-cost ﬁrm. or (3) duopoly. .. with ﬁrms having different. T indicates the number of periods to maturity.2. it is socially optimal for only one ﬁrm to invest.10) For asymmetric ﬁrms. Note. XT ) denote the proﬁt and the net present value resulting from the investment by ﬁrm i. and so on and on. may still emerge in equilibrium. . . We can recast the results of the previous section in a more general setting. 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. In the following discussion. . we have seen that in the case of two asymmetric ﬁrms.10). The mixed-strategy approach provides an alternative to resolve the coordination problem. In the intermediate region. XT ) and NPVi ( n. Let π i( n. n indicate the rank in relative cost advantage: ﬁrm 1 is the absolute (lowest) cost leader. ﬁrm-speciﬁc costs.. The threshold from the noinvestment demand region to the monopoly zone depends on the NPV of the low-cost ﬁrm (L). one speciﬁc pure-strategy Nash equilibrium yields a Pareto-optimal payoff allocation. The focal point argument used above was based on the idea that the low-cost ﬁrm invests ﬁrst in case of a coordination problem.

Firm i will invest if and only if NPVi (i. n. XT ) ≥ 0. i = 2. If this condition is not met. . . . . n−1 C C namely if XT ≥ X n−1. This is subject to aXT + ∑ n=1 c j − (n + 1) cn ≥ 0.26).9) for the asymmetric Cournot duopolist. equation (3.. j . −1 18. . where17 2 2 2 X ≡ C n ( n + 1) bδ I n + ( n + 1) cn − ∑ j =1 c j n a . The end-node NPV for ﬁrm i in case of investment with uncertain proﬁts is n ⎡ ⎤ 1 ⎢ aXT + ∑ j =1 c j − ( n + 1) ci ⎥ − Ii . (7.11) ⎥ b⎢ n+1 ⎣ ⎦ Let δ ≡ k − g. . 1) = π ( n) = . .. the proﬁt for ﬁrm n is j negative and so the nth investor will not invest. . 1) = 1 (a − nci + ( n − 1) c− i ) . XT ) ≥ 0. where18 X n−1 ≡ n bδ I n−1 + ncn−1 − ∑ j =1 c j a. . where k is the risk-adjusted discount rate and g the rate at which the underlying uncertain factor grows. i = 1. i = 1. .. . n.236 Chapter 7 ﬁrms in the market. ⎥ bδ ⎢ n+1 ⎣ ⎦ Firm n has an absolute cost disadvantage and will invest (as the latest C entrant) if and only if NPVn ( n. this reduces to expression (7. . ⎥ b⎢ n+1 ⎣ ⎦ The equilibrium proﬁt value for ﬁrm i in case of uncertain end-node proﬁts is similarly C i C i n ⎡ ⎤ 1 ⎢ aXT + ∑ j =1 c j − ( n + 1) ci ⎥ π i( n. n. If n = 2 . Alternatively. . n. Similarly ﬁrm n − 1 will invest if and only if NPVn−1 ( n − 1. b ( n + 1)2 2 n i = 1. In chapter 3. .. we have n ⎡ ⎤ 1 ⎢ a + ∑ j =1 c j − ( n + 1) ci ⎥ π ( n. . where c ≡ ∑ j =1 c j n is the average variable production cost in the industry and c− i ≡ ∑ j ≠i c j (n − 1) the average production cost for all other ﬁrms except ﬁrm i.12) 17. .. namely if XT ≥ X n . namely if XT ≥ X iC .. a⎣ j =1 ⎦ i = 2. This is subject to aXT + ∑ n=1 c j − ncn−1 ≥ 0 . . This can be generalized to any ﬁrm i. . XT ) ≥ 0. n. XT ) = . where ( ) X iC ≡ i ⎤ 1⎡ ⎢( i + 1) bδ I i + (i + 1) ci − ∑ c j ⎥ . n. (7. we derived the proﬁt for ﬁrm i in an oligopoly setup with n ﬁrms in case of certainty ( X t = 1) as π iC ( n. XT ) = i = 1. NPVi ( n.

.9 Investment decisions and payoffs (NPV) in an asymmetric Cournot oligopoly with n ﬁrms i X iC = ⎡(i + 1) bδ I i + (i + 1) ci − ∑ j =1 c j ⎤ a . 0 0 .. n}. of ﬁrm 1) preempting all others. 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. . . . ⎣ ⎦ . n. a and for the high-cost ﬁrm (H). XT) . the equilibria and payoff functions for the asymmetric ﬁrms in a Cournot oligopoly can be ranked as shown in ﬁgure 7. . . < X n . . 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 is that of a monopolist given in equation (7.. < X iC < . .Option to Invest 237 In the special case of the ﬁrst investor (i. XT) ~ . . .. . Binomial tree evolution Threshold Investment decision Payoff function ~ NPV1 (n. The investment trigger of the low-cost ﬁrm (L) is M XL = 2 b δ I L + cL .12) thus applies to the case where i = 1 is included in the set {1. 0 ~ t=0 T Figure 7..9.e... XT) High XT ≥ XnC ~ All firms invest ~ NPVi (n.4) previously: X iM ≡ 2 bδ I i + ci ... Since M C C X 1 < X 2 < . .. XT) ~ NPVi (i.. … Low C XT < X1 … None invests … 0 . XT) ~ NPVn (n. a Equation (7. … X0 Intermediate C XiC ≤ XT < Xi+1 … Only first i firms invest … ~ NPV1 (i. i = 1...

4) and (7. In this section we turn to the case of actions that are strategic complements characterizing price competition. namely if XT ≥ X iB. For expositional simplicity we rely on equation (3. equations (3. with same variable cost c ( ≥ 0 ). X t ) = ai X t − b ( qi + sq j ).5. 7.10). help better illustrate under which conditions these outcomes may occur. when presented in strategic form.1′). which uses identical demand intercepts.14) 19.9) derived in the preceding section on asymmetric Cournot duopoly under uncertainty.4) and (3.4 for each of the above two industry structures. The results. where19 2 − s ⎞ bδ I (1 − s 2 ) + c X iB ≡ ⎛ . s (0 ≤ s < 1) captures the degree of substitutability. .238 Chapter 7 Table 7. 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. a This conﬁrms equations (7.4 Project payoffs (end-node NPVs) under differentiated Bertrand price competition Monopoly (ﬁrm i ) Bertrand duopoly ( i = 1. This strategic form representation is depicted in table 7.13) where b > 0 characterizes a downward-sloping demand.10). Vi B ( XT ) ≡ (1 − s ) ( ai XT − c ) b(1 + s) ( 2 − s ) δ . This formula is an approximation. Using the equilibrium proﬁts for monopoly and for simultaneous differentiated Bertrand price competition derived in chapter 3. and ai is a constant price parameter assumed speciﬁc to ﬁrm i (ai ≠ aj). These are summarized in table 7. following equation (3.3 Differentiated Bertrand Price Competition The analysis in the previous section assumed that ﬁrm actions were strategic substitutes and that ﬁrms engaged in quantity competition. For more realism we consider the general case where products are differentiated and ﬁrms may have different demand functions. C XH = 3 b δ I H + ( 2 c H − cL ) . we obtain the end-node NPVs. 2) 2 NPVi B ( XT ) ≡ Vi B ( XT ) − I 2 NPVi M ( XT ) ≡ Vi M ( XT ) − I 2 Note: Vi M ( XT ) ≡ (ai XT − c ) 4bδ . ⎝ 1− s⎠ ai (7. is assumed to be of the form: pi (Q. (7. Costs are here assumed symmetric: ﬁrm i’s cost function is Ci (qi ) = cqi. If NPVi B ( XT ) ≥ 0. The uncertain market (inverse) demand function for ﬁrm i. Each ﬁrm must incur the same capital cost I upon entry.

Firm i has no dominant strategy to invest while ﬁrm j has a dominant strategy. ﬁrm j has a dominant strategy to invest.4). where. ⎣ ⎦ ﬁrm i has a dominant strategy to invest since its value as a monopolist is higher than its value as a (differentiated) Bertrand duopolist. but ﬁrm i should invest. In this case there are two Nash equilibria in pure strategies. if ﬁrm i invests. If ﬁrm j does not invest. If XT ≥ X jB. Subject to XT ≥ c ai . namely if XT < X iM . the optimal reaction for ﬁrm i is not to invest.15) ﬁrm i will have a dominant strategy not to invest. However. ai (7. 20. Similarly. the optimal response for ﬁrm i is to invest. ⎣ ⎦ 2 2 NPVi B ( XT ) ≡ ⎡(1 − s )( ai XT − c ) b(1 + s) ( 2 − s ) δ ⎤ − I. If ﬁrm i chooses not to invest. Invest). where the ﬁrm with the higher differentiated price parameter ai invests and the other does not. Abandon) and (Abandon. if NPVi M ( XT ) < 0.Option to Invest 239 Table 7. If X iM ≤ XT < X iB. ﬁrm j has a dominant strategy not to invest. the best reply for ﬁrm j is not to invest. The two Nash equilibria are (Invest. by extension of equation (7. In this case.5 Strategic form of end-node investment game under differentiated Bertrand price competition Firm j Invest Firm i Invest Do not invest (abandon) 2 Do not invest (abandon) ⎛ NPVi M ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 ⎛ 0⎞ ⎜ 0⎟ ⎝ ⎠ ⎛ NPVi B ( XT )⎞ ⎜ ⎟ B ⎝ NPVj ( XT )⎠ 0 ⎛ ⎞ ⎜ NPV M X ⎟ ⎝ j ( T )⎠ Note: NPVi M ( XT ) ≡ ⎡( ai XT − c ) 4bδ ⎤ − I. to identify the purestrategy Nash equilibria two cases need to be distinguished: 1.20 X iM ≡ 2 bδ I + c . ﬁrm j should invest. 2. A focal point may be found. but ﬁrm i should not invest. . Neither ﬁrm i nor ﬁrm j has a dominant strategy to invest. A similar argument holds for ﬁrm j. there is no dominant strategy for ﬁrm i. If ﬁrm j invests. If XT < X jM.

The optimal investment option value reﬂects ﬁrms’ optimal future behavior in interaction with rivals and the resulting equilibrium industry structures. they have to anticipate whether and when the rival will exercise its investment option in future states. both ﬁrms invest as (differentiated) Bertrand duopolists. The Cournot model or its extensions may be more appropriate in case of option games involving long-term capacity investment decisions.e. the resulting industry structure is a monopoly. Again.e. 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 7.240 Chapter 7 Let ﬁrm i be the ﬁrm with the high-price parameter aH. no one invests. . and M B for an intermediary demand zone ( X H ≤ XT < X L ). We ﬁrst examined the monopolist’s deferral option to help identify the main factors inﬂuencing the investment policy of a ﬁrm. for example. Firm j is the ﬁrm with the low-price parameter aL.10. For M low demand (i. Based on these investment triggers. 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 investment trigger.. 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 outcomes of the shared investment option game under differentiated Bertrand price competition at maturity are depicted in ﬁgure 7.. for high demand (i. We later extended the analysis to quantity and price competition. Due to the existence of strategic interactions in the market. M M B B X H < X L and X H < X L. Firm i is denoted H henceforth. XT < X H ). We showed the importance of deriving the trigger strategies as part of the ﬁrm’s investment policy under uncertainty. we identify three regions of demand.6). ﬁrms cannot simply set a trigger as a monopolist. B XT ≥ X L ). As noted. Conclusion In this chapter we have built upon the materials developed earlier in chapter 3 to derive the value and optimal exercise formulas for benchmark option games under uncertainty. 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. Some combinations are again mutually exclusive.

X iB ≡ ⎛ ⎜ ⎝ 1− s⎟ ⎣ ⎠ i = L. ⎦ ⎣ ⎦ ⎣ ⎦ 2 241 .6 Investment triggers and equilibrium payoffs (NPV) under differentiated Bertrand price competition Low-demand ﬁrm (L) Low demand M XT < X L M B X L ≤ XT < X L B XT ≥ X L Option to Invest Intermediary demand High demand Highdemand Firm (H) Monopoly Monopoly Focal point NA Monopoly No investment ⎛ 0⎞ ⎜ 0⎟ ⎝ ⎠ 2 High demand B XT ≥ X H Bertrand Intermediary demand M B X H ≤ XT < X H M ⎛ NPVH ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVH ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVH ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 M ⎛ NPVH ( XT )⎞ ⎜ ⎟ ⎝ ⎠ 0 B ⎛ NPVH ( XT )⎞ ⎜ ⎟ B ⎝ NPVL ( XT )⎠ NA Low demand M Xm < XH * NA 2 − s⎞ ⎡ Note: X iM ≡ 2 bδ I + c ai. NA = nonapplicable. H. ( ) ( ) 2 bδ I (1 − s 2 ) + c ai ⎤.Table 7. NPVi M ( XT ) ≡ ⎡(ai XT − c ) 4bδ ⎤ − I. NPVi B ( XT ) ≡ ⎡(1 − s )( ai XT − c ) bδ (1 + s) ( 2 − s ) ⎤ − I.

1994. Vi B ( XT ) ≡ (1 − s ) ( ai XT − c ) bδ (1 + s) ( 2 − s ) . Investment under Uncertainty. L) B NPVH (XT) B NPVL (XT) High B XT ≥ XL ~ ~ ~ Both firms invest X0 Intermediate M B XH ≤ XT < XL ~ High-demand firm invests (monopoly)... investment decisions. Smit. Smit. and payoffs (NPV) in differentiated Bertrand price competition 2 NPVi M ( XT ) ≡ Vi M ( XT ) − I . Princeton: Princeton University Press. Dixit. ⎣ ⎦ 2 2 Selected References Smit and Ankum (1993) extend binomial trees with embedded strategicform games. X iB ≡ ⎡((2 − s) (1 − s)) bδ I (1 − s 2 ) + c ⎤ a .10 Thresholds. Ankum. Avinash K.242 Chapter 7 Binomial tree evolution Threshold Investment decision Payoff function (firm H. A real options and gametheoretic approach to corporate investment strategy under competition. Financial Management 22 (3): 241–50. Pindyck. H . Dixit and Pindyck (1994) discuss some of these issues in continuous time. 1993. A. i = L. Princeton: Princeton University Press. Han T. NPVi B ( XT ) ≡ Vi B ( XT ) − I . J. Vi M ( XT ) ≡ ( ai XT − c ) 4bδ . Han T. and Lenos Trigeorgis. Low-demand firm does not (0) M NPVH (XT) ~ 0 Low M XT < XH ~ None invests (0) 0 0 t=0 T Figure 7. and L. and Robert S. X iM ≡ (2 bδ I + c) ai . Strategic Investment: Real Options and Games. .. J. 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. 2004.

while section 8. 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 commitment.8 Innovation Investment in Two-Stage Games R&D investments are typically made under uncertainty. and Rubinstein 1979).2 considers an application involving determination of optimal patenting strategies. is uncertain. Section 8. When moves are hard or costly to reverse.g. Smit and Trigeorgis (2001. Ross. The uncertainty in demand is modeled as a multiplicative binomial process (e. Firms cannot safely predict the state of demand when the resulting product offering will be launched in the marketplace. Now we consider two-stage games . nor what the competitive situation will be. In section 8. Box 8. namely demand.. or competitors’ strategies).1 we discuss the problem of investment in R&D when ﬁrms face spillover effects.3 discusses the incentive to create goodwill in a context where ﬁrms compete in price. costs. the value of preserving ﬂexibility must be explicitly assessed and traded off against the strategic beneﬁts gained from early investment commitment.. To address this issue. Here we complement such analysis with game-theoretic thinking. see Cox. 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.g. The chapter is organized as follows. demand.1 Innovation and Spillover Effects In chapter 7 we analyzed quantity competition involving asymmetric costs that were given exogenously. Strategic investments are often made under conditions of uncertainty about key market factors (e.1 discusses how real options analysis can provide intuitive insights regarding R&D investment. 8. 2004) extend Fudenberg and Tirole’s (1984) business strategy framework when one key underlying factor.

Even the “terminal value. It deserves wide attention. 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. the payoff estimates produced by the quantitative analyses are usually too low. the distant estimates are considered highly speculative and are heavily discounted. on average. that have some bearing on the company’s main business. The Y is unsalable because it’s unquantiﬁable. The beneﬁts of X are easily quantiﬁable. and hence salable to top management for funding. say. The Y may involve a wide range of possible outcomes and new markets but with. When all is said and done. the technique works something like this: Suppose there are two emerging technologies. The rigid equations and models currently used unfortunately have replaced the instinct and intuition that once guided US entrepreneurs. And if it’s a long-term project that would take. How to get American companies to act on their intuition again? There is a new technique that will go a long way toward that.244 Chapter 8 Box 8. because technically they seem unfeasible. . 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 measures. Designed after well-developed stock-options theories. They stand little chance of beating that ultimate yardstick—the cost of capital. for it comes closest to simulating the old-fashioned gut feeling. Perhaps the most fundamental problem with the current techniques is that they fail to take into account the consequences of not pursuing a technology. Nine out of 10 projects. Many of the assumptions aren’t reliable.” the value of the plant and other assets upon commercialization. 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. But it’s often overlooked that from the very start US corporations put their emerging technologies at an enormous disadvantage because of the techniques they use to evaluate payoffs.1 Real options and gut feeling in R&D In R&D. Some are tenuous at best. An auto maker may give up on ceramic engines. Dozens of assumptions go into this methodological overkill. The X may involve a well-understood technology and a market. 10 years to commercialize (ﬁve years being the outer limits of American corporations’ horizon). 40 percent chance of technical failure. X and Y. say. even though it seems more promising. is assumed to be zero. the Next Best Thing to a Gut Feeling Amal Kumar Naj. fail the test.

. • In the early 1980s.” says Peter Boer. Grace decided to invest in a new technology for catalytic converters for the automobile aftermarket. fundamentally. says he doesn’t have much use for quantitative techniques now. in effect taking a “call option” on the underlying technology. General Electric initially ignored the emerging magnetic resonance imaging (MRI) technology for medical diagnosis. the company commits small amounts to develop the technology. W. 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. The option allows R&D people to explore its technical possibilities. “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. What looked like a sure-ﬁre technology now can’t compete on price. Consider: • In 1984. And most important. Suppose the automotive catalyst technology had been given a thumbs-down by the quantitative techniques. help identify the unapparent outcomes that may be the most important reasons for undertaking the investment. Boer. The discounted cash ﬂow analysis—which used a generous “terminal” value—showed that it was an “attractive” project. in plants to reduce ozone emissions.” he says.Innovation Investment in Two-Stage Games 245 Box 8. market opportunities. but the other downstream markets loomed on the horizon. director of planning at GTE Laboratories in Waltham. it would have cannibalized the market for GE’s existing CT diagnostic machine. Massachusetts.” says Mr. R&D options.” The loss is limited to the small initial funding (the value of the R&D option). The MRI market was unclear. who has co-authored a paper on options valuations of R&D with Graham Mitchell. the option is allowed to “expire. which uses X rays. director of GE’s R&D. development costs and competitors’ strategies. If these don’t become clear within the time period of the option. “We didn’t accurately predict the price-performance requirement we needed in the aftermarket. someone else was going to. GE overruled the directive of the discounted cash ﬂow technique.” says William Hamilton of the University of Pennsylvania’s Wharton School. as it realized that if it didn’t cannibalize the CT market. Grace would have dropped the project. chief technical ofﬁcer. and in utilities to control emissions. “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. Walter Robb. except that other opportunities for that technology intervened. just as in the stock option. The recent clean-air legislation has created applications in cogeneration plants.1 (continued) Instead of ignoring Y.R.

Having the low-cost ﬁrm ( L ) make the strategic investment is simpler. strategic technology planner of US West. 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. and (2) for substantial change in the cost differential. also has taken the options approach. • US West. “It was a tricky thing to convince the management. The management agreed to take an “option” on automating the plant. Merck also wasn’t certain about the technical success. 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. the labor savings didn’t justify the investment. Copyright © 1990 Dow Jones & Company. When it considered the idea ﬁrst for a drug packaging and distribution plant. . two effects would result: (1) ﬁrm H ’s cost position is improved. with no prior experience with robots. to plan extensive automation. affecting all the players’ investment triggers. we are more in line with Fudenberg and Tirole’s (1984) analysis where the value function is differentiable in the ﬁrst-stage investment. By focusing on the problem where the low-cost ﬁrm may improve its cost position. “Our company doesn’t have the maturity and experience to act on gut feelings.246 Chapter 8 Box 8. But it is the ﬁrst clear mechanism for R&D people to communicate with their ﬁnance men. The options technique needs reﬁning (how to calculate the value of an R&D option is a subject of debate. where a ﬁrm may make a ﬁrst-stage strategic investment (K) that can inﬂuence future variable costs. for instance). 1990. a telecommunications concern in Denver. Suppose that the low-cost ﬁrm in a duopoly invests in an R&D process innovation to further reduce its variable cost cL.1 (continued) • It’s the downstream rewards that are allowing the pharmaceutical company Merck & Co. a company spawned in 1984 by the AT&T breakup.” says Judy Lewent. Moreover. 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). the low-cost ﬁrm faces a lower investment trigger and the project is 1. If the high-cost ﬁrm ( H ) is the one making such an R&D investment.” says David Sena. This second effect creates a discontinuity in the value function. Considering the reverse problem would make the analysis more involved while being unable to isolate the pure strategic effect resulting from the commitment. faced with fastchanging technologies in its industry. Publication date: May 21. Inc. Reprinted with permission of The Wall Street Journal.1 By reducing its second-stage variable cost. But options valuation allowed engineers to articulate a whole range of outcomes and their beneﬁts. chief ﬁnancial ofﬁcer at Merck.

g. M C 3. resulting in a (greater) cost disadvantage for its rival. R&D in process innovation) or not.” By comparing the base case of no investment and the case involving strategic investment. C 2. when the incumbent ﬁrm (L) lowers C its future variable cost. The investment trigger of the rival ( X H) increases. 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. We next discuss this problem at length. . At the intermediate demand zone. and consequently the low-cost ﬁrm is more likely to enjoy longer temporary monopoly proﬁts. namely the opportunity to invest will be of higher value. the proﬁt made by the low-cost ﬁrm is higher (with process innovation leading to a decrease in its variable cost). The investment trigger of the low-cost ﬁrm ( X L ) decreases.Innovation Investment in Two-Stage Games 247 more likely to be worthwhile (“in the money”). That is. Four concurrent effects inﬂuence the investment decision as a result of this action: M 1. C 4. In analyzing strategic investment commitment. At t = 0 ﬁrm i may decide to commit to an early strategic investment (e. At the same time this cost improvement reduces the rival’s incentives to enter in that it cannot extract as much value upon entering. We ﬁrst analyze the case when ﬁrms compete in quantity à la Cournot. If ﬁrm i does not commit now. Once the base case is set. we can assess whether early strategic investment commitment has a positive or a negative incremental value and compare the relative value of the investment strategy with versus without commitment. X L ≤ XT < X H. we can determine the incremental value of commitment. 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. When demand is very high ( XT ≥ X H ) and the high-cost ﬁrm also enters resulting in a Cournot duopoly structure. one has ﬁrst to set a benchmark.. so it is more likely to invest (its option value increases). This is the “base case. it still has managerial ﬂexibility to wait. the low-cost ﬁrm may achieve higher proﬁt (than without the upfront R&D investment). the investment trigger for its rival X H rises such that the high-cost ﬁrm is less likely to invest as a Cournot duopolist.

such as when the demand shock parameter X t in the demand function p (Q. it may partly or fully beneﬁt from ﬁrm L’s investment in R&D as well. if γ = 1. The high-cost ﬁrm H does not itself invest in R&D.4) and (7. We assume that there is already a cost advantage for the low-cost ﬁrm even without the new commitment (cL < cH). the high-cost ﬁrm simply free-rides from innovative ﬁrm L’s R&D investment (fully shared R&D). there are no R&D spillovers (the proprietary R&D case). If γ = 0. X t ) = aX t − bQ (8.g. Low spillovers means that the investing ﬁrm can effectively protect its innovation and is the sole party beneﬁting from the R&D investment. for example in R&D investment. Spillovers measure to what extent the investment in R&D is “shared. The unit production cost for the high-cost (noninvesting) ﬁrm reduces to cH ′ ≡ cH ′ (ω ) = cH − γω . From chapter 7. To analyze strategic commitment. The base case involves the situation where ﬁrm L does not invest or reap the beneﬁts of R&D investment. the investment triggers under the pre-R&D asymmetric cost structure are given by M XL ≡ 2 bδ I + cL a and 2. by an amount ω (0 < ω < cL) to cL ′ ≡ cL ′(ω ) = cL − ω.1) follows a multiplicative binomial process. 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.9).248 Chapter 8 The model developed previously makes it possible to value option games when one of the underlying factors is uncertain.” High spillovers mean that the competitor also beneﬁts or free-rides on the investing ﬁrm. equations (7. cL.2 In some cases (e. but due to R&D spillovers in case R&D is made and shared. in patent licensing) γ can be a decision variable. 1]. it is useful to distinguish between “proprietary” and “shared” R&D investment. . 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. Suppose that the R&D effort by ﬁrm L decreases ex post production cost..

X H ′ ≥ X H if γ ≤ 1 2 (a and ω are positive numbers). depending on the size of the cost savings from innovation (ω ) and the degree of spillover (γ ). In patent licensing (see later section 8. so the innovating ﬁrm keeps the innovation beneﬁts to itself. this means that the low-cost ﬁrm will invest earlier in the production stage. note ﬁrst that X L ′ < X L (for all ω such that 0 < ω < cL). For an American-type investment option this means that the rival invests later. a (8. In the American-type option framework we analyze later on (see later continuous-time analysis). With process innovation. if the investment is proprietary or spillovers are low. this investment makes the rival ﬁrm less aggressive in the product market stage (i. it invests later on). By making the strategic R&D investment. A lower investment trigger resulting from innovation implies that the investment will be more attractive. Investing in R&D makes innovative ﬁrm L tough. Since C C C C X H ′ − X H = (1 − 2γ ) ω a. the cost and investment trigger of the investing ﬁrm decline and the likelihood that its option is in the money increases. For a low degree of spillover (γ ≤ 1 2)..Innovation Investment in Two-Stage Games 249 C XH ≡ 3 b δ I + ( 2 c H − cL ) .e. post-R&D cost structure. and the rival ﬁrm responds less aggressively in the competition . ﬁrm L invests earlier in production (lower investment threshold for the low-cost ﬁrm). a M C Let X L ′ and X H ′ be the investment triggers under the new.2) and C XH ′ = 3 bδ I + ( 2cH − cL ) + (1 − 2γ ) ω . This has interesting implications on whether ﬁrm L should invest in R&D or not. This case with low spillover corresponds to the proprietary R&D investment case in Smit and Trigeorgis (2004). These are given by M XL ′ = 2 b δ I + cL − ω a (8.3) M M Comparing these investment triggers. Another insight is that the ﬁrst-stage R&D investment of ﬁrm L may alter the investment trigger of its rival. This kind of positive strategic effect leads to the “top dog strategy” in Fudenberg and Tirole’s (1984) taxonomy. the investment threshold of the rival ﬁrm rises if the low-cost ﬁrm invests in R&D.2) it corresponds to the case of not licensing out.

4) and ﬁrm H as a duopolist in equation (8. 4.3): C M XH ′ − XL = bδ I + 2 ( cH − cL ) + (1 − 2γ ) ω .250 Chapter 8 stage (strategic substitutes). 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”).3 If the spillover effect (γ ) is low. acting as a top dog. A third insight is obtained if we examine the difference between the investment thresholds of ﬁrm L as a monopolist in equation (7.” In case of high spillover (γ > 1 2). who should refrain from investing. although the investment trigger of the low-cost ﬁrm is reduced the likelihood to become a monopolist is lower. a noting that C M ∂ (XH ′ − XL ) ∂γ =− 2ω (< 0 ). In this case “overinvesting” has a negative strategic effect. ﬁrm L should refrain from making the strategic investment commitment. In this case. Only a “suicidal Siberian” would overinvest under strategic substitutes even though investment would make it soft. . 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. Since ﬁrm L’s strategic move is also beneﬁcial to the rival. so both ﬁrms beneﬁt. 3.4 So far we examined whether R&D investment has a positive or a negative strategic effect. the strategic investment in R&D by ﬁrm L reduces its own investment trigger as well as the investment trigger of its rival. Firm L should wait or “underinvest” and keep a lean-and-hungry look. 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. Firm L should thus “overinvest. the lower the discrepancy between the investment thresholds of the two ﬁrms. The low-cost ﬁrm should overinvest (in R&D or licensing out its patent). a The higher the spillover effect (γ ). however. producing a positive strategic effect for the investing ﬁrm. the net value of the investment under the two cost structures must be determined as discussed in the previous chapter. To decide whether the ﬁrm should invest in R&D (license out its patent) or not. however. it represents a soft commitment for ﬁrm L.

4) and (7. the investment triggers given by M equations (7.2 (lower than M C X L = 4). The post-R&D costs now are cL ′ = 6 and M cH ′ = 15 − 0.10 × 250 + 6 5 = 3.25 × 4 = 14. It will do so when the cost of the investment necessary to obtain this strategic effect is higher than the incremental option value created by the strategic effect. with γ = 0.1.75 ( > 1 2 ). b = 1. ﬁrm L may be better off refraining from investing in R&D even if doing so has a positive strategic effect.3. The value of the option under the pre-R&D cost structure is 82 . and risk-free rate r = 3 percent.2) and (8. Under the preR&D investment cost structure. . panel a. As conﬁrmed in ﬁgure 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 = 0.2 (same C as with low spillover) and X H ′= 6. panel b. achieving cost savings of ω = 4. The project value is consequently higher for the low-cost ﬁrm and lower for its competitor. Now suppose that the lowcost ﬁrm L makes an upfront strategic investment in R&D of K = 200 to decrease its variable costs in the competition stage.6 (lower).5 × 4 5 = 7. Figure 8.Innovation Investment in Two-Stage Games 251 Example 8.10 × 250 + 2 × 15 − 10 + 0. The new investment triggers given by equations M (8. conﬁrms that as a result of the shared beneﬁts of this R&D investment. cH = 15.1 Investment Triggers in a Duopoly Faced with Low R&D Spillover Let us revisit previous example 7.4 C (larger than X H = 7). volatility of σ = 30 percent. Suppose that the spillover effect is low.3) are X L ′ = 2 1 × 0. where cL = 10. and X H ′ = 3 1 × 0.5 ( ) ( ) ( ( ) ) Example 8.10 × 250 + 10 5 = 4 and C X H = 3 1 × 0. a = 5.10 × 250 + 2 × 15 − 10 5 = 7. I = 250 . Firm L should then invest in R&D given that this commitment makes it tough and that ﬁrms compete in quantity (strategic substitutes).75 × 4 = 12. the value of the option for the low-cost ﬁrm under the post-R&D cost structure is estimated to be 168 . Assuming a maturity of T = 5 years over 10 equally spaced time steps.1. Furthermore the investment trigger of its rival increases so ﬁrm L is more likely to act as a monopolist in the marketplace.9) were X L = 2 1 × 0. k = 10 percent. Depending on the size of the upfront strategic investment cost. both ﬁrms now face lower triggers and are more likely to invest in the product 5. the investment trigger of the lowM M cost ﬁrm decreases ( X L ′ < X L ) such that the ﬁrm is more likely to invest. If the additional cost advantage via R&D costs more than 168 − 82 = 86. g = 0 percent.25 ( < 1 2 ). 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. The new investment triggers are X L ′ = 3. Under the new cost structure cL ′ = 10 − 4 = 6 and cH ′ = 15 − 0.

0 End-node value XT Old cost structure (pre-R&D) New cost structure (post-R&D) ~ (a) NPV at maturity (in thousands) 3 2 Low-cost firm (L) 1 High-cost firm (H) 0 0 2.252 Chapter 8 NPV at maturity (in thousands) 3 2 Low-cost firm (L) 1 High-cost firm (H) 0 2.25).5 C XH ' 10.75) .0 C XH 7.0 C XH ' 7.1 R&D investment (a) With low spillover (γ = 0.5 C XH 10. (b) with high spillover (γ = 0.5 M XL ' M XL 5.5 M XL ' M XL 5.0 End-node value XT Old cost structure (pre-R&D) New cost structure (post-R&D) ~ (b) Figure 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 investment option. namely whether to license out (γ = 1) or not (γ = 0). 8. Patents presumably 6. This result. Option games analysis can extend previous gametheoretic literature on patent licensing and provide new insights about optimal decisions under uncertainty. the incentive to invest in R&D is greatly reduced and the value is lower. extending the analysis to incorporate uncertain demand along the product development phase. such as when ﬁrm L decides to license out its new innovation to ﬁrm H for a ﬁxed cash payment or for a royalty fee. 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.6) and will more likely enter.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.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.Innovation Investment in Two-Stage Games 253 market stage. We assume the same parameter values as in example 8. We examine this interesting application next. When spillover is high. .2. In this case the degree of spillover (γ ) in effect becomes a decision variable for ﬁrm L. Here the threshold at which the R&D investment destroys value is lower (134 − 82 = 52) compared to the low-spillover case.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 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. however. 8. is less likely to enjoy monopoly proﬁts than in the previous example since the rival’s entry trigger is now lower C ( X H ′ drops from 7. In this context there is no a priori external pure spillover effect (γ = 0) unless the ﬁrm holding the patented process innovation 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. compared to the previous case with low spillover. may get reversed if the innovation beneﬁts are shared with the rival beneﬁting not for free but with adequate compensation. however.4 to 6. Firm L.

the patent-holding ﬁrm proposes a deal. the post-invention monopoly price must be less than c (the price set in perfect competition) for an innovation to be “drastic. 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. If they accept it. Only the ﬁrst two forms are discussed here. royalty rate) and the terms of the contractual relationship (e. According to Arrow. They may compete either in quantity or in price. or (3) a mix of the above. Here the asymmetric case is considered.g. namely an upfront ﬁxed fee plus regular royalty payments.254 Chapter 8 encourage innovation by providing ﬁrms with temporary monopoly rights enforceable by law.” Licensing payments generally take one of the following three forms: (1) a ﬁxed fee the licensee pays to the licensor. they can use the new (cost-reducing) technology conditional on the payment of the fees to the patent-holding ﬁrm. 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.7 Licensing is a means by which a patentholding ﬁrm can derive beneﬁts from its intellectual property (IP) rights. with the optimal decisions determined by backward induction.8 Arrow (1962) analyzed cost-reducing innovations and the impact of drastic versus nondrastic innovation on competitive market equilibria. (2) a royalty rate as a function of the revenues or volumes the licensee produces. For a general overview of the game-theoretic literature on patent licensing. amount of the fee). In the last stage simultaneous competition occurs between producing ﬁrms (potentially including the patent holding ﬁrm). This model follows Wang (1998) who models Cournot duopoly with symmetric quantity competition. If the cost of producing under the old technology is constant and equal to c.. the game-theoretic interaction between the patentholding ﬁrm and would-be licensee(s) is typically as follows. Would-be licensees may either accept or refuse the proposal made by the patent holder. The game is played once and all relevant information is common knowledge to all the players. see Kamien (1992).9 Firms i and j have a shared (European) option to launch the new product in the market. In the last stage the 7. At ﬁrst. a drastic innovation is one for which the postinnovation price of a monopolist is below the pre-invention competitive price. 8. choosing the type of licensing contract (ﬁxed fee vs. The licensor works out its licensing proposal as part of a subgame perfect Nash equilibrium. This proprietary right is granted if the innovator provides public authorities with sufﬁcient information concerning the innovation content so that society and researchers can beneﬁt and further build on it. In patent licensing. 9. .

By contrast. . Firm i will license its technology if doing so makes it better off. Suppose that the two ﬁrms face a linear (inverse) demand function as in equation (3. Drastic process innovations reduce costs by a sufﬁcient amount such that the patent-holder can reap monopoly rents for some time. with Q = qi + q j.10 The would-be licensee is also proﬁt maximizing and may reject the offer if it does not make it better off. equal to: π iM ( ci .4) If the market is large for both ﬁrms to be producing. 9b (8.21) π iC ( ci . Prior to introducing the new process innovation (pre-innovation or base case). resulting in a post-invention unit production cost ci’ ≡ ci − ω . The patent-holding ﬁrm is concerned with maximizing its total proﬁt when designing the offer (setting its ﬁxed fee or royalty rate). ﬁrms’ unit production cost are ci and c j (old technology) with ci ≤ c j. ﬁrm i’s proﬁt equals the (asymmetric) Cournot equilibrium proﬁt of equation (3.1). If the market is not sufﬁciently large for both ﬁrms to produce. Kamien and Tauman’s (1986) key result relating to the superiority of the ﬁxed-fee licensing over royalty licensing stems from this differentiating feature. based on equation (3. (B) innovation is nondrastic and ﬁrm j is given no access to the technology (no licensing). nondrastic innovations are associated with a slight cost advantage over competitors. (8. c j ) = (a − 2ci + c j )2 . the only active ﬁrm (say ﬁrm i) would earn monopoly proﬁts. not sufﬁcient to drive out rivals.5) The equilibrium proﬁts for ﬁrm j are analogous. Firm i’s innovation can be drastic (offering it the possibility to pre-empt and set monopoly prices) or nondrastic (letting room for competition). setting their output independently and simultaneously (Cournot quantity competition). c j ) = (a − ci )2 4b .4).Innovation Investment in Two-Stage Games 255 duopolists compete in quantity. namely p (Q) = a − bQ. (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. 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). For the patent holder the total proﬁt consists of the proﬁt derived from its own production plus any licensing revenues. Four cases (six subcases) can be distinguished: (A) innovation is drastic and ﬁrm i prefers not to license out its process innovation.

if ω ≥ ω ).3): pM = a + ci′ ≤ cj. These cases are summarized in table 8.. if innovation is nondrastic (i.1. case B arises. Case A (ω ≥ ω ) If innovation is drastic.e. By contrast. case A emerges. when ﬁrm i licenses its technology. ﬁrm j can be driven out of the market while ﬁrm i acts as a monopolist earning monopoly proﬁts π iM ( ci′.11 Firm i’s marginal production cost with the new technology is ci′ ≡ ci − ω.256 Chapter 8 Table 8. that is. 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). if ω < ω ) and ﬁrm i insists not to license. Under no licensing. it is assumed that no spillover effects occur (γ = 0 ). . Equilibrium proﬁts for ﬁrms i and j...e.6) 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. (D) innovation is nondrastic and ﬁrm i licenses it. Drastic Innovation If innovation is drastic.e. are 11. In both cases ﬁrm i produces with its new (lower cost) technology alone. c j ). while its competitor is forced to operate its business using the old technology (if it produces at all). from equation (3. based on equation (3. In addition. ﬁrm j is driven out of the market. ω ≥ ω ).6). whereas ﬁrm j’s cost remains c j. it may either select a ﬁxed fee or a royalty payment. 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). If ﬁrm i decides not to license out its technology when the innovation is drastic (i.1 Alternative cases for licensing out a patented technology and type of innovation Innovation Drastic Innovator ﬁrm Nondrastic Case B Case D1 Case D2 i No licensing out Licensing out Fixed fee Royalty rate Case A Case C1 Case C2 and ﬁrm i chooses to license it. 2 (8.

conditional on the monetary proﬁt the patent holder will receive from licensing out. Firm i therefore sets the optimal ﬁxed fee (F*) such that π C ( ci′. In addition to the proﬁt ﬁrm i receives as a Cournot duopolist (if both ﬁrms produce). 9b π C ( ci′. Consider the cases where the patent holder decides to license out its technology. it may decide to license out its technology to its rival. π M ( ci′. it determines its optimal price by backward induction. 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). resulting in asymmetric Cournot-Nash equilibrium proﬁts: π iC ( ci′. c j ) = j (a − 2c j + ci − ω )2 . 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). c j ) = (a − 2ci + 2ω + c j )2 . c ′ ) − F ≥ π C ( ci′. c j ) = ( a − ci + ω )2 4b .8) Alternatively. 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. 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.7) Case B (ω < ω ) If the process innovation is nondrastic and the market is large enough for both ﬁrms to produce. c ′ ) = j j (a − 2c j + ω + ci )2 . j j j The maximum ﬁxed fee the patent-holding ﬁrm i can charge licensee . both ﬁrms will produce with the new technology at a marginal production cost ci′ ≡ ci − ω (respectively. 9b π C (ci′. 9b (8. j (8. As the leader.Innovation Investment in Two-Stage Games 257 π iM ( ci′. c j ) = 0. c ′ ≡ c j − ω ). both ﬁrms maximize their proﬁts by optimally selecting their output (simultaneously). c ′ ) is taken into account (backward inducj tion) when the patent-holding ﬁrm sets its optimal ﬁxed fee (case D1). 9b (8. c ′ ) = j (a − 2ci + ω + c j )2 . c j ). The innovation can be drastic (case C) or nondrastic (case D).9) The proﬁt expression π iC (ci′. it will also receive the ﬁxed-fee payment F from outlicensing. If innovation is nondrastic and licensing out occurs for a ﬁxed fee (case D1). Equilibrium Cournot j proﬁts are π iC ( ci′.

10) Firm i’s total proﬁt is thus made up of last-stage production proﬁts plus the ﬁxed-fee licensing payment.12 If innovation is drastic (case C1 with ω ≥ ω ). c ′ ) + F *) allows ﬁrm i’s management to j decide whether it is justiﬁed licensing out its technology.258 Chapter 8 ﬁrm j is such that the licensee is indifferent between producing with the new technology (having lower production cost c ′) versus the old technolj ogy (operating with cost c j). If the cost reduction is large (ω ≥ ω ). j j 12. This yields the maximum licensing ﬁxed fee the patent holder could charge: F * = 4ω (a − 2c j + ci ). the patent holder would prefer to keep its technology for itself (not licensing it out) and become a monopolist. . j j This occurs if the cost reduction obtained by the innovation ω is small (ω < ω . driving the rival out of the market. In practice. c j′ ) + F *. namely π iC (ci′.11) Comparing its proﬁt under no licensing (π iM ( c′)) and its total proﬁt i under ﬁxed-fee licensing (π iC (ci′. and c j otherwise. 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. Firm j beneﬁts from the new technology but has to pay a proportional amount R per unit of output. 13. 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. c ′ ) + F * > π iC ( ci′. it will prefer not to license out under the ﬁxed-fee licensing contract. with c ′ < ci. the maximum ﬁxed fee is thus given by F * = π C ( ci′. Since when the innovation is drastic (case C1) π iM (ci′) > π iC ( ci′. Firm i will j choose to license out its patent if π iC ( ci′. c ′ ) + F *. Equivalently. j j j j j (8. given by c ′ + R (with c ′ ≡ c j − ω ) if it licenses the technology. c ′ ) − π C ( ci′. with ω ≡ 2 ( a + 4ci − 5c j ) 3). ∞ ) = π C ( ci′. 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 . c j ). c ′ ). 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 ). 9b (8. Its marginal cost is now effectively higher. Royalty Rate Licensing Consider next the royalty licensing case (cases C2 and D2).13 The marginal cost of the patent-holding company (ﬁrm i) stays unchanged at the lower level ci′ ≡ ci − ω .

⎝ b ⎠ 2 (8. j Firm j considers ﬁrm i’s quantity as given when maximizing its own proﬁt (by selecting q j ).Innovation Investment in Two-Stage Games 259 The licensee would not accept to pay a royalty rate higher than the marginal beneﬁt from producing with the new technology. Drastic Innovation (Case C2) When both ﬁrms are active in the market. Firm j’s proﬁt is given by π j ( qi . c ′ + R). From the perspective of the patent-holding ﬁrm i. q j .13) of 1 ⎛ a − c′ − R ⎞ j q j * ( qi ) = ⎜ − qi ⎟ . 3b q j * (R ) = a − 2c j + ci + ω − 2R .12) The equilibrium quantities.13) Equilibrium proﬁts are therefore given by π i* ( R ) = π iC ( ci′. R ) = [ p (Q) − ci′] qi + R q j . namely 0 ≤ R ≤ ω. 3b (8. By differentiating the proﬁt function with respect to qi. leading to a best-reply (reaction) function analogous to (3. ⎠ 2⎝ b (8. found at the intersection of the two bestreply curves. j π j * ( R) = π C ( ci′. Firm i will select its output qi to maximize its total proﬁt π i ( qi . q j ) = [ p (Q) − c ′ − R ] q j . so the best-reply function for ﬁrm i is 1 a − ci′ qi* ( q j ) = ⎛ − qj ⎞ . in addition to its own production proﬁt it also receives an extra revenue from licensing (of R q j). R ). q j . j j (8. they will each select (simultaneously) their quantity to maximize their proﬁts. are qi* ( R ) = a − 2ci + c j + ω + R . the right-hand term R q j drops out.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 .11) 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 . c ′ + R) + R q j * ( R ).

where c ′ + R* = c j. the patent holder is indifferent between being monopolist and licensing for a high royalty rate. Once the patent holder has determined the optimal royalty rate to set. In case ci < c j . c j ) + ω q j * (ω ) > π iC ( ci′. c j ) ∂ci > 0 and ω > 0. as the proﬁt earned by the patent holder (ﬁrm i) under the optimal royalty contract. the patent holder will prefer licensing out its patent when a royalty licensing method is used and process innovation is nondrastic. Moreover.14 The would-be licensee is indifferent between being a licensee or not producing at all. Under the royalty-payment licensing 2 ci − c j ) . When the innovation is nondrastic. the maximum royalty rate is R* = ω . ﬁrm j’s post-innovation proﬁt is lower than its pre-innovation proﬁt. namely π iC ( ci′. 0} = max {( } . Comparison In case of drastic innovation (case C2). ﬁrm j will not produce. 10 (8. In the case of nondrastic innovation. under drastic innovation. 0 = 0 . max {q j* (ω*). As ∂π j * (ci . j j Firm j’s cost is the same whether ﬁrm i licenses out the technology or not. in both cases earning zero proﬁt. j π j* (ω ) = π C (ci′.260 Chapter 8 R* = 5 ( a + ω ) − ( ci + 4c j ) . ﬁrm j will refuse the licensing contract and earn zero proﬁt (as in case A). Equilibrium proﬁts for ﬁrms i and j are j π i* (ω ) = π iC ( ci′.15) 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 ′) and conj tinuing operating with the old technology (at production cost c j). c ′ + ω ) = π iC (ci′. 14. π i* ( R*). 5 15. licensing out via a royalty rate yields the same outcome as choosing not to license. it can decide whether to license out or not. c ′ + ω ) + ω q j * (ω ) = π iC ( ci′. c j ) + ω q j * (ω ).15 The patent-holding ﬁrm thus ends up earning monopoly proﬁts when the innovation is drastic. licensing out under a royalty rate fee makes the patent holder better off. c j ). c j ). since the total proﬁt the patent holder receives from licensing under a royalty rate is higher than under no licensing. Since ci ≤ c j . Given the additional beneﬁt ω q j * (ω ). Thus. R*. equals the monopoly proﬁt π iM under drastic innovation and no licensing.

receiving π iC ( ci′.16 8. royalty rate). in this region the patentee is better off licensing under the royalty rate method than not licensing. different industry structures may occur once uncertainty is considered. c ′ + ω ). for ω < ω < ω ). This extra marginal cost advantage does not exist under ﬁxed-fee licensing and does not affect equilibrium quantities.e. The difference lies in the fact that. 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 patentee will earn π iC ( ci′. c j′ ) + F *] = 9b [a − c j − 5 (ci − c j )] (> 0).. If a royalty rate is selected instead. in case of nondrastic innovation (ω < ω ) the patent-holding ﬁrm will prefer to license out its technology using the royalty rate contract. the patent holder is better off not to license than to license under the ﬁxed-fee contract. How do the ﬁxed fee versus the royalty rate alternatives compare? Several cases result depending on (1) the nature of the innovation (drastic vs. the patent-holding ﬁrm earns more by licensing out using a ﬁxed-fee contract than not licensing.2 Patent Licensing under Uncertainty The game-theoretic analysis above can be extended to incorporate product demand uncertainty. nondrastic) and (2) the type of licensing payment (ﬁxed-fee vs. . For nondrastic innovation involving small cost savings due to process innovation (i. and π j * (ω ) = π C ( ci′. 16. for nondrastic innovation involving small cost savings (ω < ω < ω ). ending up as a monopolist. For somewhat larger cost savings (ω < ω < ω ). Depending on market development. c j ) + ω q j * (ω ).2. No licensing contract makes the patent holder better off. That is. the patent holder will choose to keep the new technology for itself and become a monopolist.Innovation Investment in Two-Stage Games 261 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). the patent holder is better off licensing out its technology via a royalty rate payment (q j R*) than via a ﬁxed fee (F*). in the model above. In other words. j j In case of drastic innovation. c j ) + ω q j * (ω ). 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. ﬁxed fee) are ω [π iC (ci′. When innovation is drastic (ω > ω ). c j ) + ω qj * (ω )] − [π iC (ci′. The incremental proﬁts under the two licensing methods (royalty vs. In this case equilibrium proﬁts will be π i* (ω ) = π iC ( ci′. c j′ ) + F *. By contrast. the patent holder will not license out.

facing a reduced post-invention cost of cL ≡ cL − ω . The demand intercept a used in deterministic cases earlier is now substituted by aX t in expression (3. Suppose that the low-cost ﬁrm (ﬁrm L) is the patent holder (having a pre-invention cost cL). Suppose that in each end state at maturity ﬁrms behave optimally. where X t follows a stochastic process in discrete time. If the innovation is nondrastic (i. The necessary investment outlay is identical for both ﬁrms (I ). the patent holder will drive its competitor out of the market and earn monopoly proﬁts. If innovation is nondrastic and the high-cost ﬁrm H also enters the market. with X≡ ω − cL + 2cH . here a new threshold needs to be considered. a (8. This is the critical threshold which distinguishes drastic from nondrastic innovation. namely if X t > X . a C XH = 3 bδ I + ( 2cH − cL ) . there exists a region of demand M ( X L < X t < X) where the patent holder will be a monopolist. ﬁrm L will license out its cost-reducing technology to its com- ( ) . if ω < ω ). If innovation is drastic. The demand threshold separating drastic from nondrastic innovation is determined as follows.262 Chapter 8 However. or alternatively if demand is limited such that X t < X . For very M low demand ( X t < X L ).4) and (7. If ω ≥ ω M. The patent holder may license its technology to the high-cost ′ ﬁrm (ﬁrm H). From equations (7.9) the investment triggers in the standard Cournot option game for a monopolist and an asymmetric Cournot duopolist are given by M XL = 2 bδ I + cL . Its process innovation allows it to reduce its production cost further by ω . a Compared to the previous option games. namely ω ≡ a + cL − 2cH. set Cournot-Nash quantities and select the optimal licensing policy. If X L > X or ω < ω M ≡ cL − cH + bδ I . the patent holder will not be able to drive its competitor out of the market.16) Innovation is nondrastic if demand is sufﬁciently high for both M ﬁrms to operate proﬁtably.. This threshold increases for higher levels of the demand intercept (a). the patent-holding ﬁrm will license its technology to its rival and earn a royalty payment (at an optimal rate R* = ω ). the low-cost ﬁrm does not enter the market.e.1). Innovation is drastic if ω > ω ( ≡ aX t + cL − 2cH ). ﬁrst-stage innovation investment and second-stage licensing policy may alter industry structure altogether. that is.

drastic innovation will affect the investment behavior of the high-cost ﬁrm. that is. These are summarized in ﬁgure 8. the existence of drastic innovation does not impact the investment decision of the high-cost ﬁrm at maturity. For ω > ω C and X > X H . a (8. C C ﬁrm H will invest if X t ≥ X H > X .2 Possible outcomes for patent licensing game 0 . if ω < ω C ≡ 3 bδ I .2. ( ) Pre-innovation ∞ ∞ Post-innovation ∞ ∞ Duopoly Duopoly C XH C XH Monopoly Case A X M L Monopoly Case B X X M L X 0 0 No investment No investment ∞ X Case C M L 0 ∞ 0 ∞ Duopoly X Mutually exclusive conditions for w X X C H Case D C XH M XL Monopoly No investment 0 Figure 8. Four possible cases are distinguished.17) C If X < X H . resulting in different industry structures. 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. The ﬁrm C will invest if X t ≥ X > X H. The investment trigger (in case of licensing) for the high′ cost ﬁrm is C XH = 3 b δ I + ( 2 c H − cL ) . The unit production cost for ﬁrm H using the new technology is cH + R* = cH.Innovation Investment in Two-Stage Games 263 petitor.

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C M Case A If (ω < ω C ) ⇔ ( X < X H ) and (ω < ω M ) ⇔ ( X < X L )) (small cost savings).

**C M Case B If (ω < ω C ) ⇔ ( X < X H ) and (ω > ω M ) ⇔ ( X < X L ) (intermediate cost savings).
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**C M Case C If (ω > ω C ) ⇔ ( X > X H ) and (ω < ω M ) ⇔ ( X < X L ) (intermediate cost savings).
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**C M Case D If (ω > ω C ) ⇔ ( X > X H ) and (ω > ω M ) ⇔ ( X < X L ) (large cost savings).
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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 licensing and under licensing based on the optimal royalty rate are the same. However, from the licensee’s perspective compared to the pre-innovation 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 innovation investment here changes the industry structure dramatically. Compared to the pre-innovation case (where the high-cost ﬁrm invests if C X t > X H ), post-innovation ﬁrm H is driven out of the market in the C C region X H < X t < X . Its actual investment trigger is not X H but rises to X given by equation (8.16). 8.3 Goodwill/Advertising Strategies

In this section we discuss advertising/goodwill in price competition situations where the entry decisions by ﬁrms depend on both the ﬁrm’s

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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 differentiation parameter enters both ﬁrms’ proﬁt function. It is given by s (0 ≤ s < 1), representing the substitution effect between the two differentiated 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 highdemand 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 successfully 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 differentiated 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.

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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 competitor’s, creating in customers’ mind the feeling that the products of these ﬁrms are on an equal footing. Launching such kind of marketing campaigns 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 Damocles, 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 endogenously 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 incentive 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

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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 commitment), 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.

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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 parameters 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 commitment. Through soft commitment investment, ﬁrm H can increase its investment option value. To determine the net commitment effect, one

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Millions of euros

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+ 6.8 30.9

30 25

21.0 (3.2) 24.1

20 15 10 5 0

Tough commitment Total commitment effect Base case Total commitment effect Soft 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 M investment trigger, from equation (7.4), is X H ≡ 2 Iδ b + c aH = 2 100 × 0.13 × 2 3 + 1 12 ≈ 0.57 and ﬁrm L’s, from equation (7.14), B is X L ≡ ⎡((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 .

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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 substitution 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 M remains X H = 0.57). The low-demand ﬁrm’s trigger is slightly altered through the strategic effect of the ﬁrst-stage investment, being reduced B B from X L ≈ 0.86 to X L ′ ≈ 0.78. Firm L’s investment trigger is driven by the proﬁt the ﬁrm would make under differentiated Bertrand competition. 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 incentive 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, convincing 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.

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competitor in the second stage. In doing so, ﬁrm H increases the substitution effect (from 0.5 in the base case) to 0.8. Firm H’s investment trigger M again remains unchanged ( X H ≈ 0.57), whereas ﬁrm L’s rises (from B B X L ≈ 0.86 in the base case) to X L ′′ ≈ 1.16. The rival’s trigger is driven by strategic interactions in Cournot duopoly, affected by the ﬁrst-stage strategic 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.

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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.

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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 substitutes, e.g., quantity competition). Using option games, we have analyzed under conditions of market uncertainty various competitive strategies, depending on whether competitive 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 nonetheless 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 investor into being aggressive in the second stage and the competitor will follow suit (under strategic complements).

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When strategic actions are contrarian and the beneﬁts of strategic commitment 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.

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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.

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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.

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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 reactions (strategic complements vs. substitutes). Option games enable simultaneously 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 formulate 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 applications 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.

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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. Smit, Han T. J., and Lenos Trigeorgis. 2004. Strategic Investment: Real Options and Games. Princeton: Princeton University Press. Wang, X. Henry. 1998. Fee versus royalty licensing in a Cournot duopoly model. Economic Letters 60 (1): 55–62.

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the NPV rule) is now revised to: “undertake a project when its value exceeds the value of the deferral option. . 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. We particularly focus here on models dealing with optimal investment timing. The basic investment principle (i. The continuous-time approach is often preferable for research purposes.III OPTION GAMES: CONTINUOUS-TIME MODELS We focused so far on discrete-time analysis of option games. 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 (geometric Brownian motion). The investment outlays are treated here as a sunk cost. They speciﬁcally deal with whether and when ﬁrms should exercise their shared investment options when strategic interactions among rivals are explicitly considered. highlighting the long-term impact of strategic investment.” Option game models can address the issue of investment timing in oligopolistic markets. In part III we discuss continuoustime modeling of option games. Even if an investment has a positive NPV if undertaken today..e. Conditions for obtaining analytical solutions 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 investment timing issue is thus of critical importance. The discrete-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.

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9 Monopoly: Investment and Expansion Options We argued previously that the ﬁrm’s ability to delay investment invalidates the common “NPV rule” that asserts ﬁrms should “invest when the value of a project exceeds the cost of investment. revising the investment rule as follows: “invest when the project value exceeds the opportunity cost of waiting. It is also more intuitive. one can attempt to capture timing ﬂexibility and provide insights about optimal investment timing. accounting for the embedded ﬂexibility to defer investment? Before embarking on a study of these issues in an oligopolistic setting. We here adopt an approach based on determining investment trigger strategies that is not yet widespread in the real options literature. A reﬁnement of the NPV rule prescribes to select the project with the highest NPV among mutually exclusive projects. . remains unresolved in such a setting. In doing so. The same methodology is amenable (with some adjustment) to situations involving strategic interactions. Viewing a project with differing starting dates as mutually exclusive alternatives. The problem of determining the appropriate discount rate. however. which does not involve strategic interactions. and thus helps highlight common characteristics of optimal investment strategies. demonstrating the basic methodology to solve investment-timing games. Alternative approaches build on complex techniques originating from stochastic calculus and control theory. Our preferred approach levers on basic 1.” This raises the following implementation 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. The real options paradigm explicitly takes into consideration this opportunity cost. Real options analysis addresses this issue properly.”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. This approach provides the same results as more standard techniques but with greater ease. it is useful to ﬁrst dwell on the benchmark model of a monopolist. we also lay down the foundations of continuous-time real options analysis.

. such as lump-sum capacity addition by an electric utility. The latter serves as the foundation of continuous-time real options analysis. the monopolist has a perpetual American call option to wait for new information to come. 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). In effect. 2.1 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. Since the monopolist faces no potential rivals. 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).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). 2012). Our alternative approach has also been used by Dixit. 2. such as when to develop an oil reserve. with no fear of rival entry. In sections 9. 3.2 To smooth out the exposition. it can form its optimal investment strategy in isolation. we ﬁrst discuss the corresponding deterministic problem.278 Chapter 9 principles of microeconomics instead.1 introduces two practical examples involving such options related to investment and expansion. 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. 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. respectively. today or in the future.1 and 9. disregarding strategic interactions. 9. Suppose that there are insurmountable structural entry barriers or the patent has a very long (effectively inﬁnite) life. Box 9. This protection enables the ﬁrm to invest whenever it wants. and Sødal (1999) and Sødal (2006. Pindyck.2. The mathematical prerequisites we develop in the appendix to the book are a cornerstone for option games models applied in later chapters. namely the development of oil reserves and the trade-off between scale and ﬂexibility in capacity addition. we analyze two kinds of options faced by a monopolist ﬁrm: 1.

S. Because oil price uncertainty is not completely diversiﬁable. then. Below are a few examples to illustrate the kinds of insight that the options theory of investment can provide. A company that buys deposits is buying an asset that it can develop immediately or later. Dixit and R. The asset. the oil reserve is more valuable when the price of oil is more volatile.1 Investment and expansion options in business practice The Options Approach to Capital Investment A. K. it may overpay or it may lose some very valuable tracts to rival bidders. and the cost of developing the reserve. the greater the perceived volatility of oil prices. He would then value the reserve by discounting these numbers and adding them together. But that would grossly underestimate the value of the reserve. Depending on the current price of oil. the higher the discount rate. then. It should be not surprising. is an option—an opportunity to choose the future development timetable of the deposit. The sums involved are huge—an individual oil company can easily bid hundreds of millions of dollars. The US government regularly auctions off leases for offshore tracts of land. Consider what would happen if an oil company manager tried to value an undeveloped oil reserve using the standard NPV approach. the higher the discount rate that he would use. A company can speed up production when the price is high. The result would be just the opposite of what a standard NPV calculation would tell us: In contrast to the standard . 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. when to exercise the reserve’s option value. the lower the estimated value of the undeveloped reserve. and oil companies perform valuations as part of their bidding process. It completely ignores the ﬂexibility that the company has regarding when to develop the reserve—that is. And note that just as options are more valuable when there is more uncertainty about future contingencies. he might construct a scenario for the timing of development and hence the timing (and size) of the future cash ﬂows from production. that unless a company understands how to value an underdeveloped oil reserve as an option. opportunities to apply option theory to investments are numerous. and it can slow it down or suspend it altogether when the price is low. 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. depending on market conditions. Pindyck. Harvard Business Review As companies in a broad range of industries are learning.Monopoly: Investment and Expansion Options 279 Box 9. the expected rate of change of the price.

utilities face considerable uncertainty about how fast demand will grow and what the fuel to generate the electricity will cost. companies might be able to reduce their average unit cost while increasing proﬁtability. which says that greater uncertainty over oil prices should lead to less investment in undeveloped oil reserves. 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. Developing the reserve is like exercising a call option. By treating an undeveloped oil reserve as an option. Economies of scale can be an important source of cost savings for companies. we can value it correctly. each of which provides . whose expansion plans must balance the advantages of building large-scale plants with the advantages of investing slowly and maintaining ﬂexibility. the longer an oil company should hold undeveloped reserves and keep alive its option to develop them. it is particularly important for electric utilities. 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. The greater the uncertainty over oil prices. But at the same time. it will ﬁnd itself burdened with capital it doesn’t need. 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. For example.1 (continued) calculation. When the growth of demand is uncertain. and we can also determine when is the best time to invest in the development of the reserve. 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. or should it retain ﬂexibility by investing slowly and keeping its options for growth open? Although many businesses confront the problem. option theory tells us it should lead to more. as it often is? If the company makes an irreversible investment in a large addition to capacity and then demand grows slowly or even shrinks. Should a company commit itself to a large amount of production capacity. As a result knowing how to value the ﬂexibility becomes very important. but it is also more costly. Scale versus Flexibility in Utility Planning The option view of investment can also help companies value ﬂexibility in their capacity expansion plans. But what should managers do when demand growth is uncertain. The options approach is well suited to the purpose.280 Chapter 9 Box 9. and the exercise price is the cost of development. By building one large plant instead of two or three smaller ones. Adding capacity in small amounts gives the utility ﬂexibility.

Suppose that the monopolist has a perpetual option to invest in a new market by incurring a necessary investment outlay I . By valuing the options using option-pricing techniques. Source: Reprinted with permission of Harvard Business Review from “The Options Approach to Capital Investment. all rights reserved.1 (continued) for about a year’s worth of demand growth as needed.1 Deterministic Case We consider ﬁrst the deterministic case to help give intuition and guidance into how to solve investment-timing problems.g. at some future date. that does not mean that it is the more economical alternative. fall relative to coal prices). the company has used optionpricing techniques to show that an investment in the repowering of a hydroelectric plant should be delayed. In so doing. Utilities are ﬁnding that the value of ﬂexibility can be large and that standard NPV methods that ignore ﬂexibility can be extremely misleading. even though the conventional NPV calculation for the project is positive. The reason is that if it were to invest in the coal-ﬁred plant. The New England Electric System (NEES).” by A.. 9. the utility can assess the importance of the ﬂexibility that small oil-ﬁred generators would provide. K. has been especially innovative in applying the approach to investment planning. A number of utilities have begun to use option-pricing techniques for long-term capacity planning. The opportunity to defer investment even in the deterministic case dramatically alters traditional investment principles (e. Overlooking the basics of investment timing may lead to suboptimal choices. Pindyck. paving the way for development of the case involving uncertainty. S. the NPV rule). Copyright © 1995 by the Harvard Business Review School Publishing Corporation. the utility would commit itself to a large amount of capacity and to a particular fuel.1. Even if a straightforward NPV calculation favors the large coal-ﬁred plant. 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. 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.Monopoly: Investment and Expansion Options 281 Box 9. Among other things. for example. May–June 1995. The utility faces uncertainty over demand growth and over the relative prices of coal and oil in the future. 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 . Dixit and R.

For a given timing strategy (i. In the deterministic case with no volatility. From equation (9.. By inverting (9. The discount factor.3). These two strategy formulations are equivalent: the investor looks for the optimal timing decision or for the optimal target level at which to invest. resulting in a negative NPV..4). an alternative expression for the discount factor is4 ⎛V ⎞ B0 (T ) = B (V0 .282 Chapter 9 cost I . the ﬁrm may select directly a critical threshold value VT and invest when this value is ﬁrst reached (at time T ).4) where b ≡ r / g . VT ) = ⎜ 0 ⎟ . project value is sure to increase at a rate of g percent each year (i.2) where δ ≡ r − g ( > 0 ) is analogous to a dividend yield or opportunity cost of waiting.e.e. (9. the actual growth exactly matches the expected one). ⎝ VT ⎠ b (9. the value of the project at time T is VT = πT = V0 e gT . we obtain gT = ln (VT V0 ) so that B0 (T ) = exp [ − ln (VT V0 ) b]. we can express T as a function of the initial value V0 and the time-T value VT.1). In the deterministic case the ﬁrm’s strategy consists in selecting a prespeciﬁed investment time T at which to invest. If the project is initiated at a future (nonrandom) time T and proﬁts are received from that moment on. δ (9. Alternatively. . In this case the monopolist has an incentive to defer the investment and wait until the project becomes sufﬁciently proﬁtable before investing. From (9. The result follows. the time-0 value of the investment option equals 4. The discount factor—that translates future time-t values in today’s (time t0 = 0) terms—is B0( t ) = e− rt . to invest at time T ). obtained as a discounted perpetual stream of proﬁts. δ (9.1) The underlying proﬁt starts at π 0 and by time t ( > t0 ) it grows with certainty to π t = π 0 e gt. The time-0 gross value of the project. is V0 = ∫ (π 0 e gt ) e − rt dt = 0 ∞ π0 .3) Note that both the proﬁt and the project value grow at the rate g . Suppose that the discount rate is r ( > g ). can be thought of as a discount factor over states (V0 and VT).3). as expressed in (9.

the investment rule in equation (9. Denote by M0 (T ) or M0 (VT ) the time-0 value of the monopolist’s investment option.Monopoly: Investment and Expansion Options 283 the pre-speciﬁed forward value (net of the investment cost) VT − I . This form of the investment rule reads 5. The ﬁrst-order condition (MV (VT ) = 0) leads to the following sufﬁcient and necessary condition for the optimal (tree-size) threshold V*: V* = Π*.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 ). the discount factor B (V0 .6) can be rewritten to provide guidance into the return on investment that should be attained at the time of optimal investment. (V0 .1) or (9. This version of the optimal-timing problem is known as Wicksell model in the theory of natural (e. The optimal timing strategy is found based on standard optimization techniques.g. forest) resources. From equation (9.5 Alternatively.. It is then given by M0 (T ) ≡ M0 (VT ) = B0 (T ) × (VT − I ). NPVT ≡ VT − I . ∂B B(V0 .5) is concave in T (or equivalently in VT). I where Π* ≡ b r = ( ≥ 1) b−1 δ (9. where VT represents the forward (time-T ) value of the forest. . As VT − I is clearly increasing in the threshold. VT ) is a decreasing function of the target threshold VT.4). whether the trees should be cut).6) is the proﬁtability level that indicates whether the project should be undertaken (e. Note that b ≡ r / g can be seen as the (constant) elasticity of the discount factor with respect to the trigger value VT. and a lower present value due to discounting.4). VT ) . g the growth rate of the trees. the investor faces a trade-off between obtaining a higher forward net present value.. (9.4). The value function in equation (9. From expression (9.g.7) (9. VT ) = −b ∂VT VT The elasticity expression obtains readily. discounted back to time 0 using the discount factor in equation (9. I the cost of cutting them and r the opportunity cost that captures the patience of the landowner.

If there is growth. . The optimal investment rule suggests to invest whenever the proﬁtability index (i. It is 1 only when the project value remains unchanged over time (as the limit of Π* for g → 0).2 Stochastic Case The basic approach used previously can be extended and adapted to take account of market uncertainty. 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 ratio of the project value over the investment cost) V I exceeds the speciﬁed proﬁtability target Π* given in equation (9. suggesting to invest now if NPV ≥ 0.e. prescribing then to invest when the project value equals or exceeds the investment cost. is strictly correct in the case wherein the asset is not subject to growth. When an investor has no timing ﬂexibility (i. Even in the absence of uncertainty.e. The stochastic process X t here describes a shock affecting ﬁrms’ proﬁts.8) where π * satisﬁes V* = π * δ . it potentially leads to suboptimal investment timing and early investment. As the standard NPV paradigm does not explicitly take into consideration optimal timing or investment ﬂexibility value. the investment rule based on equation (9. it obtains that the target proﬁtability measure Π* strictly exceeds 1 (provided that r > g > 0 or δ > 0). the NPV rule will then hold. The ﬁrst investment rule is analogous to Tobin’s q theory of investment. which consists of the following steps: 1. Specify the value of the investment as a function of the target strategy chosen. 2. however.284 Chapter 9 π* = r. The second relates to the Jorgensonian rule of investment... 9. when an investor is faced with an opportunity to delay investment in an asset that grows ( g > 0).1. The static NPV rule. Our approach for the stochastic investment case is based on our proposed new methodology for valuing the option to invest. I (9.6). Determine the optimal investment strategy (trigger) given the investment payoff function (derived in the previous step).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 . From b ≡ r g . she should require project value to strictly exceed the investment cost (Π* > 1) to account for the opportunity cost to kill her growth option. is required to invest immediately).

By contrast. there is path-dependency for the industry structure. X t could be located in ( −∞. 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.Monopoly: Investment and Expansion Options 285 3.e. { } . For multiple option holders the optimal investment strategy is part of an industry equilibrium. Reassess the investment payoff given the derived optimal investment strategy. XT ) and investing when X t is found for the ﬁrst time in [ XT . The strategy consists in waiting for X t located in the region ( −∞. The ﬁrst-hitting time T is determined by the chosen investment trigger and depends on the process value dynamics with (T being a random variable). In case of a perpetual American investment option. whereby the volatility of the underlying investment is explicitly taken into account. Mariotti. the investment time cannot be selected ex ante. Since actual proﬁts evolve stochastically. T. and Villeneuve (2006) discuss such situations.7 An important metric is the ﬁrst time. the threshold XT is reached T ≡ inf t ≥ 0⏐ X t ≥ XT . These alternative deﬁnitions of the investment strategy could be readily extended in case of multiple option holders. In paradigms where the investment decisions are made based on expected proﬁt ﬂows. Investment Strategy An investment strategy is a contingent plan of action that stipulates what investment action to take for each contingency (i. for example. 128–38). pp. by deferring their decision if the market is less attractive than initially expected. Equivalently one could think of partitioning the state space. Given the growth of the market. The existence and uniqueness of the investment trigger is established in Dixit and Pindyck (1994. Before we do this. Días (2004) and Décamps. The real options approach makes sense because managers are rarely committed to an investment time schedule and can frequently revise it. The current value of the process does not perfectly reﬂect whether the ﬁrm is operating.g... 8.8 In terms of investment strategy formulation (in the uncertain 6.6 The strategy space is continuous: the option holder may adopt a continuum of different strategies (any value for XT ). XT ). When a decision maker has to choose among a number of alternatives. Since investment is irreversible. capacity expansion) is deterministic. real options theory considers stochastic investment timing. investment timing (e. ∞ ) . one can easily determine when the (expected) market size will be sufﬁciently large for the ﬁrm to invest proﬁtably. 7. the optimal investment strategy does not always take the form of a trigger strategy since the optimal investment region may be dichotomous. in each possible future state of the process). only one investment strategy is optimal and should be followed by a rational option holder. but the ﬁrm may be active if XT was previously exceeded. However. we need to deﬁne more precisely what is an investment strategy. 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).

The models by Reinganum (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. the expectation relates only to the discount factor term whose value is driven by the random timing parameter T . NPVT ≡ VT − I ). The option payoff at time T is the forward NPV (i.9 In a stochastic framework. for XT ≥ X 0.286 Chapter 9 case). In the certain case discussed above and in Reinganum’s (1981a. We prefer a more intuitive deﬁnition of the strategy in terms of triggers as in the present case involving a simple partition of the state space. More advanced mathematical treatments of this problem generally optimize over the space of ﬁrst-hitting (stopping) times (Snell envelope problem). This latter formulation consists in using an exogenous risk-adjusted discount rate k rather than the risk-free rate r. 11. even if the assumptions of risk-neutral valuation do not hold.. receiving the forward project value VT (as a function of XT ) and incurring the investment cost outlay I at time T . NPVT. b) and Fudenberg and Tirole’s (1985) game-theoretic investment timing models. is independent of the path of the stochastic process X t and is solely conditional on the target level XT . in the monopolist investor’s value expression above. however. 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 .11 If the investment strategy chosen by the monopolist is to invest now (at time t0 and state X 0). Thus investing now may not be the optimal decision. however. 10. This valuation approach applies for complete markets with no arbitrage opportunities. would kill the opportunity to delay the investment. the investment time T deﬁnes the investment strategy. These models are. Therefore.10 The monopolist will invest when the underlying stochastic (Itô) process X t ﬁrst reaches XT . the expected present value of the investment opportunity (considering the deferral option) equals the forward NPV (NPVT) discounted back at the present time (t = 0). Investing now. In part III we generally follow the risk-neutral valuation perspective presented in chapter 5. 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 time to invest cannot be determined ex ante. deterministic. For XT ≥ X 0. the value of the investment opportunity is simply the (static) NPV of the project. the forward net present value. Immediate investment therefore entails an opportunity cost. . ⎣ ⎦ ˆ where E [⋅] denotes the expected value under the risk-neutral probability measure. we also present an alternative exposition that would apply generally. 9. NPV0 = V0 − I.e. In the appendix at the end of the book. namely ˆ M0 ( XT ) = E ⎡ NPVT × e− rT ⎤ . Thus. The use of the random variable T to deﬁne the investment strategy is therefore nontrivial. it is convenient to use XT as the reference point for strategy deﬁnition rather than T .

1. ⎣ ⎦ where the expected discount factor is Alternatively. As shown in equation (A. analogous to the certainty case. we use two distinct fundamental quadratic functions.12 Under risk-neutral valuation. g gets ˆ replaced by g = r − δ . More information on the geometric Brownian motion is provided in the appendix. instead of β1 as in the appendix. the expected discount factor in case of geometric Brownian motion is 1 ⎛X ⎞ B0 (T ) = ⎜ 0 ⎟ . In the appendix at the end of the book.9) ˆ B0 (T ) ≡ E ⎡e− rT ⎤.43) in the appendix at the end of the book. one with an exogenous given discount rate and the other under risk-neutral ˆ valuation. For notational simplicity we denote here (in the main text) the positive ˆ root of the fundamental quadratic in the risk-neutral case by β1 .11) where (in the risk-neutral case) from equation (A2. ∞ )). 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 ⎪ M 0 ( XT ) = ⎨ if ⎪ ⎩ NPV0 X 0 < XT . 13.13 The time-0 value for the monopolist investor that invests when XT is ﬁrst reached is thus obtained from equations (9. In part III we generally employ the risk-neutral valuation approach. ⎣ ⎦ 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. (9. NPV0 = V0 − I. XT ).10) where g and σ are the constant drift and volatility parameters and zt is a standard Brownian motion. ⎝ XT ⎠ β (9. 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. using β1 and β1 respectively. section A.9) and (9. B0 (T ) can be understood as an expected discount factor over states X 0 and XT .11) as 12.12) ˆ ˆ with α = g − (σ 2 2).4) β1 = − ˆ ˆ 2 α r ⎛α⎞ + ⎜ 2⎟ +2 2 ⎝σ ⎠ σ2 σ ( > 1) (9. . It can be formulated as B0 (T ) = B0 ( XT ) = B( X 0 .Monopoly: Investment and Expansion Options 287 ˆ M ( XT ) = NPVT × E ⎡e − rT ⎤ = NPVT × B0 (T ).

XT (9. We have not yet determined the optimal strategy to be followed by the monopolist.13) conﬁrms the option value for a monopolist obtained by McDonald and Siegel (1986). What matters for the investor is to determine ex ante the optimal contingent investment rule. McDonald and Siegel (1986) embed the optimal timing behavior in their value function. (9. Let us denote by X* the optimal investment target (trigger) and by T* the random time when X* is ﬁrst reached. In McDonald and Siegel’s (1986) model. . 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 ). In this (monopoly) case the value-maximizing investment strategy can be deduced from standard optimization techniques. They also consider a case where both the underlying project value and the investment cost follow correlated geometric Brownian motions. the stochastic process X t corresponds to the project value. It simply helps management assess the value of an arbitrarily chosen investment strategy. The investor may potentially choose XT among a continuous set (with inﬁnite possibilities). that is. namely the overall value obtained given the optimal investment timing decision.13) of the previous section has no prescriptive implications from a strategic-management viewpoint. but it does not prescribe which strategy is the optimal to pursue. The “expanded NPV” is the value of the investment option when the monopolist invests at the optimal time. The optimal trigger X* is such that it maximizes the given investment option value expression.13) For an investment target or trigger higher than the starting value ( X 0 < XT). 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. We start with the general case of an Itô process.14 Optimal Investment Strategy The investment value presented in equation (9. the value of the strategy equals the forward NPV at future date T discounted back to the present time (time 0) using the expected discount factor of equation (9.11).14) 14. so that NPVT = XT − I . it is such that M0 ( X*) ≥ M0 ( XT ) for all XT.288 Chapter 9 β1 ⎧ ⎛X ⎞ NPVT ⎜ 0 ⎟ ⎪ ⎝ XT ⎠ M 0 ( XT ) = ⎨ ⎪ NPV ⎩ 0 (wait) (invest) if if X0 < XT . This will be discussed next. namely when exactly the monopolist should invest. where M0 ( XT ) is in general given by equation (9.13).13) for GBM. It does not necessarily provide guidelines whether or when the monopolist ﬁrm should invest (optimal behavior). X0 ≥ XT . Compared to formula (9.9) or by (9. The result given in equation (9.

an analytical solution to the expression above exists if the dividend yield δ is (strictly) positive. The premium mirrors the difference between the value of the project at the time of investment and the exercise price of the option ( I ). the optimal solution for the perpetual American investment option is to delay investment indeﬁnitely (i. Although there are exceptions (e.e. Dixit. X 0 ≥ X *. A higher price set for the product.13′) If this condition does not hold (δ ≤ 0). 16. It is of the form β1 ⎧ * ⎛ X0 ⎞ ⎪ NPVT ⎜ ⎟ M0 ( X *) = ⎨ ⎝ X *⎠ ⎪ NPV ⎩ 0 (wait) (invest) if if X 0 < X *.g.. but the result is equivalent for a pre-speciﬁed constant exercise price. The parameter δ may represent some form of a payout rate or opportunity cost (below-equilibrium return).Monopoly: Investment and Expansion Options 289 In the case of geometric Brownian motion. Pindyck. We saw then that if the monopolist sets a higher price p. although intended to achieve a higher proﬁt margin.16 Then again. The option premium is analogous to the forward net present value deﬁned earlier. may actually backﬁre because it may deter potential customers from purchasing it.. and Sødal (1999) explain this trade-off in terms of an option premium. to avoid adverse developments. 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). the monopolist may delay deciding to invest when a higher forward net present value (NPVT ≡ VT − I ) is achieved.1. 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. Merton (1973) shows that the dividend yield δ must be (strictly) positive for a ﬁnitely lived American option to be exercised before maturity. in most situations 15. Here we deal with perpetual American options. This situation is illustrated in ﬁgure 9. when demand increases with price as in the case of luxury products). never exercise the option). 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 investment trigger. First. namely by selecting a higher value for the target (trigger) XT . namely when the price decreases with industry output (∂p ∂q < 0).15 As in the certainty case the monopolist’s optimization problem here also presents the option-holding investor with a trade-off. 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. (9. .

290 Chapter 9 Discount factor B0(T ) ~ Forward NPV 1. The right-hand term is the discounted marginal investment cost savings from delaying investment.0 0.6 0. they become equal. The ﬁrst-order condition gives BX ( X*) × V* + B0( X*) × VX ( X*) = BX ( X*) × I. Volatility is σ = 20 g percent.2 0. The drift or growth parameter is ˆ = 6 percent. the resulting revenues may be higher as the quantity sold in the marketplace is higher. The investment outlay is I = 2. The optimal threshold X* is the target level XT that maximizes the monopolist’s value M ( XT ).2 1.4 0.1 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.2) (0. namely by the price elasticity of demand. VX = ∂V ∂XT . where BX = ∂B ∂XT . monopolists face this classic trade-off in setting prices. This trade-off is governed by the rate at which demand declines as price is raised.4) 2 3 4 Investment trigger XT 5 6 7 Discount factor ~ Forward NPV NPVT ≡ VT − I 6 4 B0(T ) 2 0 –2 Figure 9. A similar approach is used here to deduce the optimal investment trigger chosen by the monopolist option holder. The left-hand term is the discounted extra or marginal total reduction in gross project value V from raising the investment trigger XT by a small (inﬁnitesimal) amount dXT . The discount rate is r = 7 percent. The starting value for the process is X 0 = 1. X*.8 0. The expression above thereby leads to the following markup condition in equilibrium: . and V* ≡ V ( X *) is the optimal project value. a monopolist may lure more customers into buying by setting lower prices. To capture a larger market. even though the proﬁt margin per unit is lower.0 1 (0. At the optimum level.

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. that pricing problem is solved based on the Lerner index L≡ p* − c 1 = . V* ε B ( X*) (9. the stochastic factor is Vt) and the investment trigger is a given target project value VT.15) where ε B(⋅) and ε V (⋅) denote.e. and Sødal (1999). In this case the optimal markup rule of equation (9.16) XT ε V ( XT ) ≡ −VX ( XT ) × . Pindyck. 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. and Sødal (1999). As noted.15) reduces to Λ≡ V* − I 1 = . VT ( XT ) The optimal investment trigger X* and the corresponding optimal discount factor B0 (T*) are found at the point where the markup is given as in equation (9. B0 ( XT ) (9. the elasticity of the discount factor and the elasticity of the forward net present value.. V* ε B (V*) (9. At the time of optimal investment.15). respectively. In our more general setting the elasticity of the forward (terminal) value with respect to the selected investment trigger also intercedes.15). it is easy to see the analogy with the optimal price-setting problem of a monopolist. Pindyck. In case the underlying process is the gross project value (i. given by ε B ( XT ) ≡ − BX ( XT ) × XT . the project return Λ ≡ (V* − I ) / V* must be equal or exceed the speciﬁed level given in the right-hand side of equation (9. In the setting of Dixit. the elasticity of the forward NPV is constant and equal to εV (VT ) = −1. p* εp . 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 )).17) This conﬁrms a main result given in Dixit.Monopoly: Investment and Expansion Options 291 Λ≡ V* − I ε ( X*) =− V .

9). This conﬁrms once again that the static NPV rule.15) and setting19 Π ( XT ) ≡ ε B ( XT ) . . 18. advising to invest when the project’s gross present value equals the investment cost. the markup Λ in equation (9. From equations (9. Pindyck. I (9.292 Chapter 9 where p* is the equilibrium market-clearing price. Rewriting equation (9. This premium results from considering both the ﬂexibility in delaying the investment and the underlying uncertainty.15) is strictly positive. See also Dixit. Since XT and VT are either both negative or positive and VX (⋅) > 0. However.18) the premium (cushion) can be determined based on V* = Π*. ε B ( XT ) + ε V ( XT ) (9. Λ ≠ 1 and ε V ( X*) ≠ ε B( X*). the ‘expanded NPV’ given the optimal investment strategy is M0 ( X*) = [ Π* −1] IB0 (T*). Since I > 0 . due to the Markov property of the underlying stochastic (diffusion) process.19) where Π* ≡ Π ( X*) is obtained from equation (9. 0 ). 19. Consequently the value received from pursuing the optimal strategy V* strictly exceeds the cost required to undertake the project. In our general setting. The elasticity of the forward value is negative and is also independent of the starting value.18) with XT = X*. it may not always be constant. ε V ∈[ −1. is not strictly correct. the elasticity of the discount factor is independent of the starting value X 0. The gross proﬁtability index is sometimes interpreted as Tobin’s q or as the market-to-book ratio attained at the 17. c the constant marginal cost of production. the elasticity of the forward value is strictly negative. A certain positive premium must be attained before the investment is undertaken (in optimum).17 The elasticity of the discount factor is strictly positive (as BX (⋅) < 0). that is. requiring that the project’s NPV at the time of optimal investment be strictly positive.19) and (9.18 From the sign of these elasticities. and ε p the price elasticity of demand (ε p ≡ − ∂p ∂q × q p).20) The metric Π* is the equilibrium gross proﬁtability index and Π* − 1 is the excess proﬁtability index. (9. and Sødal (1999). The ﬁniteness of Π ( XT ) at the optimal threshold X* is thus ensured.

equation (9. on the contrary. namely the current value of the beneﬁts the asset provides. Both must hold at the point of optimal investment. ⎝ VT ⎠ where β1 is given in equation (9.11) as ⎛V ⎞ B0 (VT ) = ⎜ 0 ⎟ . what matters is its value Π* at the optimal investment trigger X*. In traditional accounting. B0 (T ). (9. M( X*) = V* − I . Although the proﬁtability index may change. The market-to-book ratio determines the excess return of the project over the necessary investment outlay. εV = −1. or the elasticity of the investment option.18) is constant: 20. The market value. Since the project value is itself the underlying stochastic factor.12). Here the underlying project is generally assumed to follow an Itô process. and the two conditions above. 21.15).20 Dixit and Pindyck (1994) propose to interpret Π* = V* I as Tobin’s q. Since the elasticities may not be constant.Monopoly: Investment and Expansion Options 293 time of optimal investment. interchangeably.10) with constant drift g (under risk neutrality g = r − δ ) and volatility σ . The geometric Brownian 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 timehomogeneous Itô processes. From optimal-stopping theory the investment trigger is determined by two “boundary conditions”: the value-matching condition. The option markup formula in equation (9. The expected discount factor is given analogous to equation (9. Dixit and Pindyck (1994) investigate this proﬁtability index in the case of geometric Brownian motion. the balance sheet is used to record assets as the sum of the costs incurred to procure them. M X ( X*) = VX ( X*).21) The parameter β1 refers.21 Example 9. to the elasticity of the discount factor. The proﬁtability index Π* of equation (9. one obtains ε B( X*) = ε M ( X*). the ratio between the real value of an asset to the cost needed to produce it.1 Geometric Brownian Motion Suppose that project value Vt follows a geometric Brownian motion ˆ similar to (9. From the markup formula in (9. reﬂects the real value of the asset. Section A. . and the smooth-pasting condition.15) becomes Λ = 1 β1. The ﬁrst-order derivative of the discount factor with respect to the investment trigger XT is BV (VT ) = −β1 B0(VT ) . The elasticity of the option is ε M ( XT ) ≡ − M X ( XT ) × XT M( XT ).4 in the appendix summarizes brieﬂy the relevant optimal-stopping theory.16). the proﬁtability index Π ( XT ) may vary with the target investment trigger XT . VT β1 Hence the elasticity of the discount factor is constant and equal to ε B = β1 ( > 1).

it may be possible (if a solution exists) to derive a closed-form solution (e.7) in the certainty case discussed earlier.25 Utilizing the standard rule (under certainty) for investment problems involving uncertainty. which admits only one root. box A. The standard contingent-claims analysis or dynamic programming approaches (presented in Dixit and Pindyck 1994) consist in solving partial differential equations under appropriately speciﬁed boundary conditions. As σ = 0.23) The investment rule derived in the deterministic case is a special case of this investment rule under uncertainty. I β1 − 1 (9. β1 − 1 (9.24 If σ = 0. 23.7) given by Π* = r δ . McKean (1965) ﬁrst derived this closed-form formula for perpetual American call options. b = r g.2. with the proﬁtability index in (9. Given these conditions. in case of GBM). This version of the proﬁtability index given in (9. 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. In the deterministic growth case.294 Chapter 9 Π* ≡ β1 . The difference lies in the fact that under deterministic growth. Karlin and Taylor (1975. relying on an analogy with basic markup trade-off problems common in other ﬁelds of economics.g. leading to 22.22) The expression above is similar to equation (9.. β1 = b = r g . This methodology requires the use of involved mathematics (stochastic calculus and optimal control). Our preferred approach is simpler and more intuitive. .22 Their demonstration is based on the standard contingent-claims analysis approach (see appendix to this chapter). while McDonald and Siegel adopt the risk-neutral pricing approach. 25. See the appendix of the book. pp.6) as V * = Π * I. McDonald and Siegel (1986) and Dixit and Pindyck (1994). which may be quite unintuitive for the nonseasoned reader. 24. however. Our simpliﬁed derivation of optimal investment rules is done by using the expected discount factor in case of GBM. the fundamental quadratic simpliﬁes to r − gβ (see box A. This result is analogous to the one derived under uncertainty in (9. for example. b is a function of r and g solely.2 in the appendix at the end of the book).22) has been used extensively by. g . for more details on the two quadratic equations. would lead to a suboptimal result where the chosen investment trigger is lower than the optimal. rather than directly in each real option valuation. 364–65) and McDonald and Siegel (1986) developed close models.23 The optimal investment rule extended in case of uncertainty for the geometric Brownian motion is V* = Π* I ⇔ V* β1 = Π* ≡ . McKean and later Karlin and Taylor use an expression for the fundamental quadratic involving an exogenously given discount rate. except that here Π* = β1 ( β1 − 1) . the optimal trigger is given by (9. whereas here β1 is the solution ˆ of a quadratic equation involving r. and the additional volatility term σ capturing uncertainty about market developments.23). Stochastic calculus is not absent from our proposed approach either.

The net present value received at that time is S − VT .23). Since β1 > 1 ˆ ˆ ˆ and δ > 0. Let π* be the proﬁt earned at optimal investment. The exit option (full closure) can be priced analogously. if V0 ≤ V* .24) Modiﬁed Jorgensonian Rule of Investment In the case the uncertain proﬁt π t follows a geometric Brownian motion.26 From equations (9. The exit option value is then worth β2 ⎧ ⎛ V0 ⎞ ⎪(S − V*) ⎜ ⎟ M0(V*) = ⎨ ⎝ V* ⎠ ⎪ ⎩S − V0 (wait) (divest) if V0 > V*. where VT is forgone project value. the project value follows the diffusion process Vt ≡ π t δ . ˆ With β1 being a root of r − αβ − (σ 2 β 2 2) (fundamental quadratic).25) The modiﬁed Jorgensonian rule of investment suggests to invest when the project’s return on investment exceeds a certain hurdle compensation for both the interest rate (r) and the incentive (option) to delay investment in an uncertain world (β1σ 2 2). The expected discount factor in case of exit (low barrier) involves the negative root of the (risk-neutral) fundamental quadratic. The markup is thus larger in the uncertainty case. as ∂Θ ∂σ > 0 . by contraposition. (9. Suppose. where Vt and π t are characterized by the same stochastic differential equation (but have different starting values). if V0 ≥ V* .23) can be reformulated as a modiﬁed version of the Jorgensionan rule prescribing to invest when π t is such that πt π* 1 > = Π* δ = r + β1σ 2 I I 2 ( > r ). with Π* as in (9. that θ ≡ r (r − g ) − Π* ≤ 0 . which contradicts the assumption. it obtains that Θ = β1 ( β1 − 1) σ 2 2 > 0 . .Monopoly: Investment and Expansion Options 295 premature investment. such that V* S = Π*. Suppose that a salvage value S is received upon exiting. This modiﬁed rule under uncertainty is more stringent in terms of proﬁtability (hurdle) 26. β2 = − ˆ ˆ 2 α r ⎛α⎞ − ⎜ 2⎟ +2 2 . Θ = r − β1α − (β1σ 2 2) .13) and (9. 2 ⎝σ ⎠ σ σ with ˆ ˆ α = g − σ 2. this implies that Θ ≡ δ (β1 − 1) θ ≤ 0. (9. Since g = α + (σ 2 2) . Moreover. with Π * = β 2 ( β 2 − 1). 2 1 The optimal lower barrier is V*.23) the monopolist’s investment option value under uncertainty is27 β1 ⎧ ⎛ V0 ⎞ ⎪(Π* − 1) I ⎜ ⎟ M0 (V*) = ⎨ ⎝ V* ⎠ ⎪V − I ⎩ 0 (wait) (invest) if V0 < V*. the higher the volatility. 27. Equation (9. the higher is the discrepancy between the optimal investment trigger and the trigger obtained when ignoring the volatility.

the second (volatility) term in equation (9. Investment cost I = 2.8) for the certainty case. In a world of uncertainty. This property may be used by managers to readily identify (some) projects to be deferred. projects that do not meet the requirement using the standard Jorgensonian rule of investment (under certainty) a fortiori do not fulﬁll the requirements under uncertainty either since uncertainty imposes an extra hurdle (the second term).46 5 6 7 Initial value V0 Investment region Figure 9.296 Chapter 9 Value for monopolist 5 4 NPV = V0 − I 3 V* − I 2 Expanded NPV M(V*) 1 0 0 1 2 3 4 I=2 Waiting region V* = 4. requirements than the standard version under certainty. Figure 9. McDonald (2000) examines whether the use of arbitrarily chosen hurdle rates and proﬁtability indexes by management can roughly proxy for optimal investment decision making. investment) regions for the monopolist’s investment option.2 illustrates the value (waiting vs. Building upon such optimal investment rules.25) vanishes and equation (9. . it is optimal to invest 28.25) reduces to the expression given in equation (9. He ﬁnds that (under mild conditions) such hurdle rate and proﬁtability index recommendations can provide close-to-optimal investment rules.46.28 Under certainty (σ = 0). The discount rate is k = 12 percent. For V0 > V* = 4.2 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. waiting longer if the standard Jorgensonian rule is not fulﬁlled.

the proﬁtability index (Π*) in equation (9. A number of variables affect the size of this premium through their impact on the proﬁtability index: As ∂Π* ∂σ > 0. Since for any value of the elasticity of the waiting option (for σ ≠ 0). Example 9. If the project is extremely risky (σ very high). exp ( β1vT ) (9. there is an incentive to defer investment as investing immediately would kill the option to wait.22) is strictly greater than one. which is strictly positive in this region. the option holder is indifferent between keeping the option open or investing immediately (at this point the slopes of the two value functions are equalized). the monopolist will defer the investment indeﬁnitely and never invest (with Π* becoming extremely large). • As ∂Π* ∂δ < 0.26) The elasticity of terminal value is ε V = −1. the lower the investment trigger. • • As ∂Π* ∂r > 0. the monopolist will defer the investment longer.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. δ . (9.27) 29. For V0 ≤ V*.Monopoly: Investment and Expansion Options 297 immediately. At this point the value of the opportunity to invest (E-NPV) just equals the value of the committed investment (NPV = V* − I ).29 The NPV line (=V0−I) is tangent to the option value (E-NPV) function at X*. when the risk-free rate is higher.41) in the appendix. . the higher the dividend yield or opportunity cost of waiting. At V*. asserting that both the value function and its ﬁrst-order derivative are continuous at the optimal trigger threshold X*. The monopolist ends up investing earlier when δ is high. from equation (9.23) the value of the project V* should exceed the necessary investment cost I by a certain positive premium. Monopolists require a larger excess return before irreversibly investing when the market is riskier. the expected discount factor is B0(T ) = exp ( β1v0 ) . the greater the underlying uncertainty (σ ) the higher the markup Π* between the optimal investment trigger and the investment cost. As obtained in equation (A. This property stems from the value-matching and smooth-pasting conditions.

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. The markup for the option to invest in equation (9. If the monopolist exercises 30. The monopolist thus has an option to expand its production capacity. Hence from equation (9. Although this model can accommodate many applications. expansion to a new country.16). The proﬁtability index (at equilibrium) in equation (9. . as Dixit and Pindyck 1994 assume). for instance. Now we look at a slightly modiﬁed investment problem relating to the option to expand. Suppose that the monopolist is already active in the market and holds a certain amount of production capacity. ˆ ˆ it is replaced by α vt with α = r − δ . whereas in the contingent-claims analysis version. Since (as explained in the appendix in the last chapter) this stochastic process is reasonably descriptive of many economic phenomena. dynamic programming is considered the “general” approach as long as one can identify the correct discount rate (which may not be an exogenous constant.15) is Λ ≡ (v* − I ) v* = 1 β1v*. the risk-neutral version). The preceding examples serve to conﬁrm the extent to which the geometric Brownian motion is convenient for the derivation of closed-form solutions. vT ). The ﬁrst-order derivative of the discount factor with respect to the investment trigger is Bv (vT ) = −β1 B (v0 . in the adoption of new technology. the monopolist may invest in added capacity to take advantage of the demand upsurge. it is widely used in economic and ﬁnancial analysis. β1v* −1 Since the proﬁtability index is not constant. or refurbishment of existing assets to improve efﬁciency.298 Chapter 9 where β1 is given in (9. The fundamental quadratic comes from a different ordinary differential equation (ODE) for ABM than for GBM.30 In this case. ε B ( vT ) = −β1vT . 9.12). Here we principally interpret this model in the context of adding capacity. for expositional simplicity we here follow one interpretation. In the dynamic programming version of the ABM. that of capacity expansion. 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.18) becomes Π* = Π ( v *) = β1v* . the derivation of an analytical solution is cumbersome in this case. As noted. the drift is α . If the market becomes more proﬁtable than expected. though it may also apply in other contexts. the elasticity of the discount factor is not constant.

. but it sometimes allows for powerful analytical results from a research viewpoint. 20 percent. whereas models involving investment in additional capacity rely on optimal stopping and/ or impulse control methods (e.g. involves a lumpy capacity expansion investment (ΔQ) generating a proﬁt ﬂow increase by a given discrete amount. referred to as additional capacity models. In this sense the investment opportunity can be thought of as the initial scale project plus an (American) call option on the future expansion opportunity. smooth-pasting condition).Monopoly: Investment and Expansion Options 299 its real expansion option.g. Once again. the problem for the monopolist is to decide when exactly to invest in added capacity.. The second approach involves incremental (very small) capacity expansion additions (dQ)—these models are referred to as incremental capacity investment models. management may have the ﬂexibility to alter it in various ways at different times during its life. As in the case of the deferral option.31 9. supercontact condition). In the ﬁrst stage. 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. Here the marginal effect on ﬁrm proﬁt matters. The ﬁrm does not immediately expand capacity since incurring the sunk investment cost may not be justiﬁed under the present 31. when the monopolist expands its capacity. it earns a higher proﬁt ﬂow than previously (π 1) due to the added capacity. Management may ﬁnd it desirable. In the second stage. In the additional capacity case two stages are usually distinguished. for example. The additional capacity investment should occur at an optimal (random) time T .1 Additional (Lumpy) Capacity Investment Consider ﬁrst the case where the ﬁrm can increase its capacity and proﬁt ﬂow by a lumpy (large) amount. Expansion options may be modeled in two ways. The second (incremental) approach seems less realistic. Once a project is undertaken. We look at the additional capacity case ﬁrst because it is more intuitive and realistic.2. The ﬁrst approach. 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. for example. 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. to build additional capacity if it turns out that its product is more enthusiastically received in the marketplace that initially thought. . Models of incremental capacity investment typically require the use of instantaneous control techniques (e. The exercise price of the expansion option is I. its new (higher) proﬁt ﬂow will reﬂect both the production capacity owned before the new investment as well as the newly added capacity.

30) The ﬁrst right-hand term.32 The expected value for the monopolist (as of time t0 = 0) from investing in additional capacity at random time T equals (for X 0 ≤ XT) ∞ ˆ T M0 ( XT ) = E ⎡ ∫ π 0 e− rt dt + ∫ π 1 e− rt dt − I e− rT ⎤. =− ΔV* ε B ( X*) (9. in the value expression for M ( XT ) in equation (9. (9. X( T ) ⎪ B( T) B0( XT ) ⎪ ⎨ ⎪ε ΔV ( XT ) = − ΔVX ( XT ) × XT . Using standard optimization techniques. ΔV( XT ) ⎪ ⎩ 32. As before.28) ⎢ 0 ⎥ T ⎣ ⎦ Using property (A. The notation for the proﬁt ﬂows is summarized in table 9. Letting ΔVT ≡ VT [π 1 − π 0 ] and ΔV * ≡ ΔVT *. (9.300 Chapter 9 Table 9.31) where the elasticity of the discount factor (ε B) and of the additional terminal value (ε ΔV) are ⎧ε X = − B X × XT . and π 1 > π 0 .1.45) in the appendix at the end of the book. the monopolist maximizes its value by selecting the optimal investment trigger X*. V0 [π 0 ].1 Firm’s proﬁts in the two stages (regions) surrounding capacity expansion Industry structure Before capacity investment After capacity expansion t 0 ≤ t ≤T t ≥T Stochastic proﬁt Certain proﬁt π0 π1 π0 π1 economic conditions. . 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 ]. 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. the ﬁrst-order condition becomes Λ′ ≡ ΔV* − I ε ΔV ( X*) . Note that π 1 ( X t ) > π 0 ( X t ) for all X t .29) where Vt [π ] is the forward perpetuity value of receiving proﬁt π from time t on.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).

In the previous section on the option to invest (defer). and (9.31) can be reformulated as ΔV* = Π*. σ ( X t ) is the diffusion and zt is a standard Brownian motion.16). Let us deﬁne it generally as π (π 0 before capacity addition and π 1 afterward). which depends on demand. 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. Several models to derive the certain proﬁt in oligopolistic markets have been investigated previously (see chapter 3).33 A multiplicative stochastic shock. I (9. where project value follows a geometric Brownian motion with no decomposition of uncertain proﬁts into two components.19).34 This modeling assumption is slightly different from what we used in the discrete-time part. Equation (9.15). This notion of deterministic reduced-form proﬁts can be readily extended to competitive settings. . This component results from optimal behavior at each stage by the monopolist. 34. costs. In the following chapters this decomposition of the stochastic proﬁt ﬂow into two components will be used extensively. Previously uncertainty was introduced in the 33. (9. These expressions are analogous to the results obtained for the investment option in equations (9. with ΔV replacing V . 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. 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). and price. This shock multiplies the certain proﬁt component π capturing exogenous uncertainty about the market development. dX t = g ( X t ) dt + σ ( X t ) dzt. which follows an (time-homogeneous) Itô process of the form • where g ( X t ) is the drift. p.32) where Π* ≡ Π ( X*) and Π ( XT ) ≡ ε B ( XT ) [ε B ( XT ) + ε ΔV ( XT )] as per equation (9.18).142) and Trigeorgis (1996. we assumed a setting close to McDonald and Siegel’s (1986) model as summarized by Dixit and Pindyck (1994.Monopoly: Investment and Expansion Options 301 with BX (⋅) = ∂B ∂XT and ΔVX (⋅) = ∂ΔV / ∂XT. Let us be more speciﬁc concerning the uncertainty in the market. p. It is a reduced-form expression of the monopolist’s proﬁt. X t . 204).

the elasticity of the discount factor B0 (T ) is β1. ⎢ δ δ ⎣ ⎦ (9.34) Here X* is such that ΔVX* = Π*. X t .1). the exchange rate between a foreign currency and the domestic currency. so M ( XT ) = π0 (π − π 0 ) ⎤ X 0 + B0 (T ) ⎡ 1 XT − I ⎥.32) and (9. . for example. Suppose that investment in added capacity enhances production made in the domestic country but that products are sold in a foreign country. 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 ) ⎜ M( X*) = ⎨ ⎝ X* ⎟ ⎠ ⎪ ⎩V1 X 0 − I if if X 0 < X *. There is no reason to believe that the (idiosyncratic) underlying factor evolves differently before versus after the capacity expansion investment. p ( X t .33) If X t follows the geometric Brownian motion. 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.36) 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. is assumed the same for both stochastic proﬁt ﬂows. Q) = aX t − bQ. (9.302 Chapter 9 linear inverse demand function of equation (7. I with Π* ≡ (9. Here the demand level is deterministic as captured by the reduced-form certain proﬁts. Foreign currency must be repatriated to the parent ﬁrm at the prevailing currency exchange rate X t .16) is ε ΔV ( XT ) = −1. while proﬁts are affected by a stochastic multiplicative shock. The multiplicative shock may represent. via the demand intercept X t hypothesized to follow a speciﬁed stochastic process. This represented an additive shock affecting ﬁrms’ proﬁts. The underlying (exchange-rate) stochastic process. From equations (9.35) β1 . β1 − 1 (9. V1 ≡ π 1 δ . With V0 ≡ π 0 δ . and ΔV ≡ V1 − V0 = (π 1 − π 0 ) δ deﬁned.33). X 0 ≥ X*. the elasticity of the terminal value obtained from equation (9.

Let vT (Q) ≡ VT [π Q × dQ]. 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: { } ˆ M0 ( XT . which is a function of the capacity already installed.37) Since the incremental net present value from the project. 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. Q) ∂Q). Q.2. ⎣ ⎦ ⎣ ⎦ ∞ (9. That is. namely for a ﬁrm having the option to invest (defer) treated previously.Monopoly: Investment and Expansion Options 303 active. Q) e− rt dt + (vT (Q) − I ) e− rT ⎤ ⎣ 0 ⎦ ˆ = V0 ⎡π ( X t . does not depend on the actual path of the stochastic process. M0 ( XT . π ( X t . At the beginning. Q) ≥ M0 ( XT . For an additional capacity dQ. namely to increase its production capacity by a very small amount.2 Incremental Capacity Investment Consider now a slightly modiﬁed situation where a monopolist already active in the market contemplates investing in incremental capacity. 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 . If the ﬁrm exercises this real expansion option. Again. Q). The ﬁrm has an option to invest in incremental capacity should the project be more proﬁtable than expected. ∀XT . Q) = E ⎡ ∫ π ( X t . the monopolist ﬁrm already owns production capacity and earns a stochastic proﬁt ﬂow. BX ( X*) × vT (Q) + B0 ( X*) × vX (Q) = BX ( X*) × I . the present model reduces to the previous one. Q)⎤ + (vT (Q) − I ) B0 (T ) . 9. Q) = V0 ⎡π ( X t . 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). in addition to the proﬁt ﬂow stemming from the existing production capacity. Q) The ﬁrst-order condition. vT (Q) − I . it installs dQ of incremental capacity at an incremental cost i per unit of new capacity. ⎣ ⎦ The optimal investment trigger X* is such that M0 ( X *. If π 0 (⋅) = 0. . Q)⎤ + E ⎡{vT (Q) − I } e− rT ⎤ .

X t . The deterministic proﬁt function as a function of capacity is standard in industrial organization. we oftentimes equate capacities with quantities (assuming constant returns-to-scale production technologies). Q) dQ = (π Q × dQ) X t. where π Q ≡ ∂π (Q) ∂Q. For the sake of simplicity. If the ﬁrm invests in incremental capacity. Q) = π (Q) X t . Given the above. the optimal investment rule is v *(Q) = Π* I .38) ε B ( X*) . X( T ) ⎪ B( T ) B0( XT ) ⎪ ⎨ ⎪ε v ( XT ) = −vX (Q) × XT . the monopolist can optimally determine the production capacity needed.18). namely π (Q). vT (Q) ⎪ ⎩ Alternatively. that follows geometric Brownian motion. where. analogous to (9. The (stochastic) proﬁt resulting from the project at time t is thus given by π ( X t . the extra proﬁt ﬂow for the monopolist is given by π Q × dQ.38′) (9. while the marginal proﬁt ﬂow resulting from an incremental investment in capacity is ∂π ( X t . the terminal value is 36. . v* (Q) ε B ( X*) where ⎧ε X = − B X × XT . This value results from market-clearing mechanisms.304 Chapter 9 results in the option markup formula v* (Q) − I ε ( X*) =− v . 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). Π* = (9. Given these parameters. ∂Q Consider next the terminal value (forward NPV) and its elasticity.36 • • A multiplicative shock.

with r being the interest rate). It is shown that the higher the level of initial capacity.41) Figure 9. Alternatively. where ε p is the constant price elasticity of demand. 1989). For this special case the monopolist’s investment trigger (as a function of the capacity in place) is ⎛ ε p ⎞ 1 εp 1 X* (Q) = ⎛ r + β1σ 2 ⎞ ⎜ Q I.40) Suppose. π Q × dQ is the contribution of the incremental capacity investment to the deterministic proﬁt ﬂow for the monopolist and v (Q) is the expected present value of this incremental proﬁt ﬂow contribution. v* (Q) = X* v(Q). the optimal investment trigger for the monopolist is given by37 v (Q) X* (Q) = Π* or I π Q(Q) X*(Q) 1 = r + β1σ 2. for simplicity. This result is also found in Pindyck (1988). vT (Q) = XT v (Q). Assume. and Dixit and Pindyck (1994. for example. 2 I (9. that the monopolist faces a constant-elasticity demand function of the form p (Q) = Q−1 ε p . implying that large ﬁrms are less sensitive to positive demand shocks than smaller ﬁrms in emerging markets. p.Monopoly: Investment and Expansion Options 305 vT (Q) = (π Q(Q) × dQ) XT δ ˆ with δ ≡ k − g = r − g. where Π* = β1 ( β1 − 1). The optimal investment rule again is v* (Q) = Π* I . 364).3 illustrates the above investment trigger for incremental capacity investment by a monopolist as a function of the level of capacity initially held (Q). Letting v (Q) ≡ (π Q(Q) × dQ) δ . The elasticity of vT is again constant and equal to ε v = −1. The additional (lumpy) capacity investment model in the previous section can be thought of as a discretized version of the continuous 37. the term v (Q) represents the perpetuity value of the deterministic incremental proﬁts (π Q × dQ) stemming from the new capacity investment (growing ˆ at an annual risk-adjusted rate g . (9. .39). the higher the investment trigger X* (Q). 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 . that the monopolist has no production cost. ⎜ ⎟ ⎝ ⎠ ⎝ ε p − 1⎟ ⎠ 2 (9. Bertola (1988.39) For an initially speciﬁed (planned) amount of capacity (Q). Since from equation (9.

This reduces to the trigger expression of equation (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. If in the additional capacity investment model the monopolist’s proﬁts before and after the additional capacity investment are determined by equilibrium conditions (e..35) at the point where X* was such that (ΔVX *) I = Π* (with I being the investment outlay for additional capacity ΔQ).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. In the previous model the optimal investment trigger was found in equation (9.40) as ΔQ → 0. 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). The elasticity of the demand function is ε p = 2 . The necessary investment cost is i = 20 .g. = ΠI ΔQ) × ΔQ π Q(Q) dQ vQ(Q) 39. Note that ΔQ→0 lim ( ΔV ΠI δ ΠI = . Then the equivalence between the discrete/lumpy and continuous/incremental problems may not hold. incremental capacity investment model of this section. and starting value X 0 = 1. Total return is k = 12 percent. volatility σ = 30 percent. derived from proﬁt-optimization techniques). .38 Thus the incremental capacity investment model is the continuous equivalent of the additional (lumpy) capacity investment model discussed earlier.306 Chapter 9 Optimal investment trigger value 15 10 Investment trigger X* 5 0 1 2 3 4 5 6 Initial capacity (Q) Figure 9.

we discuss here the contingent-claims version (under the assumption of complete markets and no arbitrage). Avinash K. Avinash K. Both lump-sum and incremental capacity expansion models were considered. Sødal (2006) analyses hysteresis and the market entry and exit decisions along these lines. The standard investment timing rule has to be revised under conditions of uncertainty to properly consider the volatility in the underlying market. see Dixit and Pindyck (1994. Pindyck. We analyzed in turn the problem of entering a new market and the problem of expanding the ﬁrm’s scale of production. We derived additional intuition exploiting the analogy between the monopolist investor’s entry decision and the price markup set by a monopolist. Since option pricing is typically used for real options problems. Princeton: Princeton University Press. and Sigbjørn Sødal. . 4 and 5). Quarterly Journal of Economics 101 (4): 707–28. 1999. Robert S. and Robert S Pindyck. with the monopolist waiting longer than in the deterministic growth case. This approach based on the elasticity of the expected discount factor is also amenable to the study of other real options settings. Dixit (1989) analyzes hysteresis in a real options setting. If the ﬁrm may receive a scrap value upon exiting the market. and Sødal (1999) examine optimal investment timing and the (perpetual American call) investment option problem using classical techniques from microeconomics. Dixit and Pindyck (1994) extend this analysis to other settings. 41. Selected References McDonald and Siegel (1986) investigate the investment timing decision of a monopolist under uncertainty. The value of waiting to invest. and Daniel Siegel.41 Dixit. 40. McDonald. Robert L. even if the underlying asset is not spanned in the economy.. Dixit and Pindyck (1994) provide a solution based on dynamic programming using an exogenously given discount rate also applicable in case of incomplete markets. chs.. Investment under Uncertainty. 1986. Economic Journal 109 (455): 179–89. Dixit. in principle. A mark-up interpretation of optimal investment rules. 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). Pindyck. The two methodologies (contingent-claims analysis and dynamic programming) rely on somewhat different assumptions. The dynamic programming approach can be used. the “hysteresis band” involves a lower bound at which the ﬁrm exits.40 Dixit. 1994.. The presence 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. For further details on these two approaches regarding the investment timing problem of a monopolist.Monopoly: Investment and Expansion Options 307 barriers enabling it to ignore strategic interactions by rivals when devising its investment strategy.

This problem is generally solved by means of dynamic programming or contingent-claims analysis (CCA). Entry and exit decisions based on a discount factor approach. giving the right but not the obligation to acquire an asset at a predetermined exercise price. we can (1) construct a replicating. ⎣ ⎦ 42. In this case a replicating portfolio can be constructed. we assume that changes in X t are spanned by existing assets in the capital markets and that there exist no arbitrage opportunities.10) with g the expected percentage rate of change or growth parameter and σ the volatility parameter. Unless δ > 0. 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. the option will never be exercised because the present value of the exercise price decreases for later investment. Consider a portfolio that consists of a long position in M . Suppose that Vt follows the geometric Brownian motion as per equation (9.42 To determine M . The difference between total return k and the growth rate g represents some form of dividend yield. or equivalently when to acquire an asset given that the exercise price (which here equals the investment cost) is exogenously given and known. 2006. as is the case for most commodities. . Assuming that the short position N is held ﬁxed for an inﬁnitesimal time period dt . denoted δ ≡ k − g . r. Sigbjørn. These assumptions generally hold true in complete capital markets . risk-free portfolio and (2) determine its expected rate of return and equate that expected rate of return to the risk-free rate. a dividend δ per unit investment in the underlying asset. The short position pays.308 Chapter 9 Sødal. Let M be the value function of the monopolist ﬁrm’s option to invest. The investment-timing problem is about when to invest. the portfolio has a total expected return over the short time interval dt of E [ dM ] − N E ⎡dVt ⎤ − δ NVt dt. and a short position (N units) in the underlying asset Vt. We drop the dependence of M (and its derivatives) on the asset value Vt for notational convenience. within each time interval dt . The portfolio is therefore worth M − N Vt. To apply the CCA approach.

. ⎣ ⎦ This results in the partial differential equation: ˆ rM = gMV Vt + σ 2 MVV Vt 2. A solution to this equation (if it exists) is of the form M ≡ M(Vt ) = AVt β1 + BVtβ2 .1) in the appendix at the end of the book. ⎢ ⎥ 2 ⎣ ⎦ so that 1 E [ dM ] = ⎡ gMV Vt + σ 2 MVV Vt 2 ⎤ dt. Applying the boundary condition that limVt → 0 M (Vt ) = 0.4). 1 dM = ⎡ gMV Vt + σ 2 MVV Vt 2 ⎤ dt + σ MV Vt dzt. the portfolio is risk-free earning the risk-free return r so that N = MV . ⎢ ⎥ 2 ⎣ ⎦ From the two previous equations. 2 1 If arbitrage is precluded. the total expected return on the portfolio is ( gMV − gN − δ N ) Vt + σ 2 MVV Vt2. β1 and β 2 are the positive and negative roots of the “fundamental quadratic” given in appendix equation (A2.Monopoly: Investment and Expansion Options 309 By Itô’s lemma given in equation (A2. From the value-matching and smoothpasting conditions (see section A.4 in the appendix to the book) we get A = (V* − I ) V*(− β1 ) and V* = Π*I. where A and B are constants to be derived. 2 1 ˆ with g = r − δ . where Π* = β1 ( β1 − 1). it obtains that B = 0 (since β 2 < 0). Therefore 1 2 σ 2 MVV Vt 2 − δ MV Vt = r ⎡ M − MV Vt ⎤ .

.

oligopoly situations where ﬁrms can increase their capacity incrementally (section 10.10 Oligopoly: Simultaneous Investment In the previous chapter we discussed optimal investment timing under uncertainty for a monopolist. 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 agreement between ﬁrms having shared investment options. that simultaneous investment occurs at the same trigger value because ﬁrms agree to do so or tacitly collude. We consider. so we concentrate on the latter also obtaining analytical results for the option to defer investment as a special case.2). 1.3). obtained in the limit as the number of incumbents becomes larger (section 10. .1 A social planner interested in maximizing joint ﬁrm proﬁt would select the same investment trigger. We considered two types of options: invest (defer) and expand. the following industry structures: oligopoly situations where ﬁrms add capacity in lump sums (section 10. The models developed in the monopoly case help pave the way and set a benchmark for analyzing investmenttiming problems under uncertainty involving competition among two or more ﬁrms. This last extension requires the use of game theory. 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).1). and perfect competition. for simplicity and pedagogical usefulness. Suppose. we show how the presence of more rivals lowers the threshold that triggers investment. The value of the investment timing (or deferral) option deteriorates with more competition. so investment occurs sooner. in turn. Here we will deal with simple cases of option games involving symmetric ﬁrms. In the following sections dealing with oligopolistic industry structures.

Readers interested in the comparative effects of ﬁrm-speciﬁc or idiosyncratic shocks may refer to Caballero and Pindyck (1996) or Dixit and Pindyck (1994. before adding investment in extra capacity. σ ( X t ) the diffusion of the underlying process. After investment in added capacity units. If the process remains below the jointly selected investment trigger XT . each ﬁrm receives a higher proﬁt ﬂow. 10. 277–80). pp.1 Oligopoly: Additional Capacity Investment We discuss next the existing market model (expansion option). This set of values ( −∞. Suppose also that ﬁrms share the option to expand capacity and decide to invest simultaneously.1 Existing Market Model: Expansion Option Consider two identical ﬁrms already active in the market that contemplate investing in additional capacity.312 Chapter 10 10. modeled as a stochastic 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. As before. π 1. ﬁrms stay put (wait). XT . 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.1. and then obtain the new market model (investment deferral option) as a special case by setting an initial zero proﬁt ﬂow for each ﬁrm. XT ) is the continuation or inaction region. the ﬁrst-hitting time is a random variable. if X t < XT for all past t.1) where g( X t ) is the drift. At the outset. We denote this initial proﬁt ﬂow by π 0. (10. Since the process X t evolves stochastically. the same for both ﬁrms (as investment among symmetric ﬁrms takes place simultaneously). both ﬁrms invest. For simplicity. ∞ ) is the stopping or action region. As long as the process { } 2. that is. consider a low initial value X 0 for the demand process. At the ﬁrst time the demand process hits the boundary.2 This shock can capture exchangerate uncertainty or unexpected change in demand patterns. Firms’ joint investment strategy consists in investing simultaneously the ﬁrst time T the trigger XT (≥ X 0) is reached. X t . each ﬁrm receives proﬁts based on their existing capacity (assets in place). and zt a standard Brownian motion. We ignore ﬁrm-speciﬁc risk factors and concentrate on the industrywide demand shock. The corresponding set of values [ XT . Suppose the duopolist ﬁrms can only add capacity by a given lump sum. Two demand regions are distinguished. . given by T ≡ inf t ≥ 0⏐ X t ≥ XT .

(10.Oligopoly: Simultaneous Investment 313 remains in the inaction region ( −∞. (2) determine the investment strategy that maximizes the ﬁrm’s value given the strategy choice of rivals. The reduced-form certain proﬁts π 0. X 0 ) ≡ E0 ⎡ ∫ π 0 X t e− rt dt + ∫ π 1 X t e− rt dt − I e− rT ⎤.2) The ﬁrst right-hand term represents the perpetuity value of the ﬁrm if it stays put with its existing capacity forever.2. each ﬁrm invests and earns the higher proﬁt amount π 1 = π 1 X t onward.43) in the appendix as ⎛X ⎞ B0 (T ) = ⎜ 0 ⎟ ⎝ XT ⎠ β1 (10. each ﬁrm receives π 0 = π 0 X t. . Set V0 ≡ π 0 δ and V1 ≡ π 1 δ . section 4. we can decompose the value expression into C0 ( XT ) = V0 X 0 + B0(T ) ⎡(V1 − V0 ) XT − I ⎤. and (3) use the optimal investment trigger to obtain the expanded net present value (optimal investment value). ⎣ ⎦ (10. In a context involving quantity competition it could be Cournot proﬁts or the Paretooptimal outcome where both ﬁrms produce half the monopolist’s proﬁt if it is enforceable over time (see chapter 4.3) the expected discount factor is given by equation (A. XT ). while the second term is the additional net forward value ⎣(V1 − V0 ) XT − I ⎦ discounted back to ⎡ ⎤ the present using the expected discount factor.4) by β1 = − ˆ ˆ 2 α r ⎛α⎞ + ⎜ 2⎟ +2 2 2 ⎝σ ⎠ σ σ ( > 1) 3.45) in the appendix at the end of the book. each has a time-0 value of ∞ T ˆ C0 ( XT ) ≡ C ( XT . with δ = k − g = r − g ( > 0 ) representing the opportunity cost of delaying or a “dividend yield.3 The assessment of the investment option proceeds in several steps: (1) assess the value induced by a given investment strategy XT . π 1 capture the equilibrium proﬁts at each time t considered. As soon as the process enters the action region [ XT .t marketplace. B0 (T ). giving the time-0 value of )1 received at random future time T . ⎢ ⎥ T ⎣ 0 ⎦ where I and r denote the capital investment cost and the risk-free interest ˆ rate. ∞ ) at random time T . We do not specify the type of competition governing the time.4) with β1 (under risk neutrality) given in equation (A2.2). respectively. In the special case that the underlying stochastic factor X t follows the geometric Brownian motion.” From equation (A. If both ﬁrms follow the joint strategy to invest when XT is ﬁrst reached. dX t = ( gX t ) dt + (σ X t ) dzt.

314 Chapter 10 ˆ ˆ with α = g − (σ 2 2). (10. both ﬁrms invest simultaneously. At random time T*.7) for the capacity expansion problem. At time T*. ⎠ (10. both ﬁrms will invest immediately receiving the higher net present value V1 X 0 − I.5) 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. or I ⎛ I X* = Π* ⎜ ⎝ ΔV ⎞ ⎟.4). receiving net forward value (V1 − V0 ) X* − I .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) can be interpreted as follows. If the current demand value.7) Equation (10.2) and (10.1. By the methodology developed in chapter 9. X*). ( −∞. 10. 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. Setting the initial deterministic proﬁt π 0 to zero with V0 = π 0 δ being zero. each ﬁrm earns a reduced-form proﬁt π 0 that reﬂects the initial capacity levels. In the waiting region. To assess this net forward value in time-0 terms. the ﬁrm’s total value involves two components. based on equations (10. each will receive at the outset: β1 ⎧ ⎛ X0 ⎞ if ⎡(V1 − V0 ) X* − I ⎤ (wait) ⎪V0 X 0 + ⎜ ⎦ C0 ( X*) = ⎨ ⎝ X* ⎟ ⎣ ⎠ ⎪ (invest) if ⎩V1 X 0 − I X 0 < X*. X 0 ≥ X*. In the ﬁrst stage. the value of the option to invest in a new market is thus given by . the optimal joint investment trigger X* must satisfy ΔV X* = Π*. X 0. given by Π* = β1 . the demand process has value X*. β1 − 1 (10. receiving V0 X 0 as perpetuity value.6) If the two ﬁrms pursue the optimal joint investment strategy characterized by trigger value X*.4). is higher than the prescribed optimal investment threshold level X*. we use the expected discount factor in equation (10. This “exchange” involves a transaction cost I .

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 . In this joint venture. the investment trigger is higher in a duopoly (as ∂X* ∂V1 < 0) so that the duopolist ﬁrm invests later.Oligopoly: Simultaneous Investment 315 β1 ⎧ ⎛ X0 ⎞ ⎪(V1 X* − I ) ⎜ C0 ( X*) = ⎨ ⎝ X* ⎟ ⎠ ⎪ −I ⎩V1 X 0 (wait) if X 0 < X*. ⎝ VM 2 ⎟ ⎠ the same optimal investment trigger as in the monopoly case.4 Suppose that ﬁrms collude both on investment timing (investment stage) and on output levels (market stage). 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). The expression in equation (10. π 1 = π M 2. X 0 ≥ X*. 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. the equilibrium reduced-form proﬁts in duopoly and monopoly may differ (all other things being equal). 5. The optimal investment trigger in this collusive duopoly case is ⎛ I 2 ⎞ X* = Π* ⎜ . (10. This result rests on two key assumptions: (1) the investment cost incurred by one ﬁrm is the same whatever its market power (monopoly vs.1) and pay a constant marginal cost 4. for example. Π*.8) looks similar to that for the value of the option to invest by a monopolist obtained previously in equation (9. by investing in a joint venture in which each pays half the investment cost. as in the Cournot model of section 3. Moreover. the joint venture or collusive duopolist investment trigger is identical to the monopolist’s optimal target.3 of chapter 3. Although the form of the solution is similar. Since the proﬁt of a duopolist is generally lower than that of a monopolist.13′).8) (invest) if where the optimal investment trigger X* is given as a special case of (10.1 Cournot Quantity Competition in Oligopoly Consider the oligopoly situation where. n symmetric ﬁrms face a linear demand p (Q) = a − bQ given by equation (3. each incurs cost I 2. ⎝ V1 ⎠ with the proﬁtability index. where π M is the monopoly proﬁt as given in equation (3. duopoly) or duopolists collectively face twice the investment cost of a monopolist.5): ⎛ I ⎞ X* = Π* ⎜ ⎟ . as given by equation (10.4). This situation is equivalent to the monopoly case. . collectively paying the same investment cost as the monopolist.5 Example 10.6). The perpetuity value for each ﬁrm is V1 = V M 2 with V M ≡ π M δ . That is.

1. X n*. I . Suppose that ﬁrms coordinate their actions in the investment stage. X n*. by extension of equation (10. is given by ⎛ I ⎞ X n* = Π* ⎜ ⎝ V1 ( n) ⎟ ⎠ with Π * given in equation (10.8). they agree on a joint investment trigger. The investment cost paid by each ﬁrm.1 Stage proﬁts under Cournot quantity competition Industry structure Monopoly Duopoly Oligopoly Number of ﬁrms 1 2 n Equilibrium proﬁt 1 (a − c) 4 b 2 1 (a − c ) 9 b 2 1 (a − c ) (n + 1)2 b 2 c per unit output. ⎝ X n* ⎠ β1 (10. producing half the monopoly output after making a joint simultaneous investment if it is more descriptive of the problem at hand. Since V1 ( n) decreases with the number of ﬁrms (n).6). We could assume instead that ﬁrms collude as well in the market stage. the optimal investment trigger X n* increases. but do not necessarily collude in the market stage. the value of the investment option for any of the n ﬁrms when all ﬁrms follow the joint optimal investment strategy is. competing à la Cournot once they have entered the market. Figure 10.6 The reduced-form stage proﬁt ﬂows. beyond n = 4 or 5 ﬁrms the option 6. is constant.9) where the investment trigger optimally chosen by the n colluding ﬁrms. This result relates to the fact that investments are lumpy and that the investment cost. given by ⎛ X ⎞ C0 ( X n*) = (V1 ( n) X n* − I ) ⎜ 0 ⎟ ⎝ X n* ⎠ β1 ⎛ X ⎞ = (Π* − 1) I ⎜ 0 ⎟ . namely if X 0 < X n*. . obtained in chapter 3. is the same whatever the industry structure. are summarized for convenience in table 10. In the inaction region. I .1 conﬁrms that the investment option value dissipates fast when more ﬁrms are active in the marketplace (here.316 Chapter 10 Table 10. The multiplicative stochastic shock follows geometric Brownian motion. for example. 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. that is. regardless of the industry structure.

and the resulting Nash equilibrium 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. n. It is possible to consider an investment cost decreasing with the number of ﬁrms. g = 0. c = 2 . In lumpy investment cases—as discussed. Each ﬁrm may have an incentive to invest earlier to wield more market power and temporarily earn higher proﬁts. This would lead to higher values for the investment trigger and the option. p (Q) = 6 − Q. preemption poses a real threat.7 10. Sustainability of such collusive agreement is doubtful. X 0 = 1. The option value does not vanish completely. But with more ﬁrms following closed-loop strategies.Oligopoly: Simultaneous Investment 317 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. σ = 20 percent. k = 12 percent. Simultaneous investment models in a dynamic setting are more challenging.08 . value becomes very small).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. if ﬁrms are permitted to devise closed-loop strategies. Rivalry can hasten rather than delay investment. . The investment option value decreases as the proﬁt value of an oligopolist ﬁrm declines with the number of ﬁrms. For both openloop and closed-loop strategies the monopolist will wait more since there is no preemption threat. that is. We discuss this issue at length in chapter 12. especially in an oligopoly with a large number of ﬁrms. In most cases the problem is formulated with open-loop strategies. but in most cases tacit collusion is not likely. I = 100 .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. for instance. however. in Huisman and Kort (1999)—tacit collusion can sustain as (Markov) perfect equilibrium for a certain range of parameters.

Q) = π j ( X t . favorable shocks by adding capacity incrementally (by an amount dq). . The proﬁt ﬂow is the same for all identical incumbent ﬁrms. 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 . We here examine expansion options in the context of production capacity problems. 9. 11. In this section we develop a comparable model based on our approach for investing at an optimal target level. Capacity is inﬁnitely divisible so that the stage action set is continuous. Firm j receives uncertain proﬁt ﬂow π j = π j ( X t . We do not intend to give a mathematical treatment of this problem here but rather to stress the economic intuition.9 Suppose again that n ﬁrms already active in the market face Cournot quantity (or capacity) competition and contemplate investing in new capacity. The proﬁt-ﬂow function is differentiable with respect to capacity.8 This model is fairly general since it can accommodate various stochastic (Itô) processes and demand functions. Since ﬁrms can add capacity by any incremental amount. lump-sum investment. To avoid use of two subscripts. Once again. 10. 12. we make the assumption that symmetric ﬁrms invest simultaneously and by the same capacity increment. q j . not the industry as a whole. Consider the general case ﬁrst. rather than waiting longer for a large favorable shock to occur to justify a larger. with the understanding that these formulas concern an individual ﬁrm.11 VT [π j ] denotes ﬁrm j’s forward value as a perpetuity of proﬁt ﬂows π j ( X t . assume that an industry organization is responsible for the industry’s common interests and wields sufﬁcient power to enforce its investment-timing decisions. interpreting them in terms of capital stocks. it receives an extra proﬁt ﬂow amounting to π j ′ dq j . 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 (10.10 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. For simplicity. with { } 8. Thus. and technological expertise. Q− j ) from time T onward. including capacity. Pindyck (1988) and Dixit and Pindyck (1994) take a broader approach.318 Chapter 10 expand capacity by any small increment. human capital (new labor. where qj denotes ﬁrm j’s individual capacity and Q− j the combined capacity of all other ﬁrms except ﬁrm j. enhanced intellectual capital). Q = q j + Q− j. they are more likely to react to small. In this incremental capacity investment problem. Let Q be the current level of total industry capacity.1). we drop the use of the subscript j henceforth. rather than by a lump sum. Q− j ). q j .12 When ﬁrm j invests incrementally in new capacity (by small amount dq j).

VT [⋅] is a forward perpetuity value operator. I (10. This value for ﬁrm j is ∞ ∞ ˆ c0 ( XT .10). (10. v ( XT . Q).38) derived earlier for a monopolist having the option to invest incrementally in capacity. Q ) (10.10) or net forward value of vT (Q) − I . the elasticity measures ε B(⋅) and ε v(⋅. Q) being the proﬁtability index (function) given by Π ( XT . The equation above can simplify to c0 ( XT . vT . q j . Q− j ). Q) ≡ VT [π j ′ dq j ] (10. it receives the forward perpetuity value vT (Q) = v ( XT . is lower than the incremental value increase in the case of a monopoly . This expression is analogous to equation (9. Q) = E0 ⎡ ∫ π j e − rt dt + ∫ (π j ′ dq j ) e − rt dt − I × e − rT ⎤. ∂q j At random time T when ﬁrm j raises its capacity by dq j.13).Oligopoly: Simultaneous Investment 319 π j ′ = π j ′ ( X t . Q) satisﬁes v* (Q) = Π* (Q). Q) are given by ε B( XT ) = − BX (T ) × XT .11) To determine the optimal investment strategy. ε B ( XT ) + ε v ( XT . A signiﬁcant difference exists. we need to determine the * optimal joint cutoff value X n = X*(Q) that maximizes the expression n above. Q) denote ﬁrm j’s time-0 value of investing at target level XT given industry capacity Q. In equation (10.12) where Π*(Q) = Π ( X n *. B0 (T ) XT . Let c0 ( XT . Q) = − vX (Q) × where BX (⋅) = ∂B ∂XT and vX (Q) = ∂v ∂XT . with Π (⋅. T ⎣ 0 ⎦ The ﬁrst term in the expectation is a perpetuity value that is independent of the investment strategy choice. however. Q− j ) ≡ ∂π j ( X t . Here the incremental value change (due to capacity addition). Q ) = ε B ( XT ) . This is found at the point where v*(Q) = v ( X*.13) In equation (10. Q ) ε v( XT . Q) = V0 (Q) + B0 (T ) [vT (Q) − I ]. qj .

and an industrywide multiplicative shock that follows an Itô process as per equation (10. Q− j ) = X t π j ( q j . the market price decreases in proportion to dQ. Since the (inverse) demand function is downward sloping. The ﬁrst-order derivative of ﬁrm j’s proﬁt function is π j ′ (Q) = p (Q) + q j p′ (Q). . Q). Following Grenadier (2002).14) We can now specify the incremental forward value given in equation (10. Q− j ) = [π j ′ dq j ]V[ XT ]. Since all ﬁrms are symmetric and q j = Q n. Since all ﬁrms invest simultaneously and by the same increments. Given that all ﬁrms invest simultaneously. Q− j ) = q j p (Q). Since the shock is multiplicative. when each ﬁrm j increases capacity by dq j. equation (10. the industry increases total capacity by dQ = n dq j . dq j n (10. Case of Multiplicative Shock Suppose now that the total uncertain proﬁt ﬂow. p (Q):13 π j (Q) = π j (q j . π j (Q).10). assume that incremental production costs are negligible or that ﬁrms maximize revenues. total industry capacity rises by n times this increment when joint investment occurs. consists of a deterministic reduced-form component.320 Chapter 10 due to the presence of competing ﬁrms acting as a negative externality. Q− j ). so Q = nq j at all times. when ﬁrm j increases its capacity by a certain amount (dq j). The optimal investment trigger X n* (Q) for each ﬁrm 13. q j . The stochastic proﬁt ﬂow for ﬁrm j is now given by π j ( X t . In other words.10) obtains as vT ( q j . π j ( X t . 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. the equilibrium value is not affected solely by ﬁrm j’s capacity increase but also by the entire industry’s capacity expansion (dQ) as all rivals follow suit at the same time. q j. The deterministic proﬁt then equals ﬁrm j’s quantity. We assume the (inverse) market demand function is downward sloping and twice continuously differentiable.1).14). this simpliﬁes to π j ′ (Q) ≡ dπ j Q (Q) = p(Q) + p′ (Q). multiplied by the market-clearing price.

p (Q) + (Q n) p′ (Q) (10. consider the case of geometric Brownian motion based on equation (10. the expected discount factor. π j ′ (Q) δ (10. B0 (T ).14) as V [ X n*(Q)] = Π* i . We can thus compare these results. The result above is fairly general and tractable. and unit production costs are negligible in a monopoly context. Two polar cases are of interest: (1) monopoly. n. where δ ≡ k − g = r − g. that capital has no scrap value.Oligopoly: Simultaneous Investment 321 in an oligopoly in equilibrium with n symmetric ﬁrms obtains from equations (10. and Π* = β1 (β1 − 1) is the proﬁtability index in case of geometric Brownian motion.2 Oligopoly with Isoelastic Demand Suppose again that the shock process follows the geometric Brownian motion of equation (10.15) as X n*(Q) = Π*i . X 1*(Q) = Π*I . π ′ (Q) δ with π ′ (Q) = p(Q) + Qp′(Q).15) where i is the investment cost per unit of capacity. To illustrate.14 In this case the perpetuity value is obtained from equation (A. The preceding general model for oligopoly is in line with previous literature on real options. and the elasticities readily obtain.14). including the case of monopoly. V [ X n*(Q)]. For a monopolist. where n → ∞.40).30) in the appendix as ˆ V [ X n*(Q)] = X n*(Q) δ . Pindyck (1988) also assumes a multiplicative industry stock that follows a geometric Brownian motion. Example 10.16) where π j ′ (Q) is given in equation (10.15) depends on the industry structure through the number of ﬁrms. and (2) perfect competition. equation (9. The value expression in equation (10.12) and (10. with n = 1.16) with n = 1. The optimal investment trigger for each of the n oligopolist ﬁrms is obtained from equation (10. being a special case of the expression in (10.3).3) where the perpetuity value. . This conﬁrms the investment trigger for the monopolist based on the proﬁtability index investment rule derived in chapter 9. but that now ﬁrms face an (inverse) demand function of the constant-elasticity form 14.

16).14) and π j ′ (Q) into equation (10.17) This conﬁrms the result obtained in Grenadier (2002). so that more competition hastens rather than delays investment. 10. 16.16 This holds under most typical demand functions and stochastic process speciﬁcations. Figure 10. The investment trigger in equation (10. ∂X n* (Q) ∂Q ≥ 0. Here the proﬁt is given exogenously by a function continuous in capacity Q. The asymptote 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. ⎟ ⎝ ⎠ ⎝ nε p − 1 ⎟ ⎝ nε p − 1 ⎟ ⎠ ⎠ 2 (10. equation (21). See Grenadier (2002) for derivation of the ﬁrst-order derivative of the trigger function under other stochastic processes and demand functions. 17.15 The ﬁrst-order derivative of the demand function is p′ (Q) = − (1 ε p ) Q− (1 ε p )− 1 (< 0 ). 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 1 X n*(Q) = Π* i δ ⎜ Q = ⎜ r + β1σ 2 ⎞ i ⎜ Q . . where −ε p is the price elasticity of demand. Under certain conditions for the constant elasticity of demand (see footnote 15).322 Chapter 10 p (Q) = Q−1 ε p .2 illustrates the sensitivity of the investment trigger to the number of ﬁrms n for a given installed industry capacity Q. When this value is substituted into equation (10. We assume that ε p > 1 n > 0 . 18. It conﬁrms that the investment trigger decreases with the number of ﬁrms. ∂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. It is still not correct to say that in perfect competition the NPV rule holds.17) has the following ﬁrst-order derivative: ∂ X n* X *(Q) (Q) = − n (< 0 ) .17 For a very large number of ﬁrms (approximating perfect competition) the option to wait to invest almost vanishes. 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.18 Appendix 10A provides an alternative derivation based on dynamic programming.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.

Oligopoly: Simultaneous Investment 323 Optimal trigger value 80 60 Monopoly (n = 1) 40 Duopoly (n = 2) Oligopoly (n = 5) 20 0 1 2 3 4 5 6 Initial installed industry capacity (Q) (a) Optimal trigger value 60 Expected investment time (years to investment) 80 40 Expected investment time 60 40 Optimal trigger 20 20 0 1 2 3 4 5 6 7 8 9 10 0 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 . . growth g = 8 percent. initial installed industry capacity Q = 2. The discount rate is k = 12 percent. For panel b. with constant ε p = 2 . Investment cost i = 100 (per ﬁrm). and volatility σ = 20 percent.

324 Chapter 10 of ﬁrms. Equivalently. not by rival capacity adjustments. 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. 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. Myopic investment policies turn out to be socially optimal. n.6). 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. increases. 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.16) as n approaches inﬁnity: X ∞ *(Q) = lim X n*(Q) = lim n →∞ n →∞ Π* i δ Π*i . Consider again the case of geometric Brownian motion as in equation (10. the capital investment cost i . The optimal threshold in perfect competition is thus deﬁned explicitly in terms of the current industry capacity Q. considering the market price dynamics as exogenous. the market-clearing price p (Q) given the existing capacity. The connection between the socially optimal investment threshold and the trigger obtained under perfect competition was ﬁrst noted by Leahy (1993). and the opportunity cost of waiting δ .18) as p (Q) X ∞ * (Q) 1 = Π*δ = r + β1σ 2. the return on investment satisﬁes the modiﬁed Jorgensionian rule of investment obtained from equation (10. the proﬁtability index Π*.25) seen in the monopoly case. The investment trigger of a ﬁrm operating in perfect competition can be obtained as the limit of X n*(Q) from equation (10. = p (Q) + (Q n) p′ (Q) p (Q) δ (10.18) where the proﬁtability index Π* is given in equation (10. 2 i This is analogous to equation (9.3). in perfect competitive equilibrium. A myopic ﬁrm behaves as if industrywide production capacity (going forward) remains ﬁxed and that the future price process is solely driven by exogenous shocks.

the equilibrium strategies obtained by Grenadier (2002) would fail to be subgame perfect. myopic strategies. formulate closed-loop strategies). noting the optimality of myopic behavior that ignores rivals’ capacity expansion decisions. Leahy (1993) introduces strategic 19. We then extended the analysis to settings where ﬁrms can expand capacity by any small or incremental amount. Grenadier 2002. Formulating the dynamic capacity-expansion problem in closed-loop strategies is rather difﬁcult. Selected References Pindyck (1988) paves the way for the analysis of irreversible investment in incremental units of capital. Back and Paulsen (2009) discuss the appropriateness of the Nash or open-loop equilibrium concept employed in models of oligopoly and perfect competition (e. Baldursson and Karatzas 1996). We discussed also the special case of perfect competition.. 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. If ﬁrms could in effect respond to their rivals’ actions (i. the perfect competition outcome derived in Leahy (1993) is part of a perfect closed-loop equilibrium. comparing the results obtained in Nash equilibrium with the choice of a social planner. We ﬁrst considered a case where ﬁrms make lumpy investments and agree to cooperate on joint investment timing.Oligopoly: Simultaneous Investment 325 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). Back and Paulsen show that in the limit. an aggregate index of “committed capacity. simpliﬁed Markov state that keeps track of both assets in place and capacity under construction. . Some special cases admit closed-form solutions. they would face the risk of preemption. Optimal open-loop strategies form a Nash equilibrium as part of the open-loop equilibrium. If ﬁrms were to pursue such Nash equilibrium open-loop strategies even though they observe their rivals’ actions and can revise their strategies accordingly.” 20.e. Dixit (1991) further examines investment behavior in a perfectly competitive market with exogenous price ceilings. Baldursson (1998) considers both expansion and downsizing decisions. Baldursson 1998.20 Conclusion We analyzed here oligopolistic market structures considering the investment decision of ﬁrms when they invest all at the same time and by the same lump sum or increment.g. The presence of completion delays or time to build still allows use of a Markov state space provided one uses a new. establishing the correspondence among perfect competition. and social optimality for a larger family of processes using a probabilistic approach to stochastic control theory..19 Baldursson and Karatzas (1996) consider capacity expansion decisions involving non-Markovian stochastic processes.

Pindyck. American Economic Review 78 (5): 969–85. 1993.326 Chapter 10 considerations to this setting and points out their irrelevance in the context of perfect competition. Steven R.19) 21. Leahy. Under uncertainty the underlying proﬁt ﬂow has both an exogenous (demand) and an endogenous (strategic) value component.21 Consider an oligopoly consisting of n symmetric ﬁrms competing over a single. Option exercise games: An application to the equilibrium investment strategies of ﬁrms. For simplicity we disregard variable unit production costs obtaining: π j (Q) = X t π j (Q) = X t q j p (Q). 1988. and Q− j denotes the output produced by all other ﬁrms except ﬁrm j. a reasonable assumption in highly competitive markets. an exogenous industrywide demand shock process. We refer more analytically minded readers to this appendix. The appendix at the end of the book is more precise on how to derive HJB equations and the relevant boundary conditions. The uncertainty is modeled by X t . Output is assumed inﬁnitely divisible. Investment in competitive equilibrium: The optimality of myopic behavior. Irreversible investment. Grenadier (2002) extends the analysis considering oligopolistic industry structures and completion delays. Quarterly Journal of Economics 108 (4): 1105–33. Suppose that the exogenous shock is of the multiplicative form and follows the Itô process of equation (10. When the underlying asset is not affected by other investors’ exercise policies. Here we sketch a derivation based on dynamic programming to obtain the partial differential equation and boundary conditions derived by Grenadier (2002). Grenadier. The output produced by n ﬁrm j is denoted q j . Review of Financial Studies 15 (3): 691–721.1). John V. . 2002. Appendix 10A: Derivation Based on Dynamic Programming An investment opportunity is commonly treated in the real options literature as being analogous to a perpetual American call option written on a real asset. (10. Robert S. we can analyze such investment opportunities by means of contingent-claims analysis. Q = ∑ j = 1 q j is the total industry output. nonstorable homogeneous product. capacity choice and the value of the ﬁrm.

the change in the value of ﬁrm j over an inﬁnitesimal time period dt is given by 1 dc = ⎛ cX gt + cXX σ t ² ⎞ dt + cX σ t dzt ⎜ ⎟ ⎝ ⎠ 2 (10. Firms at any time may invest in extra capacity. When taking expectation. denoted by X n* (Q). The ﬁrst. X *.Oligopoly: Simultaneous Investment 327 In such a symmetric oligopoly. . After substituting the result derived from Itô’s lemma in equation (10. 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 investment cost I .and second-order derivatives in equation (10. the instantaneous total expected return should equal the continuously compounded cost of capital. Q). Investing in added capacity involves a capital expenditure by ﬁrm j of I ≡ i × dq j. ﬁrms increase output all at the same time in response to a favorable market development. each increasing their output by a small increment dq j. so at all times qj = Q n ∀j = 1. the second right-hand term in equation (10. Q) dt + E (dc ) = rcdt. n.2). analogous to a “dividend yield. Q) with respect to X 0.” and (2) the expected value increase or “capital gain.21) into . Q. Over a small time period of length dt .. zt being a standard Brownian motion. This threshold. ﬁrm j determines its optimal investment strategy taking other ﬁrms’ (optimal) strategies as given.” E ( dc ).21) with gt ≡ g( X t ). X *. where i ( > 0 ) is the price of one unit of capacity. In equilibrium. Q).20) From Itô’s lemma given in equation (A1.21) are the derivatives of c ( X 0 . is a function of the number of ﬁrms and the total industry capacity. (10. 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 . . σ t ≡ σ ( X t ). The optimal exercise strategy can be found in terms of trigger policies. In Nash equilibrium. . 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 .21) drops out since E [ dzt ] = 0. the return to ﬁrm j consists of (1) the proﬁt ﬂow from existing capacity π j ( X t . This leads to the following Bellman equation in continuous time (or HJB equation): π j ( X t .

q j . Q− j ) − I = c ( X*. Conditions (10. . Smooth-Pasting Condition At the optimal investment trigger point. Q) + cX gt + cXX σ t 2 = rc. Q− j ) ≡ ∂c ( X*. Q− j ) ∂Q− j . Q− j ). we obtain the following partial differential equation: π j ( X t . q j + dq j . When the state variable reaches the threshold X*. subject to speciﬁc boundary conditions. X*. the smooth-pasting condition for cq j holds. (10. X*. q j . (10. q j . at optimal exercise. Q− j ). If we assume that symmetric ﬁrms invest at the same time and by the same increments. q j . Value-Matching Condition If ﬁrm j invests in dq j capacity units. Q− j ) = cX ( X*. q j . X*. Q− j + dQ− j ) = c ( X*. its value will be c( X 0 . q j + dq j . yielding cq j ( X*. q j .23) where cq j (⋅. X*. ﬁrm j is indifferent between investing or keeping open its option to wait.23) and (10.328 Chapter 10 the HJB equation (10. The investment opportunity value c must satisfy the equation above. X*. discussed below. X*. q j .24) where cQ− j ( X*. q j + dq j . X*. X*. q j .22) This equation describes the option value dynamics under the optimal investment policy. Q− j ) ∂q j . so that c ( X*. Q− j ). q j . q j . Firm j’s optimal investment strategy is to increase capacity when the shock variable X t reaches the threshold level X*. Q− j ) = i . This leads to cQ− j ( X*. Q− j ) − I . X*. 1 2 (10. c ( X*. X*. X*.24) are the value matching conditions. X*. Q− j ) = 0. X*. namely cX ( X*.20). Q− j ) ≡ ∂c (⋅.

Special choices for the stochastic process. X*. and (10.25).22 No general analytical solution exists for partial differential equation (10. (10. Sometimes the term smooth-pasting condition is used in this context. however. such as the geometric Brownian motion. Q− j ) = 0.23).25) This boundary condition is the super-contact or smooth-pasting condition. 22. this condition is the super-contact condition since it is of second order. make the analysis amenable to closed-form solutions. ∂q j (10. qj . Smoothpasting condition is a ﬁrst-order condition that here applies to the ﬁrst-order derivative of the value function with respect to the capacity level. Rigorously speaking. Refer to Dumas (1993) for details.24).Oligopoly: Simultaneous Investment 329 obtaining ∂c X ( X*.22) subject to boundary conditions (10. .

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real options analysis and game theory. The following sections extend this basic. Such investment-timing games can help explain ﬁrm leadership and early-mover advantage.1 discusses the basic deterministic game-theoretic framework of Reinganum (1981a) that shows why sequential. ﬁrms precommit and are not permitted to revise their strategies in view of rivals’ actions over the play of the game. Reinganum (1981a) shows that simultaneous investment does not arise in equilibrium in such games.11 Leadership and Early-Mover Advantage In the previous chapter. Here we consider strategic interactions among ﬁrms.1 Section 11. models of simultaneous investment among oligopolists were discussed. particularly if the leader has distinctive capabilities with sufﬁciently high competitive advantage that makes it possible to disregard the competitor’s investment decision. Sections 11.4 deals with the option to expand production capacity. In chapter 9 on the 1. rather than simultaneous. 11.3 focus on the option to invest in a duopoly and in an oligopoly setting. Reinganum’s (1981a. such as Joaquin and Butler (2001). so collusive simultaneous investment is ruled out as a Nash equilibrium of the investment game. It is simpler ﬁrst to deal with option games involving no risk of preemption as in open-loop models. In such cases preemption does not occur. that is. We focus here on models involving open-loop strategies. These models assumed that investment timing was decided collectively (or by a social planner able to enforce its investment-timing decision). deterministic framework allowing for a market evolving stochastically. Section 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. Investment may occur sequentially. respectively. . b) approach to open-loop equilibrium provides the basic (deterministic) setting underlying option games involving sequential investment. investment emerges as the equilibrium when duopolist ﬁrms hold a shared investment option.2 and 11.

the option to invest and the option to expand) when the option holder faces no competition or when the investment opportunity is protected by high structural entry barriers. in capacity expansion) and increase their proﬁts accordingly (existing market model). For a treatment of option games with a focus on technology adoption.g. their results and insights are tractable and applicable to other classes of problems.g. it does not adequately address situations when real options are “shared” among several rivals. the methodology we mastered along the way to solve such decision-theoretic models will serve us well as a ﬁrst building block for analyzing such shared option games. see Huisman (2001). We present it ﬁrst and discuss Fudenberg and Tirole’s model in the upcoming chapter. . Nonetheless. Two key articles that have had a major impact on this ﬁeld are those by Reinganum (1981a) and Fudenberg and Tirole (1985). The second building block is game theory and industrial organization. Both ﬁrms have the option to make an investment (e. Both deal with investment timing when there is no stochastic uncertainty regarding the payoffs ﬁrms will receive upon acting.332 Chapter 11 investment option of a monopolist. with a particular focus on games of timing. We extend these results within the real options framework and apply them to provide insights into the strategic investment challenge under market uncertainty. 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. we elaborated how one can obtain analytic solutions for certain real options problems (e. Assume that ﬁrms’ investment strategy consists in choosing an investment date a priori and committing to it. Reinganum’s (1981a) model does not require the use of mixed-strategy equilibria in continuous time and is less technical as a starting point. Although standard real options analysis gives interesting insights into how a monopolist ﬁrm should behave. it is clear that capacity expansion by one of the ﬁrms is made at the expense of its rival: 2.2 In contrast to Fudenberg and Tirole (1985). assuming a ﬁxed investment schedule is reasonable. such as timing of market entry or of (lumpy) capacity expansion. Although these authors explicitly deal with technology adoption. These settings are typically modeled in continuous time.. Since for now we assume that there is no stochastic uncertainty concerning the underlying market development. so it is useful to develop some understanding of game theory in continuous time before dealing with uncertainty in integrated realoptions and game-theoretic models. Supposing that we deal with capacity expansion..

For option games a necessary useful step is to consider that players select an investment trigger. McDonald and Siegel 1986. 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 . with g < r.4 Assume a constant investment cost I .g. deﬁnes the random time of investment. each ﬁrm earns a proﬁt denoted π 0. Fudenberg and Tirole 1985) and option models of investment timing under uncertainty (e. making the investment at a time when the market is larger and more proﬁtable. At the beginning of the game. here the two ﬁrms are symmetric but may choose distinct investment times (Ti and 3. There is an incentive to delay. By contrast to the previous chapter where we assumed competitors invest (collusively) simultaneously. the problem here simpliﬁes to selecting a certain time T ( ≥ t0 ) at which the ﬁrm invests. while the expanding ﬁrm may earn higher proﬁts due to the combined effect of increased quantity (market share) and lower price.. In Reinganum’s framework the investment time is deterministic. 5.g. Reinganum 1981a. This brings out a key difference between deterministic game-theoretic models of timing (e.5 A differentiating feature between Reinganum’s (1981a) model and our option games approach is that Reinganum does not consider uncertainty relating to the underlying process. In the deterministic game-theoretic models the investment strategy directly relates to the investment timing. This holds if there are negative externalities from capacity expansion or. The duopolists have an inﬁnite planning horizon and can choose to invest at anytime.Leadership and Early-Mover Advantage 333 as price declines.3 The problem for the option holder lies in selecting the right time to stop waiting and initiate the expansion project. the appropriate discount rate is the risk-free interest rate. whereas in option models of investment under uncertainty the investment trigger is a strategic choice parameter that. Consider ﬁrst the deterministic case. Dixit and Pindyck 1994). independently of the discounting effect. in turn.. Here these assumptions are reversed: proﬁts are growing with time and investment cost is constant whether investment occurs today or in the future. Assuming no arbitrage opportunities in a complete market. 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. 4. growing (compoundly) over time at a constant growth rate g (percent) per unit time. Reinganum (1981a) models the incentive to delay investment in a setting involving a constant proﬁt ﬂow and an investment cost decreasing over time. The net effect on the incentive to wait is analogous. r. Firms face the same interest rate r. . the rival ﬁrm whose capacity has remained ﬁxed loses revenues. rather than a predetermined investment timing directly. if the inverse demand function is downward sloping. equivalently.

the roles are reversed. The leader suffers somewhat from a capacity expansion by its rival. The leader earns a higher proﬁt (π L > π 0) as it beneﬁts from capacity expansion. For t ≥ max {Ti . and π F from the old capacity of the follower. at least one of the ﬁrms invests.334 Chapter 11 Tj). Suppose a weak ordering of ﬁrm roles with ﬁrm i being 6. This industry structure occurs for t such that t0 ≤ t ≤ min {Ti . but the overall proﬁt after the new investment. The optimal investment strategies must thus be part of an industry Nash equilibrium. both ﬁrms invest in additional production capacity. we set ∫ 0 π 0 e −(r − g )t dt − I < 0 . 7. each ﬁrm already earns at time t a proﬁt amounting to π 0 exp ( gt ).1 summarizes the proﬁts for the duopolist ﬁrms depending on the time elapsed. 2. When the ﬁrst of the two thresholds (min {Ti . with π L > π C > π F. there emerges an industry structure involving a “leader” and a “follower” wherein only one ﬁrm (the leader) expands capacity.7 Table 11. If the lowest investment time threshold is reached. They do not represent the additional proﬁt from the new investment.8 Consider next the time thresholds of the leader (TL) and the follower (TF ). Tj }. To ensure this. . the follower being unfavorably affected by its rival’s investment through negative externalities. These proﬁt ﬂows substitute for the initial proﬁt ﬂow π 0. that is. The follower receives a lower proﬁt π F ( < π 0 ). Which player actually becomes the leader or the follower is discussed later. L stands for leader and F for follower. but not yet the second one. the value increment from leadership (π L − π 0 ) is larger than the value increment from followership (π C − π F ). No one invests in additional capacity. for Tj ≤ t ≤ Ti. 8. Suppose as well that no ﬁrm has an incentive to invest right at the outset. The subscript C stands∞for competition. Note that the proﬁt ﬁrms earn depends on their rival’s investment strategy. Note that the notions of leader and follower here are different than in a Stackelberg game setting. π L is the total proﬁt of the leader stemming from the old and the new capacities. Tj }) is reached. such as price decrease in Cournot quantity competition. ﬁrm i is the leader and ﬁrm j the follower. The value (payoff) is consequently affected by strategic interactions. If both time thresholds are exceeded. with π 0 ≥ 0. Tj } ≥ 0 both ﬁrms earn at time t a proﬁt equal to π C e gt.6 There are two types of possible leader–follower industry structures: for Ti ≤ t ≤ Tj. Three industry structures may occur: 1. Both ﬁrms invest (expand capacity). Suppose further that there is a higher incentive to invest as a leader than as a follower. When no ﬁrm has yet invested in additional capacity. 3. Only one ﬁrm invests. In case of capacity expansion.

Tj } or t ≥ Tj ≥ Ti). In the competition stage.10 The value for ﬁrm i in this stage where ∞ both duopolists have expanded capacity is ∫ π C e −δ t dt.9 When the market is far from being sufﬁciently proﬁtable for a new investment to occur (for t ≤ min {Ti . Tj } Ti ≤ t ≤ Tj Tj ≤ t ≤ Ti t ≥ max {Ti .Leadership and Early-Mover Advantage 335 Table 11. In the following stage. The leader does not have a sustainable competitive advantage (ﬁrst-mover advantage) through being the sole investor in the previous 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 timeinconsistent (see section 8. The leader incurs TF at time of investment (TL) the given investment outlay I . when Ti ≤ t ≤ Tj. This inconsistency justiﬁes the assumption of the model by Reinganum (1981a). meaning Ti = Tj . the leader. This question is central to understanding the Stackelberg model of duopoly. Whether a ﬁrm has gained a sustainable advantage by being the ﬁrst investor is a tricky issue from a game-theoretic viewpoint. In the “history” of the game (with t0 = 0 < Ti = TL). it earns exactly the same proﬁt as its rival in the third stage. earning duopoly proﬁts π C e gt. the leader earns π 0 exp ( gt ) at time t. . ﬁrm i competes head-on with ﬁrm j.2 in Tirole 1988). the leader will go through three different time stages characterized by distinct proﬁt ﬂows.1 Proﬁts for capacity-expanding duopolists depending on timing Proﬁts Time t ≤ min {Ti . 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. If ﬁrms invest at the same 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. Since there is no uncertainty concerning the market development. The value of being (during that period) the stand-alone TF investor in new production capacity is ∫ π L e −δ t dt. there is no need to use expectation in the value expression. This occurs if Ti ≤ Tj. which must be discounted back at the present time. Tj } Industry structure No one invests Only one invests Both ﬁrms invest Firm i Firm j π 0 e gt π L e gt π F e gt π C e gt π 0 e gt π F e gt π L e gt π C e gt Note: π L > π C > π F and π L > π 0 > π F . that is. 10. Models involving uncertainty differ on that dimension. the second region (Ti . 11. In the third stage TL (t ≥ max {Ti . Tj ) reduces to a null set. Tj }). ﬁrm i gains a leader status earning π L e gt at time t.

TF ) = − (π L − π 0 ) e−δ TL* + rI e− r TL* = 0 . ∂TL or ⎛ π L − π 0 ⎞ e gTL* = r . TF ) = ∫ TL 0 π 0 e −δ t dt + ∫ TF TL π F e −δ t dt + ∫ ∞ TF π C e −δ t dt − I e− rTF .1 also identiﬁes those stages. Alternatively. This is the Jorgensonian rule for expanding investment under certainty. In other words. it is optimal for the follower to invest at the time when the excess return on investment equals the interest rate. or equivalently one should invest in additional capacity the ﬁrst time the project’s excess return on investment exceeds the cost of capital. one can obtain from equation (11. At the optimal time of investment. (11. The optimal investment time is found at the point where the ﬁrst-order derivative of the value function equals zero. the project’s excess return on investment equals the cost of capital. . The optimal investment time for the follower can be determined and interpreted similarly: ⎛ π C − π F ⎞ e gTF * = r ⎜ ⎟ ⎝ ⎠ I V − VF ⎞ gTF * b . TL* ( > 0 ) is such that ∂Li (TL*. ⎜ ⎟ ⎝ I ⎠ (11.2) By symmetry. 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). TL* and TF * are not explicit (reaction) functions of the rival’s investment time.3) with TL* = ln (rI (π L − π 0 )) g.336 Chapter 11 Li (TL . As before. r. ⎜ ⎟ ⎝ I ⎠ b−1 (11. or ⎛ C = ⎜ ⎟e ⎝ ⎠ I b−1 (11.4) where b ≡ r g .3) the optimal time for the leader TL* based on the following proﬁtability index investment rule: ⎛ VL − V0 ⎞ e gTL* = b .5) In this case as well. The condition δ ≡ r − g > 0 ensures that the investment time is ﬁnite. r.1) For the follower there are also three distinguished stages. ﬁrm j (ﬁrm i)’s value as leader (follower) is identical. Table 11. (11. The value of ﬁrm j as a follower is given by Fj (TL . TF ) = ∫ TL 0 π 0 e −δ t dt + ∫ TF TL π L e −δ t dt + ∫ ∞ TF π C e −δ t dt − I e− rTL .

namely (TL *. ⎪T * if Tj > TP *. TF *) > Fi (Ti . As noted. that is for Ti < TP *. in that ﬁrm i is better off investing now as a leader than delaying investment further. TF *} if Tj = TP *.6) Before this time.5). (11. If ﬁrm j chooses to invest at exactly time TP *. As seen in ﬁgure 11. The best-reply functions intersect at two distinct points: (TL*. After this indifference point (Ti > TP *) there is an incentive to become leader as Li (Ti . TF *) .1. . TF *) .13 To determine the Nash equilibria. TL*) *. By assumption. TF *) < Fi (Ti .4) above. The ﬁrst Nash equilibrium is that ﬁrm i invests as a leader and ﬁrm j as a follower. TF *) = Fi (TP *. TF *) or f (t0 ) < 0 . These two 12. ﬁrm j were to invest early. we need to consider the best-reply functions for ﬁrms i and j. TF *) > Fi(TL*. optimally investing as a follower at time TF * as given in equation (11.4) or TF * as in equation (11. Set f (T ) ≡ Li(T . TF *). according to equation (11. ⎧TF * ⎪ Ri (Tj ) ≡ Ti * (Tj ) = ⎨{TL*. before time TP * (Tj < TP *). TF *) − Fi(T . If. the leader enjoys a ﬁrstmover advantage with Li(TL*. in such a case ﬁrm i optimally chooses to invest at time TL* as per equation (11. there are two Nash equilibria in pure strategies. This point is discussed in detail in the following chapter. By strict monotonicity.5). ﬁrm j. the root of f (⋅)—which. TF *) < Fi( t0 . TF *). ﬁrm i maximizes its value by either selecting TL* as in equation (11. The subscript P stands for preemption. 13. During the period (TP *. a ﬁrm is better off delaying investment than investing right now since Li (Ti . f (⋅) is continuous and strictly increasing on (t0 . corresponds to the (preemption) point TP *—obtains to be unique with t0 < TP* < TL*. Thus the reaction function of ﬁrm i with respect to the investment time chosen by its rival. TF *). TF *) and (TF *. is given by if Tj < TP *. Tj ) there exists a ﬁrst-mover advantage for ﬁrm i. Li(t0 .6).1. namely (TF *. ⎩ L The reaction functions for ﬁrms i and j are illustrated in ﬁgure 11. ﬁrm i will wait. TF *) or f (TL*) > 0. Suppose that ﬁrm j selects beforehand an investment time Tj strictly higher than TP *.Leadership and Early-Mover Advantage 337 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 *. with ﬁrm j’s best-reply function being obtained symmetrically. TF *) *. however. TL*). The second one is that ﬁrm j takes the lead with ﬁrm i following suit. It also holds that TP * < TL* < TF *.

Time TL* is determined by the modiﬁed Jorgensonian rule of investment in equation (11. in contrast. meaning that the leader receives a higher . Another interesting outcome is that the values the ﬁrms receive are decreasing in the order of entry. TL*)* TP* Firm j’s best-reply function Ri (Ti) TL* (TL*.5). Note the difference between this model and the situation in chapter 10. whereas TF * satisﬁes equation (11. given the pure-strategy equilibria for symmetric ﬁrms—based on the model assumptions of Reinganum (1981a)—simultaneous investment never happens due to strategic interaction. 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.4). TF*)* TL* TP* TF * Firm j’s strategy Tj Figure 11.338 Chapter 11 Firm i’s strategy Ti Firm i ’s best-reply function TF * Ri (Tj) (TF*. Here. Previously we assumed that symmetric ﬁrms invest simultaneously.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 follower. Which of the two Nash equilibria in pure strategies is the most reasonable to expect is not speciﬁed a priori. 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.

the outcome of the Pareto-optimal investment sequence corresponds to the outcome of the perfect equilibrium in closed-loop strategies. Joaquin and Butler (2000) follow a similar analysis based on a speciﬁc stochastic process—geometric Brownian motion—assuming that (certain) 14. TF *) > F (TL*. In chapter 12 we show that for large ﬁrm asymmetry. 16. π L. Within a sequence of n ﬁrm investments. namely if the difference among ﬁrms is higher than a certain threshold. TF *) . . the end result is essentially the same: there are several Nash equilibria in pure strategies but none involves simultaneous investment.2 Duopoly with Sequential Investment under Uncertainty In this section we consider the option to invest in a duopoly under uncertainty (with stochastic proﬁts) and examine the industry dynamics when one of the ﬁrms has a substantial competitive (e.16 Finally. F (TF *. L (TF *. Since ﬁrms are symmetric.. As suggested by Reinganum (1981a). cost) advantage justifying a natural leader–follower industry structure.g. TF *). 15.15 It can be extended to asymmetric ﬁrms. We also extend the analysis by assuming asymmetric ﬁrms to allow for a more natural (focal-point) ordering of ﬁrms’ investment timing. • • In the following sections we discuss these extensions and provide reﬁnements allowing for uncertainty in market development. Such a situation is discussed by Reinganum (1981b).Leadership and Early-Mover Advantage 339 value than the second entrant in equilibrium. 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). As shown later. the Pareto-optimal sequence corresponds to the open-loop sequence with the advantaged ﬁrm investing ﬁrst. Since the follower’s value is increasing in its rival’s entry time. TF *) = F (TF *. It can be extended by considering stochastically evolving proﬁt values (π 0. TF *) ≥ L (TF *. π F. as in Flaherty (1977). Each Nash equilibrium involves a sequential ordering of ﬁrms’ investment. we extend the previous analysis to the case of a large oligopoly facing uncertain market development. 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. If Pareto optimality is deﬁned from the ﬁrms’ perspective. and so the value decreases in the order of entry L (TL*. By deﬁnition of the Nash equilibrium. Thus there are n! pure-strategy Nash equilibria. and π C). Although such an analysis is more involved. TF *) . 11. roles are interchangeable. TF *) > F (TL*.14 The leader thus enjoys a ﬁrst-mover advantage stemming from the monopoly “rents” it earns before the rival’s expansion. this assumption is reasonable when asymmetry is substantial. TF *). L (TL*.

the multiplicative shock X t and a deterministic proﬁt component. The approach herein is general and tractable to different stochastic processes and market demand functions.e. at time t0 = 0) is denoted by X 0.. Firm i invests. large enough to accommodate both ﬁrms). Uncertainty enters as a multiplicative stochastic exogenous shock (the exchange rate) X t . At the market’s early stage. the follower (ﬁrm j) will wait for the market to develop further before deciding whether to also invest. When the market is just large enough for only one player..7) The value of the process at the beginning (i. The main source of uncertainty here is the exchange rate at which ﬁrms repatriate proﬁts from the foreign country into domestic currency. When the market is too small.2 summarizes the proﬁts in the resulting three stages. receiving nothing for the time being. We proceed by considering the follower’s Table 11. earning monopoly rents. Table 11. Their model is therefore a special case of the one we elaborate herein. (11. while the follower waits. ﬁrm i due to its competitive advantage is the ﬁrst (only) one to invest. 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). only one ﬁrm (the leader) can invest and earn positive economic proﬁts.340 Chapter 11 proﬁts are Cournot outcomes in simultaneous quantity competition.2 Proﬁts for duopolist ﬁrms in three development stages Stochastic proﬁts Time t ≤ TL TL ≤ t ≤ TF t ≥ TF Industry structure No one invests Only one invests (ﬁrm i leads) Both ﬁrms invest Firm i 0 i πL i πC Firm j 0 0 j πC Certain proﬁts Firm i 0 i πL i πC Firm j 0 0 j πC . no one invests and the two ﬁrms earn no proﬁts. π L or π C. earning Cournot duopoly proﬁts. which follows a (time-homogeneous) Itô process according to the stochastic differential equation dX t = g ( X t ) dt + σ ( X t ) dzt. When the market becomes more mature (i. Suppose that due to a cost advantage one of the ﬁrms (ﬁrm i) is more likely to become a leader. We assume as before that stochastic proﬁts can be decomposed into two components.e. the follower also enters and both compete in the foreign marketplace.

Π ( XT ) measures the proﬁtability of the strategy that prescribes to invest at a speciﬁed trigger level XT . as before. I (11. given that it selects the strategy to invest at time T . Equation (11. Investment Decision of the Second Entrant (Follower) The follower contemplates investing in the foreign country when the trigger exchange rate it has chosen..9) above shows that the follower can choose its trigger myopically. We analyze the leader’s strategy formulation subsequently.e. ε B ( XT ) + ε V ( XT ) (11.11) where TF * = inf t ≥ 0⏐ X t ≥ X F * and Π ( X F *) − 1 is the excess proﬁtability index (higher than zero). This measure is given by Π ( XT ) = ε B ( XT ) . is ﬁrst reached at random time T ≡ inf t ≥ t0 ⏐ X t ≥ XT . The value of the option for follower ﬁrm j given that it follows the optimal investment strategy given in equation (11. meaning its investment trigger is exactly the same as the one it would have chosen as a monopolistic option holder j earning π F ( X t ) in perpetuity from time TF * on. For X 0 ≤ XT . The forward net present value at time T is NPVT ≡ VT − I with VT ≡ V ( XT ) . The ﬁrm has an option to postpone investment and will optimally invest when the investment trigger X F * that maximizes the follower’s value Fj (⋅) in equation (11. XT . the expected present value accruing to the follower Fj (⋅). (11. is { } Fj ( XT ) = NPVT B0 (T ) = (VT − I ) B0 (T ). provided this critical target value has not previously been reached (i. This is the same value expression for the { } .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 . (11.8) is ﬁrst reached.8) instead. provided that X 0 ≤ X F *).10) Π ( X F *) is the proﬁtability required when the ﬁrm formulates the optimal investment strategy.9) where.Leadership and Early-Mover Advantage 341 optimal strategy ﬁrst as it does not depend on the leader’s market-entry choice. receiving today Fj ( XT ) as per (11.9) reads therefore Fj ( X F *) = [Π ( X F *) − 1] IB0 (TF *). The optimal trigger X F * for the follower satisﬁes the ﬁrst-order condition V* = Π ( X F *).

Alternatively. is linked to the follower’s decision concerning investment timing. • In the ﬁrst stage (t ≤ t ≤ T ). ∞ ). the leader invests at time TL and earns temporary monopoly proﬁts until the follower (ﬁrm j) also invests at future (random) optimal time TF *. the leader receives reduced-form duopoly proﬁts. one can reformulate equation (11. E0[⋅] stands for the risk-neutral expectation conditional on the information available at time t = 0 . proﬁts are eroded due to the arrival of competition with proﬁts i reduced to duopoly competition rents π C. in the third stage [TF *.20).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. in the second stage [TL.12′) . TL ). Investment Decision of the First Entrant (Leader) The value of the leader. • • Once the follower has also entered the market (t ≥ TF *). the leader receives stochastic monopi oly rents π L (discounted back to present time t0 = 0). The follower thus invests as if it were a monopolist ignoring rivals. ˆ 18. no one invests and the leader earns zero proﬁt. When the incumbency proﬁts are sufﬁciently high for the leader to proﬁtably enter (but not large enough for the follower to invest). the leader earns no proﬁt (while no one 0 L invests). In the second stage (TL ≤ t ≤ TF *). There is no sustainable ﬁrst-mover competitive advantage for the ﬁrst entrant. TF *). however.12) as Li ( X L . X F *) = f1(TL ) − f2 (TF *) where the functions f1(⋅) and f2(⋅) are given by 17. If X 0 < X L. It is given by18 TF * ∞ i i ˆ Li ( X L . ⎢ ⎥ TF * ⎣ TL ⎦ (11. (11. X F *) = E0 ⎡ ∫ π L ( X t ) e − rt dt + ∫ π C ( X t ) e − rt dt − I e− rTL ⎤.342 Chapter 11 monopolist in equation (9.12) In the ﬁrst stage [ t0 . it will earn temporary monopoly proﬁts until the follower also enters. the history of the market for the leader is characterized by three sequential stages. There is a discontinuity in the leader’s proﬁt function at the time the follower’s investment takes place: before TF * the leader receives monopoly proﬁts but just after the rival enters the leader’s proﬁt jumps down i i to competitive duopoly rents (π C (⋅) < π L (⋅)).

Suppose that two European electric utilities. This expanded NPV for the leader (as monopolist) is.19 Two effects must be accounted for. In other words. on the other hand. The option value for the ﬁrst entrant (leader) consists of two terms.Leadership and Early-Mover Advantage 343 ∞ i i ˆ f1(TL ) = E0 ⎡ ∫ π L ( X t ) e − rt dt ⎤ − I B0 (TL ) = [VTL (π L ) − I ] B0 (TL ) ⎣ TL ⎦ = NPVTL B0 (TL ) ∞ i i i i ˆ f2 (TF *) = E0 ⎡ ∫ (π L − π C ) ( X t ) e − rt dt ⎤ = [VTF * (π L − π C )] B0 (TF *). Note that VTF *(π L − π C ) is positive as π L > π C. which depends on when the second entrant invests—not on the investment decision of the ﬁrst entrant. The ﬁrst term. the trigger is selected myopically.10). VTF * (π L − π C ). B0 (TL*). ⎣ TF * ⎦ Note that function f2 (⋅) drops out in the ﬁrst-order derivative of Li (⋅. it earns competitive duopoly proﬁts in perpetuity. the ﬁrst entrant loses its monopoly proﬁt stream in perpetuity when the second entrant decides to invest (at random time TF *). Consider an application from the energy sector. 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.2 presents the market structure regions depending on the value reached by the exogenous stochastic demand shock X t . The ﬁrst-order condition leads to the following proﬁtability-index formula: V * = Π ( X L*) I . from that time on. 19. the proﬁt in the second period (duopoly proﬁt) does not impact the leader’s optimal investment strategy X L* or. This second (competitive-erosion) component. The Nash equilibrium value (expanded NPV) of the leader is thus i i i Li ( X L*. . [VTL * (π L ) − I ] B0 (TL*).13) for X 0 < X L*. 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. On one hand. with Π (⋅) deﬁned as in equation (11. The forward NPV. XC *) = [VTL * (π L ) − I ] B0 (TL*) − VTF *(π L − π C ) B0 (TF *) (11. eroded due to the competitive (follower’s) arrival. however. VTL * (π L ) − I . X F *). 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. Figure 11. Enel of Italy and Eon of Germany. is discounted back with use of the expected discount factor B0 (TF *). equivalently.

. Here the sequence of investment is driven by cost asymmetry in the industry. Table 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. Suppose that the exchange rate follows geometric Brownian motion of the form dX t = ( gX t ) dt + (σ X t ) dzt. (11. Each ﬁrm’s strategy once in the market consists in selecting its output given its rival’s strategy. though realized future growth will likely ﬂuctuate around this long-term average depending on the volatility σ . sharing an option to invest.15) where Q is total industry output. If ˆ 20. The case above corresponds to a continuous-time extension of the model of Smit and Trigeorgis (1997) by Joaquin and Butler (2000).3. (11.344 Chapter 11 No investment Monopoly Duopoly −∞ XL* XF * ∞ Figure 11.14) where zt is a standard Brownian motion. The local currency has had an annual drift of g percent and is expected to move forward similarly. Equilibrium (reduced-form) proﬁts are Cournot duopoly outcomes as obtained previously in chapter 3.20 The (deterministic) proﬁt component in local currency is driven by the (inverse) linear demand function p (Q) = a − bQ. we assume that g ≡ r − δ > (σ 2 2). For technical reasons (ﬁniteness of the ﬁrst-hitting time). which provides valuable insights into real-world investment games. They are summarized in table 11.3 Proﬁts in asymmetric Cournot duopoly Industry structure Leader Follower Monopoly proﬁts i πL = Duopoly proﬁts i πC = (a − ci ) ² 4b (a − 2ci + c j )2 9b 9b NA j πC (a − 2c j + ci )2 = contemplate investing in an eastern European market.

17) ˆ ˆ ˆ with α = g − (σ 2 2). Thereafter. As discussed in the discrete-time analysis in the Cournot setup. they will earn asymmetric Cournot proﬁts.Leadership and Early-Mover Advantage 345 one of the two ﬁrms invests ﬁrst. Social optimality is reached when the low-cost ﬁrm invests ﬁrst since higher cumulative proﬁts are reached. as both ﬁrms are operating in the market. Such sequential investment is characteristic of an industry with asymmetric costs. then 21. or ⎝ β 1 − 1 ⎠ ( a − 2 c H + cL ) 2 j πC XF * 1 = r + β1σ 2 . 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. Firm j is the follower. g = r − δ . it will enter at the time when the leader’s optimal investment threshold is ﬁrst reached. The two competing ﬁrms may agree that the Pareto-optimal equilibrium is a focal point of the game. just as its rival.16) where β1 (in the risk-neutral case) is given by β1 = − ˆ ˆ 2 α r ⎛α⎞ + ⎜ 2⎟ +2 2 2 ⎝σ ⎠ σ σ ( > 1) (11.18) The equilibrium value for the leader (ﬁrm i) from (11. use of Schelling’s (1960) focal-point argument suggests a more likely Nash equilibrium solution for this sequential investment game. 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.11) is ⎛πj ⎞⎛ X ⎞ Fj ( X F *) = ⎜ C X F * − I ⎟ ⎜ 0 ⎟ ⎝ δ ⎠ ⎝ X F *⎠ β1 ⎛ X ⎞ = (Π* −1) I ⎜ 0 ⎟ . 9 bδ ⎛ β ⎞ XF * = ⎜ 1 ⎟ I .21 Suppose that here ﬁrm i has a substantial cost advantage ensuring it the position of cost leader. The reader can intuit which of the two equilibria is likely to occur.13) is (for X 0 < X L*). In this case the equilibrium value for ﬁrm j as follower from (11. 2 I (11. Π* = β1 ( β1 − 1) is the proﬁtability index and the investment trigger X F * satisﬁes the modiﬁed Jorgensonian rule of investment. . The ﬁrst entrant will temporarily earn monopoly proﬁts up to the random time when the follower’s trigger value X F * is reached. A social planner would have an incentive to promote this equilibrium and enforce it on the two ﬁrms. ⎝ X F *⎠ β1 (11. The ﬁrst entrant will earn Cournot duopoly rents.

18) is 2.3 shows simulated results for this example.27.15) is characterized by a = 50 and b = 5.27 − 1⎟ ( 50 − 2 × 20 + 18 )2 ⎠ From equation (11.02. .17) is β1 = − 0.10 and α = g − (σ 2 2) = 0. The linear (inverse) demand in equation (11. Example 11.05. 2 I (11. Readers may derive the second Nash equilibrium as an exercise. The opportunity cost of delaying or dividend yield is δ = 4 percent. one gets the deferral option value of the two ﬁrms as a function of the initial value X0. the elasticity of the investment option based on equation (11. ⎜ ⎝ 2. and cH = 20 for the high-cost ﬁrm.015.19) β1 ˆ with δ ≡ k − g = r − g ( > 0 ) being a form of convenience or dividend yield.20) The two equations above conﬁrm the results obtained by Joaquin and Butler (2000). + ⎛ + ⎜ 2 2⎟ ⎝ 0. They are analogous to equation (9. Given these parameters.70. The investment cost (exercise price) I amounts to &500 m.04 XF * = ⎛ × 500 = 2.015 ⎞ 2 (0. Figure 11. X F *) = ⎜ L X L* − I ⎟ ⎜ 0 ⎟ ⎝ δ ⎠ ⎝ X L* ⎠ β1 X *⎤ ⎛ X ⎞ i i − ⎡(π L − π C ) F ⎥ ⎜ 0 ⎟ . or ⎝ β1 − 1⎠ (a − cL )2 j π L X L* 1 = r + β1σ 2 .27 ⎞ 9 × 5 × 0. The risk-neutral ˆ drift for the foreign country is thus g ≡ r − δ = 0.10 ⎠ 0.06 ) ≈ 2. The duopolists face cost asymmetry: the unit cost for the low-cost producer is cL = 18. The risk-free rate is r = 6 percent.19).015 0.10 0. ⎢ δ ⎦ ⎝ X F *⎠ ⎣ (11.20). The y-axis represents the value functions of the leader and the follower 22.16) and (11.25). The volatility of ˆ ˆ the exchange rate is σ = 0. 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.22 By substituting these values into the expanded-NPV expression for the follower and the leader in equations (11. the investment trigger for the low-cost ﬁrm is X L * = 0.10 2 2 The investment trigger of the second-entrant obtained from equation (11. and X L* such that ⎛ β ⎞ 4 bδ X L* = ⎜ 1 ⎟ I .346 Chapter 11 ⎛πi ⎞⎛ X ⎞ Li ( X L*.1 Duopoly Consider two ﬁrms competing in quantity.

The preceding model of sequential investment may be realistic than the previous models involving simultaneous investment—which assumed simultaneous investment is the industry equilibrium.5 2. δ = 4 percent. In this case the high-cost ﬁrm never enters and the low-cost ﬁrm (as ﬁrst entrant) enjoys monopoly proﬁts in perpetuity. When the cost differential between the two ﬁrms gets very high (approaching inﬁnite).5 XL* XF* Initial value X0 Figure 11. cL = 18 . 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. The parameters of the stochastic (risk-neutral) process (GBM) are r = 6 percent. and σ = 10 percent.000 E-NPV leader 750 500 E-NPV follower 250 NPV follower 0 0. and cH = 20 . The follower’s NPV is tangent to this curve at XF*.250 1. for the relevant exchange-rate regions.0 0. b = 5.05 is readily seen.0 2. with the low-cost ﬁrm being the leader and the high-cost ﬁrm the follower.Leadership and Early-Mover Advantage 347 Project value (in millions of euros) 1. The asymmetric model presented here stresses the importance of asymmetric variable .0 1.3 Leader and follower values in asymmetric duopoly The deterministic linear demand and proﬁt function parameters are a = 50. this stems from the myopic stance of the follower.5 1. the result of the previous model reduces to McDonald and Siegel’s (1986) result for the investment-timing problem of a monopolist. Investment cost is I = 500. in equilibrium. A kink in the leader’s value at the follower’s investment trigger X F * = 2.

The risk-free interest rate is r and optionholding ﬁrms have the same beliefs about the underlying exogenous shock evolution (drift and diffusion terms). See the discussion in note 16 above.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. .. In case of an additional multiplicative shock. When the low-cost ﬁrm is the ﬁrst entrant (as ∂X L* ∂ci > 0 and ∂X F * ∂ci < 0 ). 25. from “substantial” cost asymmetries among ﬁrms active in the industry. .. . its proﬁt will drop if a new rival ﬁrm enters the market. 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. Formally. resulting in higher ﬁrm value. this deterministic proﬁt ﬂow can be readily transformed to a stochastic proﬁt ﬂow by multiplying by X t . ..20) as π C ( m) = 1 a−c b m+1 ( ) 2 .348 Chapter 11 costs and cost leadership in investment timing games. where m is the number of ﬁrms which have already invested. If ﬁrm i has already invested.23 In addition to the traditional. A delayed competitive entry may result due to a substantial cost advantage enjoyed by the leader. n − 1. . n). . 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. (3) it increases its proﬁts as Cournot duopolist in the second stage once the high-cost ﬁrm enters. In case of quantity competition in a Cournot oligopoly. causing discontinuity in the proﬁt ﬂow. 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. proﬁt-ﬂow beneﬁts a ﬁrm obtains from following a generic cost-leadership strategy. 11.25 The investment cost (exercise price) I i is speciﬁc to ﬁrm i ( i = 1.24 The uncertain proﬁt accruing to ﬁrm i (i = 1. for instance. (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). . The initial value of the stochastic process is X 0. . 24. This “natural” sequential investment may result. 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 j i 23. n ) is denoted by π i ( m). the certain equilibrium proﬁts for an oligopoly with m identical ﬁrms are given in equation (3. . . π i ( m) is such that π i ( m + 1) ≤ π i ( m) for all m = 1.

(11. . . ⎦ n ) one obtains ∞ Tm Ti ˆ ˆ ˆ g (T ) = E0 ⎡ ∫ π i ( n) B0 (t ) dt ⎤ + ∑ E 0 ⎡∫ {π i ( m − 1) − π i ( m)} B0 ( t ) dt ⎤ − E0 ⎡∫ π i ( i ) B0 ( t ) dt ⎤ . In Nash equilibrium. X i * maximizes Fi (⋅. Letting T ≡ (T1 . X − i ). ⎢ ⎥ ⎣ 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 ) . X − i ) = [VTi ( i ) − I i ] B0 (Ti ) − m= i +1 ∑ [V n Tm ( m − 1) − VTm ( m)] B0(Tm ). Assuming X 0 < X i *. X − i *) given that rivals also act optimally following investment triggers X − i *. The expression in equation 26. ⎩ ⎭ m= i + 1 m =i +1 Recognizing that the term in brackets {⋅} is zero.Leadership and Early-Mover Advantage 349 investment trigger is ﬁrst reached at random time Ti. What really matters is to determine the investment trigger X i * when ﬁrm i should optimally invest. the values of all entrants (except the last one) depend on when and how many other ﬁrms enter afterwards. Tn ) and n ˆ ⎡ g (T ) = E0 ⎢ ∑ ⎣ m =i (∫ Tm+ 1 Tm ⎤ π i (m) B0 (t )dt ⎥.21) above results. the value for ﬁrm i is given by Ti +1 Ti + 2 ˆ Fi ( X i . where X − i stands for the investment triggers of all other ﬁrms except ﬁrm i. 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 ) = E0 ⎡ ∫ π i (i ) e − rt dt − I i e − rTi + ∫ π i (i + 1) e − rt dt + … + ⎢ Ti Ti +1 ⎣ ∞ ∫Tn π i ( n) e− rt dt ⎤ ⎦ ⎤ ⎡ n Tm+1 ˆ π i ( m) B0 ( t ) dt ⎥ − I i B0 (Ti ) = E0 ⎢ ∑ ∫ Tm ⎦ ⎣ m=i 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). we see that equation (11. ⎢ ⎥ ⎢ ⎥ ⎢ ⎥ ⎣ 0 ⎦ m=i+1 ⎣ 0 ⎦ ⎣ 0 ⎦ ∞ ˆ Let VT ( n) ≡ E0 ⎡∫ π i ( n ) BT (t ) dt ⎤ . From equation (A.45) in the appendix we have ⎢ T ⎥ ⎣ ⎦ T ˆ E0 ⎡ ∫ π ( X t ) B0( t ) dt ⎤ = V0 − B0(T ) VT . .21) where VTm ( m) is the perpetuity value to ﬁrm i valued at future (random) time Tm when the mth active ﬁrm enters. In such an oligopoly game where followers’ entries affect the investment value of incumbent ﬁrms. .. The value of ﬁrm i (ith investor) obtains as26 ( ) Fi ( X i .

consisting of the perpetuity proﬁt value VTi (i ) minus the investment cost (I i) incurred by ﬁrm i at that time. Therefore ﬁrm i can behave in a myopic way and choose its optimal strategy regardless of followers’ investment time schedules. the appropriate expected discount factor is B0 (Ti ). At time Ti. In this sense it can be treated as exogenous by ﬁrm i. The value of this “exchange. occurring at each random entry time Tm is discounted to the present time (time t0 = 0) by the expected discount factor B0 (Tm ). respectively. In effect the second term in equation (11. Given that the investment occurs at random time Ti. When ﬁrm i selects its optimal investment strategy. (11. VTi (i ) − I i.350 Chapter 11 (11. Π ( XT ) = ε B ( X T ) + ε V ( XT ) ε B ( XT ) = − BX ( XT ) × . V* ε B( X i *) The optimal investment rule is. Subsequently.21) represents the present value of competitive erosion. V * = Π ( X i *) I . It only depends on the timing of other rival ﬁrm entries (T− i). of the forward value and the proﬁtability index are given.22) where the elasticity of the discount factor. by XT . at each random time Tm ( m ≥ i + 1) when a new competitor enters.21) can be interpreted as follows. 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 . VT ( XT ) ε B ( XT ) . Note that this competitive loss does not depend on the investment time Ti of ﬁrm i and is consequently independent of ﬁrm i’s investment strategy. equivalently. This occurs for all subsequent competitive arrivals.” VTm ( m − 1) − VTm ( m) . hence the summation. 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. ﬁrm i invests and receives the forward net present value. reduced perpetuity value under the new industry structure (with m ﬁrms).22′) (11. B0 ( XT ) XT ε V ( XT ) = −VX ( XT ) × . terms depending on its followers’ investment strategies drop out.

. n − 1. B0 (T ) = ( X 0 XT ) 1 ..Leadership and Early-Mover Advantage 351 Suppose that the industrywide shock X t is multiplicative (e. Example 11. the expanded net present value under the optimal investment strategy for ﬁrm i (ith investor) is thus β1 β1 n ⎛ X0 ⎞ ⎛ X0 ⎞ F ( X i *. from equation (11. Since π i ( m) ≥ π i (m + 1) for all m = 1.23) with n = 2.24) The ﬁrst right-hand term represents the option value to wait to invest by a monopolist.14). this is XF * = Π* I . The follower will invest later when the trigger X F * is ﬁrst reached. X i *. . . This term represents the present value of exogenous competitive erosion that negatively affects the option value of a stand-alone monopolist option holder. The optimal investment trigger for ﬁrm i.24) with n = 2. The stochastic proﬁt ﬂow then is π i ( m) = X t π i ( m) and the elasticity of the terminal value becomes ε V = −1. In case X 0 ≤ X i *.2 Duopoly Investment Case Consider the duopoly case (n = 2) we analyzed previously. ⎣ ⎦ . From equation (11.. .. . 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. . X − i *) = ⎡Vi (i) X i * − I i ⎤ ⎜ ⎣ ⎦ ⎝ X * ⎟ − ∑ ⎡Vi (m − 1) − Vi (m) ⎤ X m* ⎜ X * ⎟ ⎣ ⎦ ⎝ m ⎠ i ⎠ m= i + 1 (11. so that the second right-hand term in equation (11. 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. being an exchange rate) and follows the geometric Brownian motion of equation (11. Vi (i) (11.24) is negative. For geometric Brownian β motion. The elasticity of the expected discount factor ε B is β1.23) where Vi (i) ≡ π i ( i ) δ and Π* ≡ β1 ( β1 − 1). the expanded NPV for the second entrant (follower) is F ( X F *) = ⎡VF ( 2 ) X F * − I ⎤ B0 (TF *) .g. from equation (11. it obtains Vi (m − 1) − Vi (m) ≥ 0 for all m = 2.22′) is then given by Xi * = Π*I . n.

To allow for a natural ordering of ﬁrms. For expositional simplicity. Denote by ﬁrm i the leader and ﬁrm j the follower.19). 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.14). The expanded NPV for the leader (in case X 0 ≤ X L* ≤ X F *) is L ( X L*. j i Following analogous steps as before (and assuming X 0 ≤ X L* ≤ X F *). In the preceding formulation. the leader must have competitive advantage with respect to both the product-stage competition (proﬁt values) and access to the market (investment cost). ﬁrms may have distinct deterministic proﬁt values and investment costs.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. X F *) = ⎡VL (1) X L* − I ⎤ B0 (TL*) − ⎡VL (1) − VL (2)⎤ X F * B0 (TF *). Box 11.4) times a multiplicative shock X t following the geometric Brownian motion of equation (11. This conﬁrms the result for the follower obtained in a duopoly in equation (11. ⎣ ⎦ ⎣ ⎦ (11. VL (1) = π L δ . suppose stochastic proﬁts consist of deterministic reduced-form proﬁts (given in table 11. ⎤ ⎣ where the optimal investment triggers are given by 27. ⎣ ⎦ (11. . β 11.26) j j i i i Fj ( X L*. The expression above conﬁrms the result for the leader derived previously in the duopoly case in equation (11. it can be seen that the leader and follower’s expanded NPVs are as follows:27 j j i i i i i Li ( X L*. VL (1) with VL (1) being the perpetuity value of monopoly proﬁts for the leader.352 Chapter 11 F where B0(TF *) ≡ ( X 0 X F *) 1 and VF (2 ) = π C δ . The leader’s investment threshold obtains similarly β XL * = Π* I .25) with B0 (TL*) ≡ ( X 0 X L*) 1 . VL (2 ) = π C δ . X F *) = V0i X 0 + ⎡(Δ 1VL ) X L* − I i ⎤ B0 (TL*) + (Δ 2 VL ) X F * B0 (TFj *) . X F *) = V0j X 0 + ( Δ 1VFj ) X L* B0 (TL*) + ⎡( Δ 2 VFj ) X F * − I j ⎦ B0 (TFj *).16) previously.1 gives some ﬂavor to the problem of expanding capacity in lump sum or incrementally in the context of commercial airlines.

2004). Sources: The New York Times. an airline analyst. “Air Canada. The ﬁrst planes would ﬂy Australian and Carribean routes.” said Chris Avery. Virgin’s chairman stated.” . announced in April 2005 that it would buy new lean Boeing aircraft that are more modern and fuel efﬁcient (The New York Times. “Virgin Air Picks Airbus Over Boeing”. April 26. which seat more than 500 passengers. August 6. 2005). Air Canada. “They are trying to reinvent themselves. eliminating costly stopovers in Alaska. a heavy lumpsum capacity expansion commitment with large aircraft vs. an aviation analyst.Leadership and Early-Mover Advantage 353 Box 11. a more incremental and ﬂexible strategy with more lean aircraft to be more adaptive to an uncertain business environment. to Buy Up to 96 Boeing Planes. Other analysts said that Sir Richard’s big order was a big gamble. including China and India.” Sir Richard Branson. Out of Bankruptcy. Virgin Atlantic Airways announced it will increase its ﬂeet with the addition of 13 Airbus 340 aircraft. with options and purchase rights for 46 more 787s.2 of chapter 1. 2004. By contrast. are also reﬂective of the different business strategies of the two main commercial aircraft manufacturers. Robert Milton. The airline had an option for an additional 13 such big planes. discussed in box 1. competing directly with BA. chairman of Air Canada’s parent company. The airline had previously ordered six huge Airbus A380 planes.” These airlines’ different business models and strategies. August 6. he said. The company would also expand its international cargo service. Airbus and Boeing. 2005. 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. which emerged from bankruptcy protection just half a year earlier.” said Richard Aboulaﬁa.1 Lump-sum versus incremental capacity expansion—or big versus small expansion in aircraft ﬂeet In August 2004. a large four-engine airplane that seats more than 300 passengers (The New York Times. and April 26. given the uncertain future for European airlines. Virgin’s new deal represents “a big increase in capacity. “If you are striving for the best. The company plans to add 6. This expansion would nearly double Virgin’s ﬂeet in an effort to beat rival British Airways (BA). this is how you would do it. Boeing said it would be the largest deal so far for its new Dreamliner aircraft if Air Canada buys all 60 planes. The agreement included ﬁrm orders for 14 Boeing 787 Dreamliner jets.000 jobs as it expands. Virgin would “like to ﬂy every route British Airways ﬂies.

it effectively exchanges its old perpetuity proﬁt value for a higher perpetuity value i VL.27) with i ⎧ Δ 1VL ⎪Δ V i ⎪ 2 L ⎨ j ⎪ Δ 1VF ⎪Δ 2 VFj ⎩ i ≡ VL − V0i i i ≡ VC − VL . At time t0 = 0. V ≡ π δ C C ⎩ and Π* = β1 ( β1 − 1) is the proﬁtability index reached at the level of optimal investment. π 0j > π F > 0.354 Chapter 11 Table 11.26) above can be interpreted as follows. Subsequently. The leader’s investment occurs at random time TL*. At the random j i times of added capacity investment. The value expressions for the leader and for the follower in equation (11. at random time TFj * when the follower also invests in added capacity. which mirrors ﬁrm i’s temporary “monopoly” proﬁt stream during i the period TL * ≤ t ≤ TFj *. π > π 0 > 0. ≡ VFj − V0j ≡ VCj − VFj i ⎧ V0i ≡ π 0 δ . TL* and TF *.” ﬁrm i incurs an investi ment outlay I i. j i namely by X L* and X F *.4 Proﬁts in duopoly with expanded capacity option (existing market model) Deterministic proﬁts Time t ≤ Ti Ti ≤ t ≤ Tj t ≥ Tj i L i C i L Industry structure No one invests Only one invests (leader) Both ﬁrms invest Firm i i π0 i πL i πC Firm j π 0j j πF j πC j j j i Note: π > π > 0. VF ≡ π F δ . When it invests in additional capacity at time TL*. the leader gives up its previous perpetuity i proﬁt value VL for the lower perpetuity value of proﬁts as a Cournot i duopolist when both ﬁrms have expanded capacity. so the extra value is discounted at the appropriate expected discount factor i B0 (TL *). π C > π F > 0. the deterministic proﬁts are multiplied by the value of the stochastic shock (exchange rate). XF * = . . j j i i ⎪VC ≡ π C δ . i Δ 1VL Δ 2 VFj (11. V0j ≡ π 0j δ ⎪ i j j i ⎨VL ≡ π L δ . VC . i XL * = Π*I Π* I j . To make this “exchange. 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 i shock X0.

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. so that π i ( m + 1) ≤ π i ( m) for all m = 1. At the outset (time t0 = 0) no ﬁrm has invested in additional capacity. ⎥ ⎦ (11. of which m ( ≤ n) ﬁrms have already invested in additional capacity. Once the leader has invested. An investment strategy for ﬁrm i consists in selecting a target value X i and investing when this trigger is ﬁrst hit. with I i denoting ﬁrm i’s investment cost. .26) is analogous. ⎣ ⎦ m=1 n m= 0 ∑π n i ˆ ( m) E0 ⎡ ∫T ⎢ ⎣ Tm+1 m X t B0 ( t ) dt ⎤ − I i B0 (Ti ). . there are negative externalities (reduced equilibrium proﬁt values) resulting from competitive arrivals. When the follower subsequently invests at random time TFj *. i − 1. . 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. Let π i ( m) represent the proﬁt of ﬁrm i provided that m out of the n active ﬁrms have invested in additional capacities. . .29) 28. that is. the follower receives the certain perpetuity value corresponding to no additional capacity investment. . X − i ) = Vi ( 0 ) X 0 − ∑ ⎡Vi ( m − 1) − Vi ( m)⎤ X m B0 (Tm ) − I i B0 (Ti ). . Once again. the Cournot quantity model is best as reduced-form proﬁt in such a setting. meaning π i ( m) ≥ 0 for m = 0. X − i ) = resulting in Fi ( X i . n − 1..Leadership and Early-Mover Advantage 355 The interpretation for the follower value in equation (11. Firm i may receive proﬁts from the existing market even if it has not yet invested in additional capacity.28) (11. Investment costs are ﬁrmspeciﬁc. The value of ﬁrm i (ith ﬁrm) with an option to expand capacity is given by Fi ( X i . 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 “simultaneous” game. the follower is affected adversely due to the negative externalities of the leader’s investment.14).. it earns V0j multiplied by the initial value of the shock X 0 . At time t0 = 0.28 Oligopoly Case Consider now the more general oligopoly case involving n ﬁrms active in the market (existing market model). the follower effectively gives up its old perpetuity value in exchange for a lower one (VFj ≤ V0j).

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 . the value of ﬁrm i for a given target X i is Fi ( X i . From equation (11. the investment trigger for the follower (ﬁrm j) is given by j XF * = Π*I . 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)). each ﬁrm can behave myopically and invest as if it were a monopolist. the investment timing decision of the ith ﬁrm is independent of its competitors’ investment strategies. Tn+ 1 = ∞ (by convention). Given the presumed “natural” sequencing of investment. . . X − i ) = ∑ Vi (m) ⎡ B0 (Tm ) X m ⎤ − ∑ ⎡Vi (m − 1) X m B0 (Tm )⎤ − I i B0 (Ti ) . From above equation (11. Δ 2 VFj n 29.28). . it obtains Tm+ 1 Tm ˆ Fi ( X i . which differ depending on the industry structure. .. the only difference lies in the perpetuity proﬁt value functions. n.27).” Example 11. Effectively. 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. ⎣ ⎦ ⎣ ⎦ m= 0 m=1 n n+ 1 Equation (11.29) obtains by summation.3 Duopoly Expansion Case Consider again the special case of only two incumbent ﬁrms active in the market (n = 2). and Vi ( m) = π i ( m) δ for m = 0. X − i ) = ∑ π i (m) E0 ⎡ ∫ X t B0 (t ) dt − ∫ X t B0 (t ) dt ⎤ − I i B0 (Ti ) ⎢ ⎥ 0 ⎣ 0 ⎦ m= 0 =∑ n π i (m) ⎡ X 0 − X m+1B0 (Tm+1 ) − X 0 + X m B0 (Tm )⎤ − I i B0 (Ti ) ⎦ δ ⎣ m= 0 n m= 0 = ∑ Vi ( m) ⎡ B0 (Tm ) X m − B0 (Tm+1 ) X m+1 ⎤ − I i B0 (Ti ) . The ﬁrst-order derivative is ∂Fi ( X i .29 Firm i optimizes its value by selecting the investment trigger Xi at the point where the ﬁrst-order derivative equals zero.356 Chapter 11 where T0 = t0 = 0. holding a shared option to invest in additional capacity. XT ) V ( XT ) = 0 (as δ > 0). ⎣ ⎦ Since lim XT →∞ B ( X 0 .

VL ≡ π L δ . deriving the optimal value and trigger strategies for competing ﬁrms in oligopoly. Joaquin and Butler (2000) discuss an asymmetric duopoly quantity competition model where ﬁrms are ordered in their entries. the sequence of investment may involve a natural ordering. ⎣ ⎦ i i i with Δ 1VFj ≡ VFj − V0j and Δ 2 VL ≡ VC − VL. The investment trigger of the leader (ﬁrm i) is i X L* = Π*I . When a ﬁrm has a “substantial” competitive (e. cost) advantage over its rivals. from equation (11. with δ ≡ k − g = r − g. VCj ≡ π C δ and VFj ≡ π F δ .b) in a deterministic setting. assuming X 0 ≤ X L* ≤ X F *.29) with n = 2 is j j i i Fj ( X F *) = V0j X 0 + (Δ 1VFj ) X L* B0 (TL*) + ⎡(Δ 2VFj ) X F * − I j ⎤ B0 (TFj *) ⎣ ⎦ and for the leader (ﬁrm i) j i i i i i Li ( X L*) = V0i X 0 + ⎡( Δ 1VL ) X L* − I i ⎤ B0 (TL*) + ( Δ 2VL ) X F * B0 (TFj *). We analyzed the option to invest in a new market as well as the option to expand (by a lumpy amount) an existing market. 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. The value for the folj i lower (ﬁrm j).Leadership and Early-Mover Advantage 357 j j ˆ where Δ 2VFj ≡ VCj − VFj . The result above conﬁrms the results obtained in equation (11. Moreover in the present context. Conclusion In this chapter we have shown how the pure-strategy Nash equilibria in investment games can exhibit a sequencing of investment timing..26) for the duopoly case.g. early investors enjoy an early-mover advantage as their value function as leader exceeds their later entrants’ value. Their model is a continuous-time version of Smit and Trigeorgis’s (1997) discrete-time asymmetric duopoly model. i Δ 1VL i i i i i where Δ 1VL ≡ VL − V0i . with the lowest cost ﬁrm entering ﬁrst. even for a priori symmetric ﬁrms. Selected References The formulation of games of sequential investment timing has been introduced by Reinganum (1981a. and V0i ≡ π 0 δ . .

. Domingo C. pp. Smit. Butler.358 Chapter 11 Joaquin. Jennifer F.. Bell Journal of Economics 12 (2): 618–24. and Lenos Trigeorgis. Jennifer F. In Michael J. Brennan and Lenos Trigeorgis.. Han T. 1981a. 324–39. . and Competition: New Developments in the Theory and Application of Real Options. New York: Oxford University Press. Working paper. 2000. Reinganum. Project Flexibility. Competitive investment decisions: A synthesis. On the diffusion of new technology: A game-theoretic approach. Review of Economic Studies 48 (3): 395–405. 1997. Agency. Reinganum. Market structure and the diffusion of new technology. Columbia University. Flexibility and competitive R&D strategies. J. 1981b. eds. and Kirt C.

2. When ﬁrms are nearly identical. In section 12. Fudenberg and Tirole (1985) provide a solution for this coordination problem using symmetric mixed-strategy equilibria in a deterministic. continuous-time setting. Mixed strategies may give further insights and help determine what might happen when ﬁrms are not sufﬁciently distinct.. Throughout the chapter. there are multiple Nash equilibria in pure strategies and the more likely outcome of the game cannot be readily determined. however.3. and the option to expand an existing market in section 12. deriving implications for investment strategies and optimal investment timing in competitive settings. . there appears to be a “coordination problem” in determining who acts ﬁrst and becomes the leader. Investments are still made in sequence but in an industry with n ﬁrms there are n! different pure-strategy Nash equilibria.g.12 Preemption versus Collaboration in a Duopoly In the previous chapter we analyzed oligopoly models involving sufﬁcient competitive advantage or asymmetry such that ﬁrm roles (who is the leader and who the follower) were arguably rather clear and determinable a priori. 1. We discuss the option to invest in a new market in section 12. For simplicity. cost) advantage. we focus the discussion on duopolistic markets. We discuss this approach next and subsequently extend the analysis to option game situations under uncertainty. The chapter is organized as follows.1 When no ﬁrm has a clear competitive (e.1 we present the original deterministic model by Fudenberg and Tirole (1985) to help analyze preemption versus cooperation. we look at the impact of ﬁrm asymmetry on the equilibrium investment behavior of ﬁrms. We then extend this in more complex settings to account for stochastic market uncertainty.

Reinganum ﬁnds that there is a sequencing of investments even if ﬁrms are identical. a natural leader-follower equilibrium results where the ﬁrm with a large competitive advantage invests ﬁrst as part of a focal-point equilibrium. In the duopoly competition stage both proﬁt ﬂows are equal. In the previous chapter we discussed how the model by Reinganum (1981a) might ﬁt certain option game situations. not the market or commercialization stage. The ﬁrst-mover advantage refers to the investment stage only. precommitment to a ﬁxed investment-timing schedule seems rather unrealistic. we apply a reﬁnement of Reinganum’s model of investment timing proposed by Fudenberg and Tirole (1985) who adopt a continuous-time mixed-strategy approach. consider investment-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. In this strategic setting. If there is a large ﬁrst-mover advantage tapped by the leader.2 This setup changes if there is a sufﬁciently large competitive advantage by one of the duopolists. 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. however. Precommitment (open-loop) equilibria fail to capture the fact that ﬁrms may be tempted 2. The model by Reinganum was based on certain simplifying assumptions. Preemption is ruled out in Reinganum’s (1981a) model given the assumed precommitment to a stringent investment timing schedule by both ﬁrms. In the present chapter where coordination problems are explicitly addressed. Preemption is. there exist two pure-strategy Nash equilibria (of the sequential-investment type) that involve a ﬁrst-mover advantage. especially those involving a natural sequencing of investment. 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. Reinganum (1981a). as well as Scherer (1967). possible in Fudenberg and Tirole’s (1985) approach. both ﬁrms will want to invest as the leader to grasp this advantage. 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). . This assumption may be justiﬁed in some cases when implementing an investment decision is fairly timeconsuming or when altering the investment plan is prohibitively costly.1 Preemption versus Cooperation Consider ﬁrst the simpler deterministic case when there is no uncertainty concerning the underlying market.360 Chapter 12 12.

or a simultaneous investor—not simply consider the 3. Fudenberg and Tirole (1985) instead consider closedloop strategies that permit the ﬁrms to condition their play on previous actions given the history of the industry. Their model implies that a ﬁrm can only become a leader by actually investing ﬁrst.. Reinganum formulates open-loop strategies where the ﬁrms’ investment decisions do not depend on the previous play by rivals but only on calendar time. not simply by having some prior cost advantage. b) for asymmetric players. namely an open-loop equilibrium. 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. Fudenberg and Tirole (1985) introduce two notions along which they differentiate their model from Reinganum’s (1981a. 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.5 The revised setup by Fudenberg and Tirole (1985) makes it possible to determine ﬁrm roles endogenously. announcing its commitment decision promptly to alter the rival’s investment schedule. at each time and state) the relative values of being a leader. in contrast with the focal-point argument used in chapter 11 where ﬁrm roles are determined exogenously in case of a large competitive advantage. Leadership is not an inherited “quality” but the result of a move as the actual ﬁrst investor. they require that the optimal closed-loop strategies form a perfect equilibrium. .4 To tackle this coordination issue. both ﬁrms will attempt to be the ﬁrst entrant to seize the ﬁrst-mover advantage. a follower. 4. b). This situation does not emerge in the model by Reinganum (1981a) since ﬁrms are assumed to precommit to an investment plan simultaneously. Fudenberg and Tirole (1985) reﬁne Reinganum’s model by relaxing the assumption of precommitment to a pre-speciﬁed future time. 5. Even if ﬁrms had to precommit to a strict investment-timing schedule. we need to resort to the closed-loop equilibrium concept of investment timing games. a ﬁrm should compare now (i. The equilibrium concept used in case of preemption was introduced by Fudenberg and Tirole (1985) for symmetric players and by Simon (1987a. We here deal only with the case involving identical players and symmetric investment strategies.Preemption versus Collaboration in a Duopoly 361 to undermine their rivals and preempt them to obtain a higher value. the existence of an early-mover advantage may still lead to timing rivalry as each ﬁrm tries to precommit ﬁrst. these are essentially myopic strategies selected regardless of rival’s reactions.e. By this assumption the industry equilibrium is a Nash equilibrium in open-loop strategies.3 This results once again in a coordination problem between option holders: if precommitment to an investment-timing schedule is not enforceable. Endogenous ﬁrm roles imply that in making its investment timing decision. That is. The underlying solution concept is known as perfect closedloop equilibrium. In order to incorporate this feature of endogenously determined ﬁrm roles in equilibrium.

if there exists at least a small time interval (including t) such that the value received by the leader is larger than the 6. qi(⋅) is called atoms function in the optimal control literature. that is. For the sake of generality. the authors use continuous-time mixed strategies and derive the perfect closed-loop equilibrium.5) give a brief overview on timing games including wars of attrition.11 The probability of occurrence of various industry structures can be determined from the strategic-form representation as illustrated in box 12. they may describe new market.7 They adopt a new formalization (presented in appendix 12A) enabling studying such games of timing. 10.” At each “round. Their strategy formulation makes it possible to circumvent this problem by introducing a second function in the strategy deﬁnition. and C (t ) is the individual payoff for each of the two ﬁrms if they invest simultaneously at time t. 7. 9.362 Chapter 12 value of leadership at the beginning of the game. The two-by-two matrix shown in ﬁgure 12. we do not characterize the payoffs as functions of model primitives. 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. 8.” with no time elapsing between “rounds. F (⋅).9 Consider ﬁrst two identical ﬁrms following symmetric strategies. F ( t ) is the payoff for the preempted ﬁrm that invests at a later date (the “follower”). Fudenberg and Tirole (1991.1 represents a repeated game that takes no time to repeat or a game in which rounds are played instantaneously with no discounting. and C (⋅) are. To address the above coordination problem. . 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.” ﬁrms play randomly. More precisely. 389–92). the values of being the leader. respectively. as was done in the previous chapter (where roles were pre-assigned). This representation is allowed by the deﬁnition of qi(⋅) as an atoms function.10 For ﬁrm i or j. time t0). the follower.6 We next discuss the coordination problem in the deterministic case as originally analyzed by Fudenberg and Tirole (1985). existing market (discussed next). The strategic-form game is repeated in “rounds. qi(⋅) allows capturing information that is lost when considering Gi (⋅) only. sec. L (⋅). L ( t ) is the payoff for the ﬁrm that succeeds in preempting its rival at time t ≥ t0 (the “leader”).1.1. the payoffs and action choices at time t (for Gi (t ) = Gj (t ) = 0) are depicted in strategic form as shown in ﬁgure 12. while a second term qi ( t ) measures the instantaneous probability or “intensity” of investing at time t. 4. 1985). An option to wait by the leader contradicts the model assumptions. or a simultaneous Cournot duopolist (discounted back to the outset. See appendix 12A for a precise deﬁnition of the strategy space. Essentially the control and action taken at time t consumes no time to take and implement. 11. or technology adoption models (as in Fudenberg and Tirole. Preemption will occur if at some time t ( ≥ t0 ) there is a ﬁrst-mover advantage.8 Strategy is redeﬁned in terms of two functions in order to describe appropriate continuous-time mixed strategies.

1 Strategic form of the investment timing game at time t qi( t ) measures the instantaneous investing “intensity” by ﬁrm i at time t. A different type of coordination problem involving a war of attrition may occur if instead there is a second-mover advantage. TC *.1 Preemption Preemption is characteristic of markets with a large ﬁrst-mover advantage and high excess proﬁts to be earned by the ﬁrm that enjoys temporary monopoly rents. if there exists an interval of time t ( ≥ t0 ) such that F (t ) > L ( t ). value received as a follower. receiving C (TC *). In such a situation there is an incentive for a ﬁrm to preempt its rival and become the leader.Preemption versus Collaboration in a Duopoly 363 Firm j Invest qj (t) Simultaneous investment Invest qi (t) Wait 1 – qj (t) Sequential investment C (t) C (t) Sequential investment L (t) F (t) Firm i Wait 1 – qi (t) No investment (waiting) Repeat game F (t) L (t) Figure 12. that is. The ﬁrst case involves preemptive timing equilibria. The follower value is not negatively . A continuous-time game-theoretic model involving a war of attrition was developed by Hendricks. Here we focus on preemption. meaning L (t ) > F ( t ). * * and (2) L(TL ) ≤ C(TC ). Weiss. In case of investment in a new market the above inequality clearly holds. instead investing earlier at TL* to become the leader. 12. while the second allows for tacit collusion outcomes that are beneﬁcial to both ﬁrms. they have no incentive to do so. 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 ). Even when ﬁrms may cooperate by waiting to invest at a later date. receiving a higher value L (TL*) > C (TC *). and Wilson (1988).1.

1) reduces to j i pL ≡ pL = pL = 1− q . qi q j .1. The subscript C is being used in the text to stand for Cournot competition or cooperation. Over an inﬁnitesimal time interval. so equation (12.1) with qi . q j ≠ 0. we can reasonably assume that no change in i the market environment will occur so that pL is stationary over such a short time period.a This leads to the following recursive expression: i i pL = qi (1 − q j ) + (1 − qi ) (1 − q j ) pL . and the probability of both ﬁrms waiting until the next “round” and simultaneously investing then. depending on the context. the probability that both ﬁrms invest simultaneously is strictly positive. (12. 1]. is given by the probability of immediate simultaneous investment by both ﬁrms.4) a.4) holds for all values of q ∈[0.1.1. q j ≠ 0. the probability of simultaneous investment is zero.b This probability satisﬁes pC = qi q j + (1 − qi ) (1 − q j ) pC . c.1. plus the probability of waiting and becomi ing the leader in the next “round. yielding i pL = qi (1 − q j ) qi + q j − qi q j (12.1 the probability of simultaneous investment by both ﬁrms as Cournot duopolists. or pC = qi q j qi + q j − qi q j (12.” (1 − qi ) (1 − q j ) pL. In this case equation (12. The connection between these notions will be made clearer in later sections.3) for qi .364 Chapter 12 Box 12. 2−q (12. For q ≠ 0 . . the probabili ity that ﬁrm i is the market leader ( pL) equals the probability of ﬁrm i being the leader now. From ﬁgure 12. pC.2) The probability that ﬁrm i is the follower (with ﬁrm j being the leader) is j 1 − pL.1 Probability of occurrence of various industry structures Given investment intensity qi (t ) ≡ qi .1. b. In case of symmetric strategies. For q = 0 . the expression above simpliﬁes toc pC = q 2−q (≥ 0). qi (1 − q j ). Identical ﬁrms are assumed to follow symmetric (mixed) strategies (q = qi = q j ). For example. for ﬁrm i one can determine the probability of occurrence of certain events at time t .

Figure 12. TP * is the earliest (or ﬁrst) time that the values of being a leader or a follower are equal. a follower (F ). 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. C(t) B F (t) C D F E G C(t) TP* TL* TF * TC* Time (t) Figure 12. Once the follower enters and both (symmetric) ﬁrms compete in the market as Cournot duopolists. or investing simultaneously as a Cournot duopolist (C).. In the region TP * < t < TF * there is a ﬁrst-mover advantage that the leader can exploit. 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. the leader’s value curve is above the follower’s or L ( t ) > F ( t ). they earn the same proﬁts hence values are equalized. For the sake of generality. F (t). it maximizes C (⋅)). TF * is the investment time for the follower.e. . described in Fudenberg and Tirole (1985). expressed in a generic form.Preemption versus Collaboration in a Duopoly 365 Present (time-0) value A L(t) L(t).13 { } 12. The optimal investment times (except the preemption point) can be determined by use of the Jorgensonian rule of investment (see chapter 11). showing the present (time-0) expected value of being a leader (L). the payoffs accruing to the players are. TC * is the later investment time that maximizes joint investment value under simultaneous investment (i. 13. TP * ≡ inf 0 ≤ t ≤ TL *⏐L (t ) = F (t ) . C ( t ) of simultaneous investment as a Cournot duopolist. for the time being. that is. that is.12 In the graph above.2 Preemption case: L(TL *) > C(TC *) L (t ) is the expected value of being the leader. F (t ) of being the follower.2 illustrates this preemption case.

If ﬁrm j would invest at TL*. neither ﬁrm can do better than receiving the leader value L (TL*) at point A. TP *. Since the rival ﬁrm is worse off by investing now than by waiting.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. We refer to TP * as the preemption time. each ﬁrm will try to preempt its rival and invest just before the rival does. Fudenberg and Tirole (1985) refer to this phenomenon above arising in the case of timing rivalry or preemption as “rent equalization. As a result of the ﬁrst-mover advantage. Prior to this (t < TP *). ﬁrm i will want to invest at time TL* − ε (where ε is an inﬁnitesimal amount). a simultaneous investment by both ﬁrms as Cournot duopolists at time TL*.2 discusses an analogous problem in the context of the ﬁrst recorded auction for the highest “prize. but the preemption time.” At the preemption time TP *. and so on and on. namely when L (TP *) = F (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 indifference between the leader and the follower roles. . In the preemption case. the perfect (closed-loop) equilibrium results in an ordering of ﬁrm roles with deterministic adoption times. would be detrimental to both ﬁrms since C (TL*) < F (TL*) < L (TL*). Firm j will then invest just before that. Ignoring strategic interactions. Competing ﬁrms are just indifferent between being the ﬁrst or the second investor. compared with the (openloop) model we discussed in chapter 11 based on Reinganum (1981a). each ﬁrm would like to invest exactly at optimal time TL* that maximizes the leader’s value. Given the coordination problem resulting from the lack of a natural leader-follower entry sequencing. or point C. Box 12. it is optimal for the rival to wait until optimal time TF * when being a follower results in a higher value. or point A is above B. meaning “rents” are equalized.366 Chapter 12 Provided that L (TL*) > C (TC *).nor second-mover advantage for either ﬁrm. However. L ( t ) < F ( t ) so no one has an incentive to invest earlier than the preemption time TP * as preemption at this stage is not a value-enhancing strategy. 14. C (TP *) < F (TP *) or point G is below D. that is. there is neither a ﬁrst. the investment timing trigger for the ﬁrst-mover is no longer the myopic investment time. In this context one of the ﬁrms (the leader) invests at preemption time TP * and the other (follower) invests at a later date (at TF *). TL*. TP * (for the leader) and TF * (for the follower). at time TL* − 2ε .” At the preemption time TP * one of the ﬁrms will invest ﬁrst.

(Source: Herodotus. see the proof of lemma 4.2 in Huisman (2001.2. I:196 [describing a custom of Eneti in Illyria]. 91).” Rich Assyrians outbid each other in an attempt to obtain the highest “prize. this reference introduces the notion of ﬁrst-mover advantage in this context.” Albeit rich. the Assyrian left with the “maiden of least fairness” is compensated by a monetary payoff so that roles are equally attractive. q j ( t ). the optimal investment triggers arising out of this strategic equilibrium are ranked as follows15 TP * ≤ TL* ≤ TF * ≤ TC *. p. with the ﬁrst “bidder” receiving the “fairest maiden. The “rent equalization” principle might apply here. Then a crier would display and offer them for sale one by one. This suggests (as in chapter 11) an ordering of advantages. “Maidens” are ranked in decreasing value in terms of beauty. Rich men of Assyria who desired to marry would outbid each other for the fairest. and that of rival ﬁrm j. This is in contradiction with the deﬁnition of TL*. the money came from the sale of the attractive ones. This suggests an extension of the rent-equalization principle to more than two “prizes” or roles. when she had fetched a great price. 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. until she fell to one who promised to accept the least. The ﬁrstmover 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. ﬁfth century BC. At the end of the process. TF *] and by deﬁnition of TP*. This can be shown by way of contradiction. could take the ugly ones and money besides.2 The ﬁrst auction and ﬁrst-mover advantage The “Father of History. he put up for sale the next most attractive. the ordinary people. For the inequality TC * ≥ TF *. with the last “entrant” getting the “maiden of least fairness. who thus paid the dowry of the ugly. who desired to marry and had no use for beauty. qi ( t ). Assyrians might bid no more than the “fairest maiden” was worth.) Besides documenting the ﬁrst known auction. selling all the maidens as lawful wives. .Preemption versus Collaboration in a Duopoly 367 Box 12.” gaining a ﬁrst-mover advantage. As shown in ﬁgure 12. Since F (⋅) is increasing in [t0 . 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. namely leader and follower. and then. Suppose TP* > TL* and TP * < TF *. Let us next determine the equilibrium mixed-strategy investment qi * (t ) of 15. it follows that L (TP *) = F (TP *) ≥ F (TL*) > L (TL*). ﬁrst the fairest of all. with a crowd of men standing around.” Herodotus. The Histories. The payoff for ﬁrm i in each region depends both on the intensity (probability) of investment by ﬁrm i.

equation (12. Here discounting plays no role since we deﬁne qi (·) as an atoms function whereby the action takes no time to implement. From equation (12. meaning L (TP *) = F (TP *). so the intensity or probability of investing at TP *. A formal description of the subgame perfect equilibrium is given in appendix 12B. (invest) (wait) The resulting equilibrium investment intensity for ﬁrm i in the subgame starting at time t ∈[TL*. between its own pure-strategy choices (here “invest” or “wait”). L (t ) − C (t ) (12. The resulting equilibrium once again leads to a sequencing of ﬁrm investments.1. it will operate as a Cournot duopolist with probability qi * and as a leader with probability 1 − qi *. At this indifference point it obtains from equation (12. pC.1. ﬁrm i invests with probability qi * = qi * ( t ) and adopt ﬁrm j’s point of view. qi ( t ) = q j (t ) = q(t ). not its own. We suppose that in equilibrium.1) simpliﬁes to q (t ) = φ (t ) ≡ L (t ) − F (t ) . is q (TP *) = 0. each symmetric ﬁrm is just indifferent between being the leader or a follower.4) with q = 0 that the probability of simultaneous Cournot investment. follower or Cournot duopolist) of its rival. If ﬁrm j delays investment. 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*).1). Lj ( t ) − C j (t ) (12. is zero. TF *] is qi ( t ) = φ j ( t ) = Lj (t ) − F j ( t ) . The strategic-form representation of ﬁgure 12.368 Chapter 12 ﬁrm i in the subgame starting at time t ∈[TP *. In a Nash equilibrium mixed-strategy proﬁle. 16. qi ( t ). given the mixed strategy played by its rival. obtained from box equation (12. TF *]. In other words. .1.2) At the preemption time TP *. If ﬁrm j decides to invest. generally depends on the value functions (as a leader. each player is willing to randomize so that it is indifferent.1) Interestingly a ﬁrm’s equilibrium investment intensity.1 helps illustrate this. In the symmetric case. ﬁrm j is indifferent among the two pure-strategy actions if16 qi * C j ( t ) + [1 − qi *] Lj ( t ) = F j (t ) .1. it will receive F j (t ).2) the probability that a ﬁrm becomes the leader at the preemption time TP * (for t0 ≤ TP *) is thus pL = 1 2.

there is a ﬁrst-mover advantage that each ﬁrm wants to grasp immediately (as L ( t0 ) > F ( t0 )).1. A coordination-timing problem arises in determining who leads and who follows suit. Thus. For t0 ≥ TF *. . TF *). is also strictly positive ( pC > 0). each symmetric ﬁrm has a 50 percent chance to become the leader over the play of the game as is illustrated in ﬁgure 12. The resulting market structure for differing values of t0 is illustrated in ﬁgure 12. This “coordination failure” is detrimental to both ﬁrms as C ( t0 ) < F ( t0 ) < L ( t0 ). For TP * < t0 < TF *. Since in this region we have L (t0 ) > F (t0 ). simultaneous investment may obtain as an industry equilibrium. both ﬁrms invest simultaneously resulting in a Cournot duopoly.3.Preemption versus Collaboration in a Duopoly 369 Probability 100% 75% Monopoly (firm i) 50% No investment Cournot duopoly 25% Monopoly (firm j) 0% t0 TP* TF * ∞ Time (t) Figure 12. if t0 ∈ (TP *.2) that the investment intensity for symmetric ﬁrms is q ( t0 ) = φ ( t0 ) ≡ L ( t0 ) − F ( t0 ) > 0. The probability of simultaneous investment at time t0.4. it results from equation (12. L ( t0 ) − C ( t0 ) Therefore someone will invest in this market with positive probability q ( t0 ).3 Probability of industry structure along market development (for t0 £ TP *) For t0 ≤ TP *. obtained from equation (12.4). TF *) coordination may fail to result in an industry equilibrium where one ﬁrm enters as a leader and the other ﬁrm follows. nonetheless if t0 ∈ (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. 12.370 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. as time passes one ﬁrm invests as a leader at time TP * and the other invests later at time TF *.4 Probability of market structure occurring at the outset (t 0 ) The graph is for illustrative purposes. 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. The value functions actually used for L (⋅). and C (⋅) may lead to nonlinear curves separating the monopoly regions from the “coordination failure” region. F (⋅). If t0 < TP *. if the ﬁrst-mover proﬁt advantage for the leader. the gain from preempting its rival is small. is low (close to π C − π F ).1.2 Cooperation in an Existing Market In the case of an existing market. Such a pattern may emerge when the follower’s value differs from the simultaneous Cournot investment value signiﬁcantly. The probability of ending up in a Cournot duopoly in the region TP * < t < TF * (“coordination failure”) is zero (for t0 ≤ TP * < TF *). Existing . Just after the preemption time TP *. π L − π 0. This happens when the follower is unfavorably affected in the intermediate region by its rival’s investment. There is some persistence of the industry structure over time.

C ( t ) of simultaneous investment as a Cournot duopolist.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. market models may exhibit such tacit collusion or cooperation among option holders. In this case neither ﬁrm has an incentive to invest earlier than its competitor. resulting in numerous simultaneous investment equilibria ( t ≥ t0 ⏐C (t ) > L (TL*) ). Figure 12. TC *] when the value of simultaneous (joint) investment just equals the optimal leader value (point C in ﬁgure 12. when TC ≡ inf TF * ≤ t ≤ TC *⏐C(t ) = L(TL*) . which rules out preemption.5 Joint investment/collaboration: C(TC*) ≥ L(TL*) L (t ) is the expected value of being the leader. C (t) F C (t) TP* TL* TF * TC TC* Time t Figure 12. There exists a region t ≥ t0 ⏐C (t ) > L (TL*) where the value of simultaneous or joint investment exceeds the value of being a leader. 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. As { { } } { } . one of them appears most reasonable.5). while new market models do not since the follower earns no proﬁt ﬂow in the intermediary region. Let TC be the earliest time within [TF *. F (t). F (t ) of being the follower. The equilibrium involving joint investment at time TC * Pareto-dominates all other joint-investment equilibria. that is.Preemption versus Collaboration in a Duopoly 371 Present (time-0) value L (t) F (t) D A C B L (t). In this region both ﬁrms invest immediately at time t (rather than invest earlier at TL* for a lower value). Although there is a continuum of joint-investment equilibria starting at time TC .

but it does not address the coordination or entry sequencing problem under (exogenous) market uncertainty. Consequently. π C are.2). . In case of entry into a new market. From the Jorgensonian rule of investment. and then consider the impact of ﬁrm asymmetry on the optimal investment strategies. the proﬁt ﬂows before and after both ﬁrms have invested. The preceding deterministic setting needs to be extended. the follower—which is not operating at the outset—does not suffer a proﬁt value drop upon entry by the rival. ﬁrst when ﬁrms are identical and follow symmetric investment strategies.17 the second is a continuum of joint-investment equilibria for t ≥ TC. and I is the required investment outlay.2. provided that the market grows at a constant growth rate g (per unit time).2) and (12. π 0.2 discusses entry into a new market. 18.1. We discuss here coordination issues arising in new market models. If TP * < t0 < TF *.4) and (12. if L (TL*) ≤ C (TC *).2). respectively.3. resulting in a sequential preemptive ordering equilibrium where the leader invests at TP * and the follower at TF *.2 Option to Invest in a New Market under Uncertainty The previous analysis based on Fudenberg and Tirole (1985) was developed in a deterministic environment. This type of structure occurs with positive probability 2 pL . TC * is the most attractive among all possible equilibria. The second is simultaneous investment at the outset ( t0 ). A formal description of the tacit collusion perfect equilibria (including the Pareto-superior one) is provided in appendix 12B. This creates a motive to invest before one’s rival. The ﬁrst is a sequential preemptive equilibrium with one ﬁrm investing at time t0 and the other at TF *. For TF * < t < TC . It provides useful insights into how ﬁrms interact in games of timing and how preemption or tacit collusion may result.2 and 12. and section 12. there exist two classes of equilibria: the ﬁrst class is the sequential ordering equilibrium discussed earlier with investment times TP * and TF *.3 extends the analysis to cases where ﬁrms earn an initial proﬁt ﬂow before expanding investment (existing market models). occurring with positive probability pC obtained from equations (12. The values of the 17. Here r is the discount rate. leveraging the insights from real options analysis to add more realistic guidance to strategic investment under uncertainty. the leader and follower roles can be reversed.18 12.1.372 Chapter 12 suggested by Fudenberg and Tirole (1985). TC * = 1 g × ln (rI (π C − π 0 )). with pL obtained from equations (12. two types of industry equilibrium may emerge. the value of being a leader is higher and there is a ﬁrst-mover advantage leading to preemption. We address this challenge in sections 12. Section 12. the most reasonable of which is joint investment at common time TC * that maximizes joint proﬁts.

the proﬁt of the leader drops and subsequently equals that of the follower.2. (12. π ( = π L . This simpliﬁed model was discussed in Dixit and Pindyck (1994) and Nielsen (2002). there is no lasting ﬁrst-mover advantage with respect to the proﬁt ﬂow. Assume that the “risky” proﬁt ﬂow π consists of a certain or deterministic proﬁt ﬂow component. The uncertain proﬁt ﬂow is thus π = X t π . The proﬁt ﬂow of the monopolist (π L) is higher than that of a Cournot duopolist (π C).3) with constant drift g and instantaneous volatility σ . Smets discusses the case of a duopoly where two ﬁrms have a shared option to make an irreversible investment to enhance their incumbency proﬁts. and Huisman and Kort (1999) involve an option to expand (existing market models). accounting for industrywide shocks. Grenadier (1996).9) VC X F * = Π* I (> 1) (12. We discuss Smets’s (1991) actual model in the next section as it deals with the option to expand an existing market. As before. Consider ﬁrst the problem faced by the follower. equation 11.1 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. Thus.Preemption versus Collaboration in a Duopoly 373 follower and of the simultaneous Cournot investment are equal. The optimal investment trigger for the follower (F ) is given by the markup rule (see chapter 11. 12. X t . where X t follows the geometric Brownian motion dX t = ( gX t ) dt + (σ X t ) dzt . Suppose that the leader has already invested and currently the second investor contemplates entry. and a multiplicative stochastic process component. π C ). . The models by Smets (1991). at the time the follower invests. We introduce here a simpliﬁcation of that model involving the option to invest in a new market.1. cooperation or tacit collusion (described in previous section 12. and π C ( ≥ 0 ) the deterministic proﬁt ﬂow earned by each ﬁrm when they are both operating as Cournot duopolists. Fudenberg and Tirole’s (1985) model presented earlier is an existing market model in a deterministic setup.4) 19. π L ( ≥ 0 ) stands for the deterministic proﬁt ﬂow of the ﬁrst investor (leader) when it is the only ﬁrm in the market.19 Consider two identical ﬁrms that follow symmetric (mixed) strategies.2) does not occur.

VC X 0 − I . X F *) = ⎨ if ⎪VC X 0 − I ⎩ β1 X 0 < X F *. 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. As a result. receiving the committed project value or static NPV. Equivalently. the follower is indifferent between investing or keeping its deferral option alive (value-matching condition). 2 I At this threshold. thereby killing their option to defer. since the leader will invest early (at t0). ⎝ X F *⎠ (12. (12. X 0 ≥ X F *. πC XF * 1 = r + β1σ 2 . The value for the follower pursuing the optimal investment strategy is given by { } ⎧(VC X F * − I ) B0 (TF *) if ⎪ F( X 0 . The optimal trigger X F * is reached at random time TF *. When ﬁrm roles are endogenous. with TF * ≡ inf t ≥ 0⏐ X t ≥ X F * .5) ˆ ˆ ˆ with α = g − (σ 2 2).7) For X 0 < X F *. there is no need to determine an optimal investment timing trigger X L* for the leader. This is a major difference between the model we discussed in chapter 11 and the model presented here. r being the risk-free interest rate.374 Chapter 12 with VC ≡ π C δ . Π* ≡ β1 (β1 − 1). X F *. (12. X F * is the ﬁrst threshold at which the return on investment equals the modiﬁed Jorgensonian discount rate.8) . the follower receives no proﬁt prior to investing. The entire value consists solely of its option to defer the investment. it is contradictory to assume an option to defer for the leader since ﬁrms take the lead by actually investing ﬁrst. For X 0 ≥ X F *. and I being the investment cost. and β1 given by β1 = − ˆ ˆ 2 α r ⎛α⎞ + ⎜ 2⎟ +2 2 2 ⎝σ ⎠ σ σ ( > 1) (12. g = r − δ . the follower has a dominant strategy to invest immediately.6) with the expected discount factor given by ⎛ X ⎞ B0 (TF *) ≡ ⎜ 0 ⎟ . X 0 ≥ X F *. When considering endogenous ﬁrm roles.19). 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 ⎪ L ( X0 ) = ⎨ if ⎪VC X 0 − I ⎩ 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). If both ﬁrms enter.56 . minus the discounted value difference (competitive value erosion) resulting from the rival’s entry at random time TF *. they compete in quantity (Cournot competition) and face deterministic linear demand p(Q) = 50 − 5Q. Once the leader has invested at current time t0 . the value of investing now (at t0) as the leader equals the net present value as a monopolist. and . δ ˆ ˆ Note that α = g − (σ 2 2) = 0. 778 .045. The risk-free rate is r = 7 percent (and the dividend yield is δ = 2 percent). it has no further growth investment opportunities and merely suffers from any adverse developments in the market. each ﬁrm would earn πC = ( a − c )2 9b = (50 − 10 )2 9×5 ≈ 35. For X 0 < X F *. 000 .2. a monopolist ﬁrm would make excess proﬁt equal to πL = (a − c )2 4b = ( 50 − 10 )2 4×5 = 80. For X 0 ≥ X F *. such as entry by the follower. δ 0. c = 10.Preemption versus Collaboration in a Duopoly 375 with VL ≡ π L δ and B0(TF *) as given in equation (12.05 − (0. VL X 0 − I . Firms have symmetric variable production cost.1 Symmetric Preemption Suppose that two ﬁrms share the option to invest in a new market for a ﬁxed investment cost I = 100. both earning VC or a net present value VC X 0 − I . In Cournot competition. Example 12. Deterministic proﬁts are subject to an exogenous multiplicative shock ˆ that follows a (risk-adjusted) geometric Brownian motion with g = 5 percent and σ = 10 percent. The value of being a monopolist forever in perpetuity is VL = πM 80 = = 4. A special case is discussed next.01 2) = 0. panel A).7).02 while Cournot duopoly value is VC = πC ≈ 1. According to the analysis in chapter 3 (see table 3.

057). both ﬁrms enter the market immediately earning the same economic proﬁts (π C). Figure 12. + ⎛ +2× ⎜ ⎝ 0.22. X P * ≈ 0. C 1778 V The entry threshold for the leader in case of preemption cannot be readily obtained. specify the follower’s and leader’s values from equations (12. as the leader enjoys a higher proﬁt while being the sole ﬁrm active in the market. β1 − 1 1.057.6) and (12. For X P * < X 0 < X F *. that is.35 β1 ≈ ≈ 3.045 0. By rent equalization.35 − 1 We can now determine the follower’s entry threshold from equation (12. exceeds the follower’s. Given the parameter values obtained above. the follower) randomly. the leader’s value. For X 0 < X P *.01 0.35.6 illustrates these value functions for the follower and the leader as given in equations (12. the leader’s threshold is obtained at the process value X P * that equalizes L( X P *) = F ( X P *.84 × ≈ 0. as a function of the starting value X 0 . we can.8). however.01 ⎟ ⎠ 0. for example. The actual ﬁrst investor will get the leader’s value and the follower will wait until the follower’s trigger X F * (≈ 0.376 Chapter 12 β1 = − =− ˆ ˆ 2 α r ⎛α⎞ + ⎜ 2⎟ +2 2 2 ⎝σ ⎠ σ σ 0.6) and (12.045 ⎞ 0. the value as a leader exactly equals the value as follower (rent equalization). . the option value as a follower exceeds the net present value of investing early as a leader. on the ﬂip of a fair coin. respectively. for a net present value VC X 0 − I . The leader incurs an investment cost I prohibitively large compared to the proﬁt ﬂow accruing to it and the value of investment commitment is largely negative. X F *).01 2 The required proﬁtability index is Π* = 1. At the preemption time TP * ( X P * ≈ 0.22 ) is ﬁrst reached.07 ≈ 1. For X 0 ≥ X F *. There are two equilibria where the ﬁrm roles are permuted.4): X F * = Π* I 100 ≈ 3. X F *). In this case (with X 0 ≤ X P *) the two ﬁrms are indifferent at time TP * between being the leader or the follower and would accept to be the leader (respectively. L ( X 0 ).84 . F ( X 0 .8).

XF*) 400 300 200 Leader’s value L(⋅) 100 Follower’s value F (⋅. δ = 2 percent.2) still holds in the stochastic case. ˆ g = 5 percent. A formal description of the perfect equilibrium strategy proﬁle is given in appendix 12B. V(qi . It obtains V( qi .20 If the market starts at low levels ( X 0 < X P *). Considering mixed strategies.05 0. q j ) be the expected value as a function of the equilibrium strategies of the option-holding ﬁrms. q j ) = [ L + (1 − q ) F − q ( L − C )] ( 2 − q ). Firms have symmetric variable production cost. q j ) = F obtains. Let V( qi . X F *).25 0.2). q j ) = pL ( L + F ) + pCC . F (⋅.1.Preemption versus Collaboration in a Duopoly 377 L (⋅). Threshold values are derived in example 12.30 XP* (100) XF * ≈ 0.6 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.1.1. the probability that each ﬁrm takes the lead at the preemption point X P * is pL = 1 2. at the preemption time TP * the investment probability (intensity) is q(TP *) = φ ( X P *) = 0.1.15 0.2) and (12.1. From equations (12.22 Initial value (X0) Figure 12. For very low values of the stochastic process.10 0.20 0.4)) is pC = 0. Investment cost is I = 100 for both ﬁrms. Moreover at random time TP * the probability of a simultaneous investment (determined as the stochastic variant of equation (12.4). c = 10 . 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. . The expected value for the leader at the preemption point equals F ( X P *. From equation (12.1. it results that V(qi . and σ = 10 percent. there is no advantage gained from investing ﬁrst. Since equation (12. XF*) 0 0. the industry 20. r = 7 percent.

378 Chapter 12 Probability of industry structure 100% 75% Monopoly (firm i) 50% No investment Duopoly 25% Monopoly (firm j) 0% X0 0.1) is positive (q ( X 0 ) > 0).06 X F * ≈ 0. g = 5 percent. and both ﬁrms invest simultaneously with positive probability ( pC = q ( 2 − q) > 0).23 in appendix 12C.10 0.05 0.22 Market development (Xt) Figure 12.30 ~ XP* ≈ 0. Investment cost is I = 100 .2 or 12. X P * < X 0 < X F *). however. If the market starts at a value X 0 higher than the preemption point but lower than the follower’s investment trigger (i.20 0.15 0.7. only holds if the market starts at a low value ( X 0 ≤ X P* ). the value as a leader strictly exceeds the value as a follower.7 Market structure evolution ( X 0 < X P *) Assume Cournot quantity competition with linear (inverse) demand p (Q) = 50 − 5Q and ˆ symmetric marginal cost. c = 10 . Threshold values are derived in example 12.e. Their result that each ﬁrm becomes leader over the ﬂip of a fair coin.8. however. In this case the probability to invest (from equation 12. structure evolution along the market development might be as seen in ﬁgure 12.. and σ = 10 percent.21 The industry structure emerging at starting time t0 for different starting values X 0 is illustrated in ﬁgure 12.1. . Dixit and Pindyck (1994) disregard this risk. 21. δ = 2 percent. assuming that each ﬁrm becomes leader with probability one-half.” each ﬁrm would receive lower value C ( X 0 ).25 0. r = 7 percent. If simultaneous Cournot investment occurs due to a “coordination failure.

2. L ( X P *) = F ( X P *.05 0. and σ = 10 percent. In chapter 11 22.6) and (12.8). many option games typically involve coordination problems in determining who is the leader or follower.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 ˆ symmetric marginal cost c = 10 . therefore β VL X P * = I + [VL X F * − I ] ( X P * X F *) 1 > I .22 0.1. Assuming the follower does not make any proﬁt (i. Lambrecht and Perraudin (2003) argue that the NPV threshold corresponds to the preemption point.e. 313).22 Therefore the standard NPV rule does not hold in case of preemption. From equations (12. 23.10 XP* ≈ 0. g = 5 percent. p.15 Intermediate 0. there is full preemption as in the case of a technology ﬁrm acquiring a perpetual patent).. In pure strategies there is only one type of equilibrium characterized by a leader-follower ordering whereby ﬁrm roles are permuted.23 12. δ = 2 percent. This conﬁrms the result shown in Dixit and Pindyck (1994.25 High 0.06 0.Preemption versus Collaboration in a Duopoly 379 Probability of industry structure 100% Monopoly (firm j) 75% 50% No investment “Coordination failure” Duopoly 25% Monopoly (firm i) 0% X0 Low 0. Investment cost is I = 100 . .30 Initial value (X0) Figure 12.2 Asymmetric Case In the intermediate demand region. X F *) = (VL X P * − I ) − [VL X F * − I ] ( X P * X F *)β1 .20 X F * ≈ 0. The leader will only invest (at time TP *) if the current proﬁt ﬂow provides a sufﬁciently high return on the invested capital. At the preemption trigger X P*(< X F *). X F *) ( > 0 ). r = 7 percent. Threshold values are derived in example 12. L ( X P *) − F ( X P *.

In such a case identical ﬁrms can be reasonably assumed to follow symmetric mixed strategies.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. Here we illustrate these insights in the case of an asymmetric duopoly without relying on a focalpoint argument. X F *. Firms are characterized by distinct proﬁt ﬂows depending on the industry structure. Consider ﬁrst the investment decision by the second investor (ﬁrm j ). Here.g. The follower does not fear subsequent investment and therefore selects its investment strategy myopically. as in (12.4). We previously discussed perfect equilibrium in case of symmetric duopolists. have asymmetric variable or ﬁxed costs). Días and Teixeira (2009.. 2010) provide a review of option games in continuous time. The optimal investment trigger j for ﬁrm j as a follower. Tj } Industry structure No one invests Only one invests (leader) Both ﬁrms invest Firm i 0 0 i πL i πC Firm j 0 j πL 0 j πC Ti ≤ t ≤ Tj Tj ≤ t ≤ Ti t ≥ max {Ti . Días and Teixeira (2009) discuss a chicken game applied to oil exploration.1 Deterministic proﬁt ﬂows for asymmetric duopolists Certain proﬁts Time 0 ≤ t ≤ min {Ti . Assume again that the “risky” proﬁt ﬂow π consists of a deterministic component π and a multiplicative stochastic shock.1. These are summarized in table 12. . I (12. Using subgame perfect mixed strategies makes it possible to solve this coordination problem more generally.3). is given by the ﬁrst-order condition j VCj X F * = Π*. they may follow asymmetric mixed strategies. we extend the previous (new market) model to account for production cost differentials.4′) Table 12. Tj } 24. Pawlina and Kort (2006) study asymmetry in a setting where ﬁrms differ in the magnitude of the required investment outlay. following Días and Teixeira (2010).24 Assuming asymmetry among ﬁrms is more realistic and descriptive of many duopolies. X t . When ﬁrms are asymmetric (e. following the geometric Brownian motion of equation (12.

The optimal investment trigger for ﬁrm i as a follower is determined symmetrically. so δ = 2 percent.. X F *) = ⎨ j if ⎪ ⎩VC X 0 − I j X 0 < X F *.9) j with B0 (TFj *) = ( X 0 X F *) and β1 as given in equation (12. X F *}. resulting in a Cournot duopoly.10) i i i i with VL ≡ π L δ and VC ≡ π C δ . Equivalently. Example 12. is j ⎧(VCj X F * − I ) B0 (TFj *) if ⎪ j F j ( X 0 . The leader (ﬁrm i) has no option to wait in case of endogenous ﬁrm roles. In asymmetric Cournot quantity competition (see table 3.1 to allow for asymmetry between ﬁrms. in chapter 3).Preemption versus Collaboration in a Duopoly 381 j where VCj ≡ π C δ and Π* ≡ β1 ( β1 − 1). For X 0 j i higher than the threshold max {X F *. j X 0 ≥ X F *. (12. each ﬁrm has a dominant strategy to invest immediately. 000. Firm L has a cost advantage.5). with cL = 10 < cH = 15. rather than in terms of ﬁxed investment costs. The risk-free rate is r = 7 percent. The value for ﬁrm j as follower (given its optimal investment strategy). similar to (12. in equilibrium the modiﬁed Jorgensonian rule of investment prescribes to invest at the ﬁrst j j (random) time the process X t exceeds X F *.6). Again. H The perpetuity value for the follower is VCH = π C / δ = 20 0.2.2 Asymmetric Preemption We extend example 12. demand is linear with p(Q) = 50 − 5Q but subject to a multiplicative demand shock (GBM) with ˆ g = 5 percent and σ = 10 percent. where X F * satisﬁes the relaj j 2 tionship X F * π C I = r + (β1σ 2). Example 12. panel B.02 = 1. We here consider asymmetry in terms of variable production costs. it receives the value of an irreversible investment commitment given by β1 j i i i ⎧(VL X 0 − I ) − (VL − VC ) X F * B0 (TFj *) if ⎪ Li ( X 0 ) = ⎨ if ⎪ i ⎩VC X 0 − I j X 0 < X F *.2 illustrates these two cases. (12. Two cases can be distinguished depending on whether the cost advantage is large or small. 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). the high-cost ﬁrm would earn H πC = (a − 2cH + cL )2 9b = ( 50 − 2 × 15 + 10)2 9×5 = 20. If it invests now (at time t0). j X 0 ≥ X F *. From this value and the required proﬁtability index Π* derived in .

000 in perpetuity. at X F * ≈ 3.8 .1. the low-cost ﬁrm (L) would earn M πL = (a − cL )2 4b = ( 50 − 10)2 4×5 = 80 .9). The low-cost ﬁrm’s threshold as a myopic leader is L X L * = Π* × I 100 ≈ 3. 250.17 .84 × ≈ 0.27 (< 0. cH − cL = 5. we can determine the high-cost ﬁrm’s investment threshold as a follower: H X F * = Π* × I 100 ≈ 3. Large Cost Advantage Consider as in example 12. In this case the follower will H invest earlier.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 collaborative investment.02 = 2. M which yields value VL = 80 0. 12.38 . L resulting in a perpetuity value of VC = 45 0.84 × ≈ 0.8 0.2.38). 000 VM In Cournot competition.382 Chapter 12 example 12. L 2. 440) ≈ 0. H 1.2 the case of a large cost disadvantage. the low-cost ﬁrm makes an excess proﬁt of L πC = (a − 2cL + cH )2 9b = (50 − 2 × 10 + 15)2 9×5 = 45 .02 = 1.10 . L 4. The leader’s threshold cannot be readily obtained but results from rent equalization.02 = 4.84 × ≈ 0. we have H πC ′ = (a − 2cH + cL )2 9b = (50 − 2 × 12 + 10 )2 9×5 = 28. or perpetuity value VCH ′ = 28.84 × (100 1. 000 VC As a monopolist. The low-cost ﬁrm’s threshold as a follower is L X F * = Π* × I 100 ≈ 3. assuming that ﬁrms pursue their . In this case (see ﬁgure 12. 250 VC If the high-cost ﬁrm’s disadvantage reduces to cH = 12 . 440.

δ = 2 percent.20 0.Preemption versus Collaboration in a Duopoly 383 Firm H value H LH(⋅). with cL = 10 and cH = 15. This is analogous to the open-loop equilibrium discussed in chapter 11 obtained using the focal-point argument in selecting among two pure-strategy Nash equilibria. That is.10 0. r = 7 percent. F H ⋅. A lower cost disadvantage would make ﬁrm L invest later.17 H XF * ≈ 0.25 0. .2.05 0. g = 5 percent. the high-cost ﬁrm thus will wait as a patient follower until H the optimal threshold X F * is ﬁrst reached. value-maximizing strategies. XF * ( ) 400 300 200 Firm H as a follower 100 Firm H as a leader 0 0.40 0.9 Project value as a leader or follower for the high-cost ﬁrm ( H ) The demand function is p (Q) = 50 − 5Q . for a cost differential higher than a given threshold. Firm H ’s value curve as leader would then come “closer” to its value curve as follower and may eventually cross it. High-cost ﬁrm H ’s value as leader is low because in equilibrium the low-cost ﬁrm enters early.25 The low-cost ﬁrm can therefore select its optimal investment trigger myopically. ˆ I = 100 .38 (100) Initial value (X0) Figure 12. Costs are asymmetric. and σ = 10 percent.15 0. making it difﬁcult for ﬁrm H to earn sufﬁcient temporary monopoly proﬁts.35 0. 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.45 L XF * ≈ 0. Figure 12. This result conﬁrms that the focal-point equilibrium considered earlier is appropriate and characteristic of certain industry situations where heterogeneity or asymmetry among ﬁrms is sufﬁciently high. ignoring the investment policy of its rival.30 0. Threshold values are derived in example 12.9 depicts the project value as a leader or follower (as a function of the initial value X 0) for 25. the high-cost ﬁrm (H) never has any ﬁrstmover advantage since its leader value curve is always located below its follower value curve.

10. Small Cost Advantage Consider now the case where the cost differential is not large. X L *. The expanded-NPV for the high-cost ﬁrm (follower) exceeds its immediateH commitment NPV for X 0 < X F *. In this case. The leader’s value (starting in state X 0) is L L L ⎧(VL X L * − I ) ( X 0 X L *)β1 ⎪ L L H H β1 ⎪ − (VL − VC ) X F * ( X 0 X F *) ⎪ L L L L H LL( X 0 . I (12. L H X L * ≤ X 0 < X F *.38.384 Chapter 12 H the high-cost ﬁrm H given its optimal investment threshold X F *.4′′′) As there is no risk of preemption by its rival in this case. X F *) = ⎨ H F ⎩VC X 0 − I if if H X 0 < X F *. The value curves for both ﬁrms are depicted in ﬁgure 12. That is. the high-cost ﬁrm will . I (12.1). H X 0 ≥ X F *. The expanded-NPV for the low-cost ﬁrm (leader) lies above that of the follower. there exists a region for X t such that LH ( X t ) > F H ( X t ). is determined by the same decisiontheoretic techniques as before. H X 0 ≥ X F *. The optimal investment threshold for the follower (high-cost ﬁrm H) H X F * satisﬁes the proﬁtability criterion H VCH X F * = Π*. Assume that either ﬁrm can acquire a ﬁrst-mover advantage in the investment stage. (12.12) H If X 0 ≥ X F * = 0. both ﬁrms invest simultaneously as Cournot duopolists. from the stochastic equivalent of (12.11) In case of a large cost differential. the optimal investment trigger for the L leader (L) or low-cost ﬁrm.4′′) resulting in follower value from (12. the expected discount factor representing the deferral option in the leader’s value expression re-appears.9) of H ⎧(VCH X H * − I ) ( X 0 X F *)β1 H F H ( X 0 . X L *) = ⎨(VL X 0 − I ) − (VL − VC ) X F * ⎪ H β1 ⎪ × ( X 0 X F *) ⎪V L X − I ⎩ C 0 if if if L X 0 < X L *. (12. It satisﬁes L L VL X L * = Π*. The L value of high-cost ﬁrm H is nonsmooth at X F * when the low-cost ﬁrm enters.

r = 7 percent.Preemption versus Collaboration in a Duopoly 385 LL(⋅).10 0. suppose that ﬁrm i decides to invest at the myopic investment trigger of the leader j i X L* ( < X F *). The preemption point for ﬁrm i is such that { } . which would force ﬁrm i to invest even earlier. a coordination problem—potentially inducing a “coordination failure” in the form of joint investment—may arise.45 H XF * ≈ 0.20 0.000 ( ) 800 600 E-NPV for the low-cost firm (leader) 400 E-NPV for the high-cost firm (follower) 200 0 0. 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. and σ = 10 percent.05 0. The threat of preemption arises because ﬁrms are not precommited. I = 100 . XFH * 1.25 0. The ensuing preemption war would end when the rival’s rents are equalized.10 L XL * ≈ 0. As the investment probability (density) of the low-cost ﬁrm is also positive.35 0.40 0. Owing to this threat of competitive preemption. ﬁrm i cannot simply i i wait until TL * ≡ inf t ≥ 0⏐ X t ≥ X L* to invest. δ = 2 percent. invest with a (strictly) positive probability qH (t ).38 Initial value (X0) Figure 12. g = 5 percent.and high-cost ﬁrms for large cost advantage ˆ The demand function is p (Q) = 50 − 5Q.2.10 Value curves of the low. F H ⋅. and so on.30 0. Threshold values are derived in example 12. and strategic interactions are accounted for via mixed (closed-loop) strategies. cL = 10 . It could then be preempted by ﬁrm j investing at an earlier threshold. To see this. cH = 15 . here a preemption threat emerges that can induce an earlier investment by the low-cost ﬁrm.15 0.

qi + q j − qi q j (12. qi + q j − qi q j (12.1.1.3) this occurs with probability pC = qi q j .13b) If one of the ﬁrms. ﬁrm L. j i This results in pL ≥ pL. In the intermediate demand region where there is a risk of preemption.1. Therefore there is a positive probability of simultaneous joint investment. Conversely. it might still happen that the high-cost rival enters H ﬁrst and the low-cost ﬁrm invests second (with probability pL ≥ 0). A formal description of the solution is given in appendix 12C. In L L H H the intermediate region (with X P * < X 0 < X F * and X P * < X 0 < X F *). i Firm j would not be willing to select a lower investment trigger than X P * at which a second-mover advantage rather than a ﬁrst-mover advantage i would result for it. cL < cH.1. A. XC *). qL ( X 0 ) ≥ qH ( X 0 ). the resulting industry structures may differ.1.386 Chapter 12 j i X P * = inf X t < X F *⏐Lj ( X t ) = F j ( X t ) . resulting L L in lower value for both ﬁrms since F L ( X 0 . X C *) and H H H H F ( X 0 .3′) and from the investment density in equation (12. that is. its investment intensity will be higher than its rival’s. hence the low-cost ﬁrm is more likely to be the leader.1. X F *) > C L ( X 0 . Nonetheless. Three possible industry structures may emerge. both ﬁrms’ investment densities are strictly positive. ﬁrm j takes the lead with probability j pL. The probability of occurrence of each can be determined from equations (12. Preemptive investment timing sequences where one ﬁrm temporarily earns monopoly proﬁts arise with positive probability (two i distinct orderings). the low-cost ﬁrm invests as a leader when . the coordination problem can be solved by use of mixed strategies. Lj ( X j ) < F j ( X j ) if X j < X P *. from (12. has a cost advantage over its rival.1) and (12. The probabilities for the leader-follower orderings from (12. with ﬁrm j being the follower. Depending on the parameters of the investment triggers and on the starting demand region. We distinguish two subcases.21) given in appendix 12C.1) are i pL = { } qi (1 − q j ) qi + q j − qi q j and j pL = q j (1 − qi ) i (≠ pL ).13a) A third possible industry structure occurs when ﬁrms invest simultaneously as Cournot duopolists. X F *) > C ( X 0 . Firm i becomes leader with probability pL. meaning X 0 ≤ X L *. 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 L trigger. that is.

The high-cost ﬁrm takes the lead and the low-cost ﬁrm becomes follower L H and invests at time TFL*. before this point there is L H no investment. If X P * < X 0 < X P *. The low-cost ﬁrm invests as the (sole) leader with probability { } L pL = qL (1 − qH ) > 0.14a) as a follower with probability L H pF = pL = qH (1 − qL ) > 0.14a). Three industry structures may emerge.14b) or as a simultaneous Cournot investor with probability pC = qL qH > 0. When X P * is ﬁrst reached at L time TP *.1.1). This is illustrated in ﬁgure 12. B. qL + qH − qL qH (12. qL + qH − qL qH (12. the low-cost ﬁrm invests immediH ately and the high-cost ﬁrm waits until time TFH *. the low-cost ﬁrm’s myopic threshold is exceeded and there is no preemption threat from the high-cost ﬁrm. there is a coordination problem. The high-cost ﬁrm invests later as a follower H L L at random time TFH * ≡ inf t ≥ t0 ⏐ X t ≥ X F * . Simultaneous Cournot investment occurs with probability pC. If X P * < X 0 < X F *. In the asymmetric case described above. with probability pF = pL as per equation (12. If X L * ≤ X 0 ≤ X P *. H If X 0 ≥ X F *. The high-cost ﬁrm invests at time TFH *.11. the low-cost ﬁrm invests as a leader. as per H H equation (12.14c) where the equilibrium investment densities are qL = φ H ( X 0 ) and qH = φ L( X 0 ). If X 0 ≥ X F *. both ﬁrms will wait. equation (12. with φ j (⋅) deﬁned in appendix 12C.2. both ﬁrms invest immediately resulting in a Cournot duopoly. qL + qH − qL qH (12. The low-cost ﬁrm invests immediately (at t0) and the high-cost ﬁrm waits to invest until random time TFH *. both ﬁrms invest immediately resulting in a Cournot duopoly with asymmetric payoffs. Low-cost ﬁrm’s preemption point below leader’s myopic trigger L H L If X 0 < X P * ≤ X P *. with probability pL as given in equation (12. the preemption equilibrium L where the leader invests earlier at time TP * (instead of at the myopic .Preemption versus Collaboration in a Duopoly 387 L H X L * (< X L *) is ﬁrst reached.14b). If L H X P * < X 0 < X F *. The low-cost ﬁrm becomes the leader and the high-cost ﬁrm enters as L follower at time TFH *. there exists a preemption threat and both ﬁrms have a ﬁrst-mover advantage.14c).

occurring at random time TFH *. it also allows it to extract monopoly rents for a longer period of time. L trigger TL *) occurs if the cost advantage of the low-cost ﬁrm is relatively small. it renders the threat of preemption by the weaker rival irrelevant. ﬁrms must take account of the strategic interaction (preemption threat). Threshold values are derived in example 12. F H ⋅. F L ⋅. The analysis above helps stress the importance of attaining sufﬁcient cost advantage in a dynamic setting.10 Firm H as follower Firm H as leader 0.388 Chapter 12 H LL(⋅). leading to earlier investment. δ = 2 percent. ˆ I = 100 . LH(⋅). the result converges to the symmetric case where ﬁrm values are equalized (rent dissipation). the open-loop sequential ordering equilibrium (where the L leader invests when the myopic trigger X L * is ﬁrst reached) results if there is a sufﬁciently large cost advantage for the low-cost ﬁrm. XFL * ( ) ( ) 600 500 400 Firm L as follower 300 200 Firm L as leader 100 0 0.20 L X F * ≈ 0. XF * .25 H X F * ≈ 0. As the cost difference (asymmetry) approaches zero. If the cost advantage is sufﬁciently large. From a dynamic viewpoint. By contrast.and high-cost ﬁrms for small cost advantage L L Here ( X P * < X L *) . its option value is eroded by the subsequent competitor’s entry. andσ = 10 percent.15 0. g = 5 percent. such an advantage enables the ﬁrm to extract more value from the market than its competitor.05 0.2. In a static setting.35 (100) H L X P * XP* Initial value (X0) Figure 12. r = 7 percent. . Nonetheless. When this is the case. 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 L invests at random time TL *.20 0. cL = 10 .11 Value curves of the low. The demand function is given by p (Q) = 50 − 5Q. cH = 12 .30 0.27 0.

Without loss of generality. it needs to enter at an earlier preemption time TP * due to strategic interaction and timing rivalry (closed-loop equilibrium). For example.3.3). Once the leader has invested in additional capacity. 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 ).2.3 Option to Expand an Existing Market We next consider expansion decisions in an existing market involving two ﬁrms already active in the marketplace. The 26. In this case tacit collusion takes the form of simultaneous investment being delayed forever.3. Lasserre. that the deterministic proﬁt under symmetric capacity expansion is lower than under the initial industry capacity. They obtain. 12. . though it is still subject to damage from competitive erosion. If both ﬁrms have invested.3. under certain circumstances. and Moreaux (2010) model capacity expansion more explicitly in a model where capacities can be expanded repeatedly in lump sums. π L .Preemption versus Collaboration in a Duopoly 389 The highly cost-advantaged ﬁrm can conﬁdently invest at the myopic L random time TL *. Upon expanding its production capacity by making additional investment I . more efﬁcient technology that improves the quality or reduces the production cost of their existing products through enhanced processes.26 The leader suffers from capacity additions by its rival as π C < π L. the ﬁrms may have the possibility to adopt a new. π C ) indicates the deterministic (reduced-form) proﬁt ﬂow under a given industry structure. If its cost advantage is L small.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. however. 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. Both ﬁrms have a “shared” option to make an irreversible investment to increase their current proﬁt ﬂow by expanding their existing market. In section 12. and outline the results for the asymmetric case in section 12. π F . 12.1 we consider the symmetric duopoly case. we focus on the situation where ﬁrms have the opportunity to invest in additional production capacities. Boyer. while π (= π 0 . they will face once again symmetric Cournot competition—though now duopoly proﬁts are higher than under the old industry structure (π C > π 0) due to enhanced production. a ﬁrm can potentially make a higher proﬁt π L ( > π 0 ). ignoring its rival’s entry timing altogether.

This feature also held in Fudenberg and Tirole’s (1985) deterministic setting discussed above. The optimal joint-investment trigger X C * at which collaboration (or tacit collusion) results in joint-value maximization satisﬁes (VC − V0 ) X I C * = Π *. (12. This effect is not present when ﬁrms are not yet invested (wait to invest). For this reason the trigger values. in the case of new market models. When the ﬁrms choose to invest in additional capacities simultaneously. and Π* ≡ β1 (β1 − 1) is the proﬁtability index. Thus.15) where VC ≡ π C δ and V0 ≡ π 0 δ are the perpetuity values of the deterˆ ministic proﬁt ﬂows π C and π 0. the follower earns no proﬁts while waiting to invest. with β1 given in equation (12. Moreover the value curve of the follower coincided with the jointinvestment value curve. Under the new market model involving the option to invest discussed in the previous section. satisﬁes (VC − VF ) X I F * = Π*. X F * < XC *.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. π F = π 0 = 0. the drop in the follower’s proﬁt between the old industry structure (π 0) and the industry state following the leader’s added investment (π F) may induce collaborative (tacit-collusion) equilibrium. In particular. Hence it suffers no damage when the leader invests. (12. in the existing market model involving the option to expand capacity. By contrast. 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. X F * and XC *. The (myopic) investment trigger for the follower. .16) where VF ≡ π F δ is the perpetuity proﬁt value as a follower. were the same. The resulting positive value increment in case of joint investment is VC − V0 . that is.5). δ ≡ k − g = r − g. X F *. This value differential is VC − VF. they both effectively “exchange” their current proﬁt ﬂow π 0 for the higher proﬁt π C. The proﬁt ﬂow for the follower decreases once the leader has invested. joint investment and collaboration (tacit collusion) do not emerge as possible equilibria.

4) is zero. the probability of having invested depends on the overall industry history. exceeds the collaboration value from jointly waiting until the common trigger XC *. with β1 as in equation (12. 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. or collaborator are given by ⎧(VL X 0 − I ) − (VL − VC ) X F * B0 (TF *) if ⎪ L ( X0 ) = ⎨ if ⎪ ⎩VC X 0 − I X 0 < X F *. but if the process value gets higher than the preemption point X P *. there is a ﬁrst-mover advantage. X 0 ≥ X F *. (12. For very low state value X t . X 0 ≥ X C *. which ﬁrm will actually be the ﬁrst investor. where L ( X 0 ) > C ( X 0 . The value functions as a leader.17c) β where for GBM B0(TF *) = ( X 0 X F *) 1 and B0 (TC *) = ( X 0 XC *) 1 . First-mover advantage and preemptive investment In this case.1. The expected value for the leader is L ( X P *). It is not clear. We refer to this Pareto-superior joint-investment equilibrium as “collaborative” or “tacit collusion” equilibrium (with subscript C). there is no advantage to investing ﬁrst. XC *) = ⎨ if ⎪VC X 0 − I ⎩ β X 0 < X F *.17a) ⎧VF X 0 + ⎡(VC − VF ) X F * − I ⎤ B0 (TF *) if ⎪ ⎣ ⎦ F ( X 0 .1) and the probability of ﬁrm i being leader and ﬁrm j being follower is 1/2. . X 0 ≥ X F *. namely the leader’s value from immediate investment. however.Preemption versus Collaboration in a Duopoly 391 In a Pareto-dominant equilibrium. (12. In the second case. (12. The perfect equilibrium strategy proﬁle is given in appendix 12C. At this preemption time qi (TP *) = 0 (from equation 12. The probability of simultaneous investment from equation (12.21 in appendix 12C. XC *).5). no ﬁrm has already invested. At time TP * the values as leader and follower are equal. at least one ﬁrm will have expanded capacity.1. In the ﬁrst case. Among all possible joint-investment equilibria. A. follower. such a ﬁrst-mover advantage does not exist and L ( X 0 ) ≤ C ( X 0 . which corresponds to the ﬁrst case considered in the deterministic setting. C ( X 0 .2). XC *). L ( X 0 ). X F *) = ⎨ if ⎪ ⎩VC X 0 − I ⎧V0 X 0 + ⎡(VC − V0 ) XC * − I ⎤ B0 (TC *) if ⎪ ⎣ ⎦ C ( X 0 . It is interesting to examine two benchmark cases.1.17b) X 0 < XC *. For low past values of the process. as seen from equation (12. it is the more plausible.15). XC *).

or low discount rate (high discount factor). Simultaneous investment as part of a collaborative equilibrium will take place the ﬁrst time the common threshold that maximizes joint value is reached (the Paretooptimal equilibrium is the most likely among the simultaneous investment equilibria). X C *). the ﬁxed investment 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. C ( X 0 . Conversely. these equilibrium proﬁles are described in appendix 12C. the equilibrium outcome is joint investment at time t0. low growth. The value to each ﬁrm corresponds to the net present value from immediate investment commitment. for a low degree of uncertainty. In comparing cases A and B above. XC *) ≥ L ( X 0 ). . B. each ﬁrm receives the lower joint value C ( X 0 . C ( X 0 . X P * < X 0 < X F *. a high growth rate g . If such a “coordination failure” happens. Collaborative investment In the case when the collaborative value exceeds the leadership value. The second class consists of strategies where ﬁrms invest simultaneously in a collaborative fashion. B). The interpretation is basically the same as in the deterministic case. XC *) = VC X 0 − I.23) in appendix 12C. 27. likely resulting in a preemptive industry equilibrium.27 As the reader might intuit. ﬁrms may ﬁnd it appealing to do their utmost to grasp a ﬁrst-mover advantage.2. This second class of equilibrium strategies forms a continuum. there are many symmetric equilibrium strategies. 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. The speed of investment increases if market conditions favor the preemptive type of equilibrium.1 the probability of investing is strictly positive with a positive probability of simultaneous investment. app. the value as leader exceeds the value as follower. For X 0 ≥ X F *. From equation (12.392 Chapter 12 For state values in the intermediate region. the outcome from strategic interaction is typically that of the collaborative type. In cases of large uncertainty (high volatility σ). The ﬁrst class consists of the sequential role orderings described in case A. No ﬁrm is better off since the expected value for each ﬁrm (even for the actual leader) equals the value of the follower. or a high discount rate (low discount factor). These can be divided into two classes. For that it is useful to perform comparative statics analysis as done by Huisman and Kort (1999) and Huisman (2001.

A primary driver is the presence of a ﬁrst-mover advantage.28 Asymmetry among ﬁrms results in distinct beliefs about the optimal joint investment thresholds.3. These results are in line with the ones obtained under ﬁrm symmetry in the previous section. When the competitive (e. as in Días and Teixeira (2010). the outcome tends to be that of a collaborative equilibrium L involving joint investment at a later (random) investment time TC *. Actual investment thus occurs at the time the lower (low-cost ﬁrm’s) trigger is ﬁrst reached. typically a market characteristic. it is preferable to invest simultaneously at a later optimal time. A second key driver relates to the size of the competitive advantage by the advantaged ﬁrm. a ﬁrm characteristic. that of a joint or collaborative simultaneous investment. heterogeneity among option holders may change equilibrium outcomes altogether. the high-cost ﬁrm will invest when the follower’s investment H trigger X F * is ﬁrst reached. driven by fear of preemption. If the cost advantage is relatively small. the low-cost ﬁrm may opt to reject the collaborative joint investment alternative and. .. invest early at time L TP *.2 Asymmetric Case As noted. If the cost advantage is small but there is a substantial ﬁrst-mover advantage. than to engage in detrimental timing rivalry resulting in cutthroat preemption. with the low-cost ﬁrm having a “collaborative” investment trigger lower than that of the high-cost ﬁrm.g. When no ﬁrm has a signiﬁcant ﬁrst-mover advantage. This case is analyzed by Pawlina and Kort (2006). Different variable production costs allow for distinct reduced-form proﬁts. Existing market models may additionally exhibit the third type of equilibrium.Preemption versus Collaboration in a Duopoly 393 12. jointly appropriating the option value of waiting against exogenous demand uncertainty. cost) advantage is relatively small and there is only a slight ﬁrst-mover advantage. Their results may be extended to cases where ﬁrms have asymmetric variable production costs. Pawlina and Kort (2006) consider an asymmetric model where ﬁrms have different ﬁxed investment costs. for the new market model case. If there is both a sizable ﬁrst-mover advantage and a substantial cost advantage. the 28. the preemption threat precipitates the investment decision of the low-cost ﬁrm leading it to invest at an earlier time that does not necessarily maximize its stand-alone value. 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 lowcost ﬁrm is sufﬁciently high. What matters from a strategic perspective is to understand the key drivers that lead to these different types of equilibria. First.

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. sequential investment refers to the 29. Collaborative or joint investment refers to the decision made by duopolists to invest simultaneously at a later random optimal time TC *. such as the magnitude of the ﬁrst-mover advantage and the size of competitive (cost) advantage. Figure 12. the open-loop sequential investment is more likely to occur than either preemption or delayed collaborative simultaneous investment.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 * .” the leader invests at an early preemption time TP * ( ≤ TL*). The separating curves are not necessarily linear. 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 preemption (closed-loop equilibrium). open-loop sequential investment where the low-cost ﬁrm invests as a monopolist ignoring its rivals will likely be the industry equilibrium.394 Chapter 12 Large Sequential investment ~ (open loop.3. In case of “preemptive timing investment. “sequential investment” refers to the (“soft”) case where the leader need not consider the preemption risk.12 summarizes the different types of equilibrium outcomes that may result depending on certain market or ﬁrm characteristics.2.2.2 and 12. .TL∗) Competitive (cost) advantage Collaborative (joint) investment ~ (TC∗) Low Low Preemptive timing investment ~ (closed loop.29 In speciﬁc market settings. Here we put this result in relative perspective and compare it to the collaborative outcome.TP∗≤TL∗) First-mover advantage Large Figure 12.

We subsequently discussed how to extend the analysis to take account of uncertainty and strategic aspects arising in real options analysis. collaboration (e.g. They show the following: 1. via cross-licensing) is a natural equilibrium across demand states. with the disadvantaged rival abandoning the market if demand is insufﬁcient. Trigeorgis and Baldi (2010) discuss a slightly different option game setting and derive similar insights. illustrating how the magnitude of competitive advantage arising from the patented innovation and the level and volatility of demand affect the optimal patent strategy. When one of the rivals has a large comparative advantage via a superior patent. 3. bracketing) at high demand to collaboration (licensing out) as demand declines. In case of a small competitive advantage at intermediate levels of demand. ignoring rival effects (open-loop equilibrium).Preemption versus Collaboration in a Duopoly 395 case (discussed in chapter 11) where a ﬁrm having a substantial competitive advantage invests myopically as a monopolist at time TL*. The authors assess the value of optimal patent leveraging strategies under demand and strategic uncertainty. the ﬁrm is better off to pursue a ﬂexible hybrid strategy..g. 2. We ﬁrst discussed the simpler deterministic setting and explained how preemption threat can impact the optimal investment timing decisions of ﬁrms. When there is no competitive advantage and rivals are symmetric. We analyzed in turn the investment timing option (new market model) and the option . a ﬁght mode is likely as the equilibrium strategy. switching from a ﬁght mode (e. the precise patent leveraging strategy may differ across demand states. However.. Conclusion In this chapter we provided an overview of several important investment timing and equilibrium issues arising in option games. to a defer (patent sleep) strategy maintaining an option on a future monopoly position should the market recover if current demand is low. 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). It may range from offensive ﬁghting (via bracketing each other’s patents resulting in a patent war) if demand is high.

Días. Huisman et al. . Continuous-time option games: Review of models and extensions. (2004) review option games contributions dealing with new versus existing market models in a lumpy-investment context. Huisman and Kort (1999) provide a comprehensive view on this problem. and when to collaborate with rivals under uncertainty. when to follow. Bouis.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 strategic investment decisions. Smets (1991) extends Fudenberg and Tirole’s framework to a stochastic setting analyzing an existing market model (expansion option). Huisman. Selected References Fudenberg and Tirole (1985) reﬁne Reinganum’s (1981a) model discussing continuous-time mixed-strategy equilibria. Huisman. Thijssen. and José P. Dixit and Pindyck (1994) present a simpliﬁed version based on a new market model (investment timing option). including the analysis of preemption. Firms may sometimes ﬁnd it preferable to coordinate their entry or investment timing decisions depending on the state and evolution of the market. This chapter provided useful insights on when to lead.396 Chapter 12 to expand (existing market model) in a competitive duopoly setting under uncertainty.. 2010. and Kort (2009) recently investigate such problems in an oligopoly context with more than two ﬁrms. Marco A. 30. They set the foundations for deterministic games of timing. Multinational Finance Journal 14 (3/4): 219–54. Días and Teixeira (2010) analyze production cost asymmetries in such a context. 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. and Kort (2002) discuss an extended deﬁnition of strategy spaces that enables handling timing issues in stochastic environments. Teixeira. 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. while Pawlina and Kort (2006) consider asymmetric investment costs. But the preferred strategy is not obvious as it depends on both market and ﬁrmspeciﬁc characteristics that merit closer assessment. G.

Appendix 12A: Strategy Space and Solution Concept Players’ strategies are deﬁned in the following fashion. CentER. Kort. 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 . CentER discussion paper 9992. 1994. Thijssen. Peter M. 1991. Huisman. Kuno J. Jennifer F. Yale University.. The Netherlands. Kuno J. Pindyck. Discussion paper 2002–81. Review of Economic Studies 48 (3): 395–405. Working paper. The Netherlands. 31. Exporting versus FDI: The effect of uncertainty. Investment under Uncertainty. Strategic investment under uncertainty: Merging real options with game theory. and Peter M. Smets. and Jean Tirole. Huisman. and Jacco J. and Peter M. Kort.Preemption versus Collaboration in a Duopoly 397 Dixit. 1999. .. and Kort (2002) since. Tilburg. in our opinion. It represents the probability that ﬁrm i has invested before or at time t ( ≥ t0 ) given that the other ﬁrm has not yet invested. Gi (⋅) is a cumulative distribution function reﬂecting the history of the industry. Tilburg University. Effects of strategic interactions on the option value of waiting. Kuno J. Reinganum. Thijssen. 2006. 2002.. Frank. Kort. For a more detailed discussion on the deﬁnition of strategy space and closed-loop strategy. J. Jacco J. and Peter M. irreversibilities and strategic interactions. Huisman. Fudenberg. J. Symmetric equilibrium strategies in game-theoretic real option models. Tilburg University. Review of Economic Studies 52 (3): 383–401. Pawlina. qi ( t )) such that:31 1. Grzegorz. Huisman. M. Kort. Preemption and rent equalization in the adoption of new technology. Princeton: Princeton University Press. Zeitschrift für Betriebswirtschaft 67 (3): 97–123. M. refer to Fudenberg and Tirole (1985) or Thijssen.. 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 ) . and Kort (2002). Real options in an asymmetric duopoly: who beneﬁts from your competitive disadvantage? Journal of Economics and Management Strategy 15 (1): 1–35. 2004. Drew. M. Huisman. On the diffusion of new technology: A game-theoretic approach. 1981a. We use here the term “continuation strategy” instead of “simple strategy” as in Fudenberg and Tirole (1985) or Thijssen. 1985. Grzegorz Pawlina. Avinash K. and Robert S.

First. hindering the use of the subgame perfect equilibrium concept that prescribes continuation strategies that form Nash equilibrium for all subgames. 11) impose some intertemporal consistency conditions on the closed-loop strategies. It represents discrete-time mixed-strategy measures which are lost when one considers only the distribution function Gi (⋅). 393) and Thijssen. Second. even those off the equilibrium path. for example by Pitchik (1982). { } 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. This approach allows for mixed strategies but is reﬁned by Fudenberg and Tirole (1985) for two reasons. with no time elapsing between “rounds. . qi (⋅) is an atoms function in optimal control theory. Huisman. 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. p. TF ≡ arg max t ≥ t0 F (t ).32 The strategic-form game depicted in ﬁgure 12. right-continuous cumulative probability that player i has invested conditional on the other player not having invested before. p. The way used. Fudenberg and Tirole (1985. which continuation strategy to pursue. 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.Tj }.” A pair of continuation strategies ( si * (t ) . We deﬁne * * * TP ≡ inf t ≥ t0 ⏐L(t ) = F (t ) . namely at time T ≡ min {Ti . and TC ≡ arg max C( t ).1 is played as soon as one of the ﬁrms invests with positive probability (qi ( t ) > 0 or q j (t ) > 0). where Ti ≡ inf s ≥ t⏐qi ( s ) > 0 or Ti ≡ ∞ if qi ( t ) = q j ( t ) = 0 for all t ≥ t0 . qi (⋅) represents the instantaneous (mixed) action taken by ﬁrm i at time t. s j *) forms a subgame perfect Nash equilibrium if for every time t ( ≥ t0 ) the pair of continuation strategies ( si * (t ) . The game is played repeatedly in “rounds” at time t. { } 32. it does not specify what happens in all possible subgames. It is a notion of the probability (“intensity” or “density”) with which ﬁrm i invests at time t. A closed-loop strategy si = {si ( t )}t ≥ t0 is a collection of continuation strategies specifying for each subgame at time t. to describe a player’s strategy involves the function Gi (·) as a nondecreasing.398 Chapter 12 2. and Kort (2002. The deﬁnition above of closedloop equilibrium is a continuous-time translation of the subgame perfection solution concept prescribing that players act optimally (as part of Nash equilibrium) at every subgame (here. the subgame at future time t ≥ t0). s j * (t )) is a Nash equilibrium.33 A pair of closed-loop strategies ( si *.

for t ∈[TP *. The cumulative distribution function for the symmetric equilibrium * * when L(TP ) > C(TC ) is given by ⎧0 if t < TP *. the value for ﬁrm i. V i (qi . Together with the (symmetric) instantaneous investing intensity (probability) if t < TP *. For t > TF *. TF *] they mix their investment decision. V i ( qi . there is no incentive for either ﬁrm to invest. q j ) is conﬁrmed from the second-order derivative. ⎩ with φ (⋅) given in (12. ﬁrms stay out. q j ) = qi q j C i ( t ) + qi (1 − q j ) Li (t ) + (1 − qi ) q j F i (t ) .2) this constitutes the perfect closed-loop equilibrium in the preemption case involving symmetric ﬁrms. for (qi . q j ) ≠ (0. ∂qi The concavity of V i (⋅.Preemption versus Collaboration in a Duopoly 399 12B.1). In the period after the preemption time * TP *. ⎧0 ⎪ q (t ) = ⎨φ ( t ) if TP * ≤ t < TF *. such that G( t ) = 1 for t ≥ TP . 0).1 * * Case L(TL ) > C(TC ) Since playing the strategic-form game takes no time. they invest with probability 1. q j + qi − qi q j The ﬁrst-order optimization condition gives ∂V i (qi *. for a mature market. q j ). ⎪1 if t ≥ TF *. q j ) obtaining. one ﬁrm in the industry will invest. 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 . so no one invests (G ( t ) = 0 and q ( t ) = 0 if t < TP *). can be expressed in a recursive manner as V i ( qi . This equilibrium strategy is interpreted as follows. Applying these conditions to the above (asymmetric) expression leads to equation (12. the follower ﬁrm invests. or qj * [(1 − qj *) Li (t ) − F i( t ) + qj * C i (t )] = 0. In the period prior to the preemption time TP *. q j *) = 0. as a function of the instantaneous investing probabilities qi = qi (t ) and q j = q j ( t ). qi (·) indicates the equilibrium intensity of investment: for a burgeoning market. . G (t ) ( = Gi (t ) = Gj ( t )) = ⎨ ⎩ 1 if t ≥ TP *.

⎪ i if t ≥ TFi * (or max { X s . (12. ⎪ Gi ( t ) = ⎨ i i ⎪ ⎩ 1 if t ≥ TP * (or max { X s .18) for any T ∈[TC . the Pareto-superior equilibrium is characterized by the following symmetric strategy proﬁles: G ( t ) ( = Gi ( t ) = Gj (t )) = and q (t ) = { 0 if 1 if t < TC *.1 * Case L( X 0 ) > C( X 0 .400 Chapter 12 12B. 0 ≤ s ≤ t} < X P *).20) . (12. and i i ⎧0 if t < TP * (or max { X s . 0 ≤ s ≤ t} ≥ X F *). { 0 if 1 if t < T. 0 ≤ s ≤ t} < X F *). t ≥ T. In the asymmetric case the perfect equilibrium strategy for ﬁrm i (ﬁrm j’s optimal strategy being obtained symmetrically) is given by i i ⎧0 if t < TP * (or max { X s . ⎪ i i i qi ( t ) = ⎨φ j ( t ) if TP * ≤ t < TFi * (or X P * ≤ max {X s . the following symmetric strategies result in a perfect equilibrium: G ( t ) ( = Gi (t ) = Gj ( t )) = and q (t ) = { 0 if 1 if t < T. XC ) The closed-loop equilibrium investment strategy for ﬁrm i again consists of two functions: a cumulative distribution function Gi (⋅) and an investment intensity function qi (⋅). t ≥ TC *.2 * * Case L(TL ) £ C(TC ) In a duopoly with identical ﬁrms where L (TL*) = C (TC ) ≤ C (TC *). Among them. 0 ≤ s ≤ t} < X P *). TC *]. ⎩1 (12. t ≥ TC *. t ≥ T.19) Appendix 12C: Perfect Equilibrium in Stochastic Setting 12C. { 0 if 1 if t < TC *. 0 ≤ s ≤ t} ≥ X P *).

(or max {X s . The choice XC * ∈[ XC . ⎪ if t ≥ TF * (or max {X s .2 Case C( X 0 . no ﬁrm has already invested. 0 ≤ s ≤ t}. The probability of entering during the next instant t becomes ⎧0 if t < TP * (or max {X s . 0 ≤ s ≤ t } ≥ X ).23) The probability of having invested is related to the overall industry history. 0 ≤ s ≤ t} ≥ X P *). ⎩1 (12. 0 ≤ s ≤ t} < X P *). 0 ≤ s ≤ t } < X ). If the process reaches values higher than the preemption point X P *.21) For the symmetric case the cumulative distribution term simpliﬁes to ⎧0 if t < TP * (or max {X s . 0 ≤ s ≤ t} ≥ X F *). ⎪ G(t ) ( = Gi (t ) = Gj (t )) = ⎨ ⎪ ⎩ 1 if t ≥ TP * (or max { X s . XC ) and T = inf {t ≥ 0 | X t ≥ X }. XC* ) ≥ L( X0 ) Symmetric collaborative (or tacit-collusion) equilibria are pairs of strategies of the form ⎧0 if t < T ⎪ Gi (t ) = ⎨ ⎪1 if t ≥ T ⎩ and ⎧0 if t < T ⎪ qi (t ) = ⎨ ⎪1 if t ≥ T ⎩ (or max {X s . 0 ≤ s ≤ t} < X F *). L (t ) − C (t ) (12.Preemption versus Collaboration in a Duopoly 401 where in the intermediate region φ j (⋅) ≡ Lj (⋅) − F j (⋅) . 12C. 0 ≤ s ≤ t } < X ). The Pareto-optimal collaborative . (or max {X s . X C *] and XC is such that L ( XC ) = C ( XC .22) where φ (t ) ≡ L (t ) − F (t ) . Lj (⋅) − C j (⋅) (12. 0 ≤ s ≤ t } ≥ X ). where X ∈[ XC . ⎪ q ( t ) = ⎨φ ( t ) if TP * ≤ t < TF * (or X P * ≤ max {X s . at least one ﬁrm has invested. 0 ≤ s ≤ t} < X P *). (or max {X s . namely for X t such that max {X s . For low current values of the process X t . XC *] that maximizes joint value is Pareto optimal and may be considered more likely to be implemented in the industry.

0 ≤ s ≤ t} < XC *). and ⎧0 if t < TC * (or max {X s .24) . (12.402 Chapter 12 equilibrium consists of the following strategy proﬁles (for i and j symmetrically): ⎧0 if t < TC * (or max {X s .25) (12. 0 ≤ s ≤ t} < X C *). 0 ≤ s ≤ t} ≥ XC *). ⎪ qi ( t ) = ⎨ ⎪ ⎩1 if t ≥ TC * (or max {X s . 0 ≤ s ≤ t} ≥ XC *). ⎪ Gi ( t ) = ⎨ ⎪ ⎩1 if t ≥ TC * (or max {X s .

2. Applications to the realestate sector are presented in section 13. a ﬁrm may wait for its rival to exit ﬁrst hoping to enjoy monopoly rents. Section 13. such as waves in real-estate markets.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. The edited book by Grenadier (2000a) provides a good collection of articles on gametheoretic option models. 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. for technological uncertainty and for information asymmetry. 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.3 elaborates on multistage R&D or patent strategies. potentially leading to early preemptive investment. 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. Situations where ﬁrms can reduce their capacity utilization to cushion against 1. Section 13. Below we review brieﬂy speciﬁc research contributions to option games analysis. When a market or industry declines. Section 13.5. .1 deals with early approaches where competitive entry decisions are treated exogenously. In this chapter we discuss extensions of the option games framework that allow for a time lag or time to build. Models dealing with exit are also addressed in section 13.4 addresses information asymmetry among option holders and how it may affect investment strategies.

At the time of a random rival entry. The mean arrival rate λ represents the random competitive arrival rate or the instantaneous probability of a random competitive entry causing a downward jump. Such “competitive arrivals” may reduce the value of the ﬁrm’s own investment opportunity by taking away market share. creating a value discontinuity captured by the jump term. 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. the incumbent’s proﬁt value suddenly drops from monopoly rents to duopoly proﬁts. This approach helped identify certain major drivers underlying option games.6.” 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. Consider an option-holding ﬁrm facing the introduction of close substitute products.1 Exogenous Competition and Random Entry Early research focused on aspects of competition that can be modeled exogenously. In market equilibrium the total return of a project ( k ) equals the expected capital gain ( g ) plus the dividend payout (δ ). it “keeps” the “dividends” that would otherwise be lost. Trigeorgis (1991) studies the impact of competition on optimal investment timing using standard contingent-claims analysis based on the geometric Brownian motion. The last section provides a broad overview of recent developments in the ﬁeld and other extensions or applications.404 Chapter 13 market downturns are addressed in section 13. g / k . . 13. 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. it risks suffering competitive damage analogous to forgone “dividends. If instead the ﬁrm invests early and thereby preempts its rivals.2 If an option-holding ﬁrm decides to wait longer. A higher dividend yield implies a lower proportion of capital gains.7 considers situations where ﬁrms make sequential lumpy investment decisions. Section 13. Competition in this context can be modeled in one of two ways. • Random rival arrivals Random arrivals of substitute products by competitors can be modeled via the Poisson term in a mixed-jumpdiffusion process with mean arrival rate λ .

making it possible to use the Black– Scholes option pricing formula. Trigeorgis (1991) assumes a ﬁnite planning horizon. The exogenous approach. Competitive arrivals are simply assumed exogenous driven by some external process in competitive markets. The approach helps explain several puzzling real-estate phenomena. however. with X t following a geometric Brownian motion (where π L > π 0).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. If only one building is refurbished. increasing their proﬁt stream accordingly. The analysis helps identify the factors that make some markets prone to bursts of concentrated development. . Real-estate markets are characterized by sudden large development efforts in some periods while smoother development patterns are observed in other periods. Reiss (1998) develops a framework to determine whether. explaining why such markets sometimes experience building booms in the face of declining demand and property values. such as booms and bursts. is limited in that it does not explain what drives competitors’ entry decisions. 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.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 anticipated or random competitive value erosion and assess the value of the deferral option in the midst of competition erosion. a ﬁrm should patent or adopt an innovation in a setting where rivals arrive randomly following a Poisson process. The two buildings currently yield a constant proﬁt stream of π 0 per unit of time. She identiﬁes several option exercise strategies applied in a context where competition is exogenously determined. This action nevertheless will affect the rival as the deterministic proﬁt ﬂow for its (nonrefurbished) building changes 3. 13. this building will earn a stochastic proﬁt stream of X t π L . and when. Consider two symmetric real-estate developers having the possibility to refurbish their buildings for an investment outlay I .

5 Grenadier (1996) establishes the existence of two classes of equilibria. In many situations. For X t ≥ X F *.1) where VC ≡ π C δ and I′ is the total cost involved in exercising the option. During this delay period the owner cannot receive rents from the building.g.2) Depending on initial demand. some equilibria are characterized by sequential development while others by simultaneous 4. For X t < X P * with ˆ X t ≡ max {X s . Grenadier (1996) assumes a strictly sequential equilibrium entry ordering where one ﬁrm is selected as leader over the ﬂip of a fair coin. thereby affecting the standard real options investment rule under uncertainty. the equilibrium strategies pursued by ˆ the two developers lead to four distinct scenarios. At the preemption threshold. In Grenadier’s model the actual leader is chosen randomly with probability ˆ ˆ one half.406 Chapter 13 from π 0 to π F ( X t ) ≡ π F . Game theorists (e. both developers decide to renovate their premises and their values are equal.4) is now adjusted to VC X F * = Π* e −δ D . π F δ . Grenadier takes into account that real estate development involves time-to-build delays. where π F < π 0 . both ﬁrms will earn a stochastic proﬁt stream of X t π C per unit of time (where π C < π L). In reality there exists a continuum of tacit-collusion equilibria. Huisman and Kort (1999) point out that this result holds only for X 0 < X P . Fudenberg and Tirole. undertaking an investment takes time. The follower’s optimal threshold previously given by equation (12. namely the investment cost I plus the value of the foregone perpetual rent stream from the old building. A tacit collusion scenario may arise for certain values of the underlying process. the follower’s value strictly exceeds the leader’s and no refurbishment investments will take place in equilibrium. . I′ (13. 1985) often assume that the Pareto-efﬁcient equilibrium is selected. If the second developer also decides to renovate its building. only one ﬁrm invests. β1 − 1 (13. X P *. Suppose that refurbishing the old building takes D years until completion. 5. The proﬁtability index is again given by Π* = β1 .4 For X P * ≤ X t < X F *. the two real-estate developers are indifferent between the leader role or the follower role (rent equalization). There may be several years between the decision to invest and the time at which the project gets completed and revenues get generated. Depending on initial conditions.. 0 ≤ s ≤ t}. He suggests that this mechanism resembles real-estate developers applying for permits with only one receiving an initial approval.

Both ﬁrms will wait for the Pareto-optimal collaborative trigger XC * to be reached and invest simultaneously. between 1979 and 1998.200 real-estate projects in Vancouver. namely the median time span between the leader’s and the follower’s investments. The inferences above are conﬁrmed by empirical real-estate studies. Based on data relating to more than 1. If TF * < TC *. despite an economic downturn. This is measured by the time interval between refurbishments. increasing the likelihood of occurrence of recession-induced construction booms. such as investment cascades and recession-induced construction booms (RCB). Bulan. With ( X F *. giving valuable . For a mature market ( X 0 ≥ X F *). Recessioninduced construction booms characterize periods where. helping us understand these puzzling real-estate market phenomena. R&D investment decisions remain challenging. Mayer. 13. a recessioninduced construction boom (RCB) results as both developers will invest in fear of being preempted. Volatile markets are more likely to exhibit construction cascades. At the same time ﬁrms face more competition than ever. During an investment cascade. even though the market demand is low. Based on this framework. For a burgeoning market (starting at X 0 < X L*). The time-to-build delay is a major driver. the sequential investment equilibrium is ruled out. a sequential investment equilibrium occurs with one ﬁrm investing at time TP * and its rival waiting to invest until time TF *. brand new buildings are being completed and commercialized. Time to build and depreciation of old buildings have no effect on the mean time span. a number of real-estate projects are being developed concurrently over a sustained time period.Extensions and Other Applications 407 investment. and Somerville (2009) provide empirical support to the argument that competition erodes option value.3 R&D and Patenting Applications Despite much technological progress made in the last decades. Probability P (TF * < TC *) indicates the likelihood of occurrence of a RCB. Canada. but volatility does. Grenadier (1996) derives a rationale for certain investment behaviors observed in real-estate markets. TF * (TC *) is the ﬁrst time when X F * ( X C *) is hit. Comparative statics for the median time span and for P (TF * < TC *) enable identifying key drivers for such real-estate market phenomena. Many technology ﬁrms put technology adoption as a primary goal. Option games can help provide powerful insights to understand competitive technology-driven industries. X C *) being the interval for initial demand.

Although Huisman (2001) focuses on technology adoption. so the expected speed of the arrival of new technologies affects the optimal investment sequence. In the socially optimal scenario. The social planner would optimally choose to phase the research. while the other ﬁrm will be left with nothing. A central planner can steer research in one of two ways: allocating R&D investment to decentralized research units or setting up a common aggregate research center with a single investment policy. the follower initiates research later on. He identiﬁes decision-theoretic models of investment under uncertainty. while the economic value of the patent evolves stochastically. some of his insights are tractable and applicable in other contexts. In technology-driven markets the availability of new technologies is uncertain. The ﬁrst ﬁrm to succeed will gain an exclusive patent yielding a stochastic proﬁt ﬂow X t . Huisman and Kort (2004) examine technology adoption in a duopoly given the possible future arrival of an improved technology. A ﬁrm’s R&D strategy sets a proﬁt trigger at which research activity is initiated. such as when to enter a foreign market. Weeds derives ﬁrst the optimal behavior imposed by a social planner on two decentralized research units. The author compares equilibrium strategies obtained in this setting with a socially optimal benchmark. Huisman (2001) discusses various types of models of technology adoption.408 Chapter 13 investment timing guidance to management. allowing for uncertain arrival time following a Poisson process. deriving implications for research policy. . He then discusses game-theoretic models in a deterministic setting. Huisman discusses symmetric and asymmetric models and examines the effects of negative versus positive externalities on the equilibrium outcome. Finally. These models help explain how competition affects ﬁrms’ research programs and the portfolio of intellectual property rights. Several authors use option games to derive insights into how ﬁrms should conduct R&D or use their patents as a strategic weapon. he combines the two approaches to deal concurrently with both market as well as competitive uncertainty. involving technology adoption policies by a monopolist ﬁrm. one ﬁrm (the leader) starts conducting research in hope of acquiring the patent when proﬁt reaches a speciﬁed threshold level X L*. Suppose that two identical ﬁrms have the opportunity to launch an R&D project by investing I . 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 technological success of research activity is probabilistic.

Option value is eroded when ﬁrms are faced with the fear of competitive preemption. but also the impact of their competitors’ decisions on their own investment policy. This contrasts with standard antitrust thinking regarding joint research ventures. A ﬁrm considering being the leader might be hurt by the follower’s entry (negative externality) or beneﬁt from it (positive externality.2). The centralized collaborative research setup leads to later investment compared to the case of independent research units (as X L* < XC ′). This threshold XC ′ is between X L* and X F *.. The combination of preemption and negative externalities can hasten investment compared to the myopic benchmark.g. e. otherwise. Two patterns of adoption emerge: sequential vs. focusing on the effect of uncertainty and externalities on the type of investment schedule (sequential vs. the optimal trigger is X C ′. They consider the irreversible adoption of a technology whose returns are uncertain when many ﬁrms are active in the market. as opposed to independent research units. Strategic interactions in this case substantially alter the investment decisions of a stand-alone ﬁrm. Competition in R&D can increase aggregate production and reduce prices.3) with Π * as per equation (13. With no ﬁrst-mover advantage and no preemption.Extensions and Other Applications 409 when the socially optimal threshold X F * is ﬁrst attained. If ﬁrms behave as a single centralized research center. a preemptive sequential investment occurs where the follower adopts earlier than the cooperative solution. simultaneous investment). . These ﬁndings challenge conventional policies that aim to foster research cooperation. the leader adopts the new technology at the simultaneous cooperative trigger point. Mason and Weeds (2002) consider further strategic interactions between option-holding ﬁrms. It can also shorten the time necessary to develop the product and raise the probability of successful development. such that X C ′ I = Π* [(δ + 2λ ) λ ]. Option holders have to take into account not only the standard factors that directly affect their own decisions. simultaneous investment. This threshold is such that XF * δ + 2λ ⎞ = Π* ⎛ ⎜ ⎝ λ ⎟ ⎠ I (13. Weeds (2002) shows that the choice made by a centralized research unit may be socially suboptimal. due to network effects). Miltersen and Schwartz (2004) analyze patent-protected R&D investments with imperfect competition in the development and commercialization of a product.

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. compulsory licensing imposed by antitrust authorities can actually reduce option values and weaken the ﬁrm’s incentive to conduct research in the ﬁrst place. such delays before completion of a project are rarely known in advance as there is additional uncertainty over the innovation success. Time-to-build delays can also affect the innovative investment strategies of ﬁrms. patents granted but kept in a stand-by or “sleep” mode. . She considers two-stage R&D investment processes with completion uncertainty and their implications for sleeping patents. However.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. that is. If the ﬁrst-stage innovation is successful. Weeds (2000) examines the uncertainty over innovation completion and its impact on the duopolists’ technology adoption decisions. Lambrecht (2000) derives optimal investment strategies for two symmetric ﬁrms sharing the option to make a two-stage sequential investment with incomplete information about the rival’s proﬁt. In R&D. volatility is high. Sleeping patents thus do not necessarily indicate anticompetitive behavior. 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. Lambrecht derives a condition under which inventions are likely to be patented without being put to immediate commercial use. IT. Technological uncertainty is characteristic of many industries. The ﬁrm invests in R&D with the aim to acquire a patent giving it exclusive access to a new market. 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). the ﬁrm can make an irreversible investment to adopt the new technology and enter the market. in this context sleeping patents may arise purely from optimizing behavior when option values coexist with completion uncertainty. and the second-stage cost is high relative to the ﬁrst-stage cost. This framework provides a rational explanation for the existence of sleeping patents. and oil exploration. 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 commercial investment option. Sleeping patents are more likely to exist in an R&D portfolio when interest rates are low. such as bio-tech. Policy makers typically regard sleeping patents as anticompetitive devices employed by dominant ﬁrms to erect entry barriers (blockaded entry).

Through their option exercise decisions. determining the leader’s and the follower’s values and their investment thresholds. or an application by a pharmaceutical company for regulatory approval of a new drug convey (bad or good) news to competing ﬁrms. and lowers the failure rate of R&D. For instance. adopting ﬁrst the technology with slowly decreasing cost and later the technology with a more rapid cost decline. At the outset ﬁrms have two technologies with the possibility to adopt both.g. We discuss . Their results challenge the common rule of thumb that a ﬁrm should upgrade or replace its production processes simultaneously if they involve complementary inputs. The development of an ofﬁce building. the leader and the follower may be better off adopting the technologies at different times. 13. Firm incentives to conduct R&D depend on market and technological uncertainty. It generally causes higher risk premia. the proprietary or shared nature of R&D beneﬁts. and competition versus cooperation (e. reduces the completion time. 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. Firms are engaged in a multiple-stage patent race under technical and market uncertainty.4 Investment with Information Asymmetry Real life is often characterized by information asymmetry among rival ﬁrms.Extensions and Other Applications 411 Smit and Trigeorgis (1997) analyze an R&D investment problem where the underlying R&D value is affected by strategic interactions. their roles (leader or follower).. which may alter their initially planned behavior accordingly. ﬁrms’ information asymmetry or learning experience. the drilling of an exploratory oil well. joint venture) in the R&D stage. a ﬁrm may have better knowledge of its own cost structure or the probability of success of its own R&D efforts. and their learning experience. Faced with uncertain revenues and technology costs. investing ﬁrms may convey signals to other ﬁrms that enable learning or revision of their prior beliefs. Azevedo and Paxson (2009) discuss investment in new technologies whose functions are complementary. R&D competition erodes the option value to delay a project. Firms choose output endogenously and may have different production costs as a result of their R&D effort success. Garlappi (2004) analyzes the impact of competition on the risk premia of R&D ventures.

Firm j has complete information.412 Chapter 13 discrete-time option models ﬁrst. 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. and then present continuous-time analyses. so that quantities are chosen as in the complete-information duopoly game. There exists a Bayesian equilibrium that maps ﬁrm i’s investment cost I i into ﬁrm i’s investment threshold. Ci (qi ) = ci qi . if ﬁrm j invests ﬁrst. whereas ﬁrm i knows its own cost ci but not its rival’s. 3b (13. the effect of incomplete information crucially depends on the order of the investment decisions. believing it to be cH with probability P or cL with probability 1 − P. However. namely P( X t . Information asymmetry effectively collapses. where Q = qi + q j is the total industry output and X t is an additive stochastic shock (demand intercept) as in Smit and Trigeorgis (2004). Firm i’s expectation about its rival’s cost is c j = PcH + (1 − P ) cL. the sequential incomplete-information equilibrium is derived analogously to the simultaneous one. its own cost being cH or cL. it will reveal its private cost information through its quantity choice (Cournot–Nash quantity). Firms face linear marginal costs. Since both ﬁrms are (ex ante) symmetric. that is. That is. cL or cH . 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 ). the outcome may be different.4) in knowledge of both costs. as if having knowledge of the leader’s cost.1) with a = 1. ﬁrm i’s exercise strategy involves a . ﬁrm j selects equilibrium quantity q* = j 1 ( X t − 2c j + ci ) 3b (13. Zhu and Weyant (2003a. b) consider two ﬁrms facing stochastic linear (inverse) demand of the form given in equation (7. Following continuous-time analysis. If ﬁrms invest simultaneously. Q) = X t − bQ.5) In case of sequential investment decisions. 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* = 1 ( X t − 2ci + cj ). If the less-informed party (ﬁrm i) moves ﬁrst.

Rival’s inaction at a new high allows a ﬁrm to update its belief about the rival’s investment trigger and thus about its rival’s investment cost (inaction by the rival is “good” news). The patent allows disregarding the entry of the follower and concentrating solely on the leader’s optimal timing decision and the interplay between preemption and information asymmetry.7) If ﬁrm i does not exactly know its rival’s investment cost. 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 .6 Accounting for the risk of i preemption. yielding value VL ( X L ) I = Π*. Murto and Keppo (2002) consider an investment game where the follower loses any possibility to enter. Thijssen. They show that the threshold in case of information asymmetry is located between the zero-NPV (preemption) threshold and the monopolist’s myopic threshold.12) and hj (·) is the hazard rate hj ( x) = xFj ′ ( x ) [1 − Fj ( x)]. the rival’s value drops to zero. it does not alter the ﬁrms’ investment strategies. 0 ≤ s ≤ t} is reached. X t = [VL ( X P ) − I i ] ⎜ i0 ⎟ ⎝ XP ⎠ ( ) β1 i ⎡ 1 − Fj ( X P ) ⎤ ⎥. Assuming a distribution function Fj (⋅) for the rival’s investment trigger X j . . As in the case of preemption with complete information. They characterize the resulting Nash equilibrium under different assumptions concerning the information that the ﬁrms have about their rivals’ valuation.2). i β 1 − 1 + hj ( X P ) (13. 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. when ﬁrm i ignores its rival’s action. 7. The authors derive ﬁrm i’s myopic threshold i i X L.6) where β1 is given in equation (9. where VL ( X P ) = X P δ and Π*′ ≡ i β 1 + hj ( X P ) . with Π * as per equation (13. and 6. When ﬁnally one of the ﬁrms invests. ﬁrm i’s value is ⎛X ⎞ i ˆ Li0 X t .Extensions and Other Applications 413 mapping from the distribution G( I j ) to a belief Fj ( X j ) for the rival’s investment trigger. ﬁrm i’s optimal investment threshold is X P such that i i i [VL ( X P ) I ] = Π*′. ⎢ ˆ ⎢ 1 − Fj X t ⎥ ⎦ ⎣ ( ) (13. I . The authors assume that the market is incontestable once a leader has entered. Huisman.7 Given the optimal timing decision. there exists a mapping from the ﬁrm’s investment cost i to its optimal investment trigger X P . While the updating process raises the value of each ﬁrm. as is the case when the market is fully protected by a patent. but knows its distribution.

They incorporate both a ﬁrst-mover advantage and a second-mover advantage in terms of information spillovers resulting from option exercise. Interestingly. This ultimately relates to the intensity and informativeness of signals. either the ﬁrst or the second-mover advantage may dominate. while in many cases observed exercise decisions may convey valuable private information. there are other instances when no useful information can be inferred. Grenadier (1999) analyzes a general setting where agents formulate option exercise strategies under imperfect information.414 Chapter 13 Kort (2006) consider a market where two ﬁrms compete for investing in a risky project. Suppose that the payoff received upon entry is not perfectly known to the ﬁrms. leading to preemption or a war of attrition game. The ﬁrm may nevertheless infer its rivals’ private signals by observing their entry decisions. Maeland (2010) combines real options theory with auction theory to develop a winner-takes-all investment model for . Depending on speciﬁc parameter choices. Markets with large information asymmetry may experience smooth exercise patterns over time. Duopolists may raise project value by conducting R&D and/or gathering more information about the project. Martzoukos and Zacharias (2001) study project value enhancement in the presence of incomplete information and R&D spillover effects. each having received an independent private signal concerning the true underlying value. This may occur when optionholding ﬁrms ﬁnd their private information overwhelmed by recent information conveyed by others and adapt their behavior accordingly. In such settings investment strategies can generate equilibrium outcomes that differ signiﬁcantly from the standard full-information equilibrium outcome. This setting provides a general foundation for solving many problems arising under imperfect information. Due to information spillovers. 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. more competition does not necessarily lead to higher social welfare. However. they act strategically by optimizing their behavior conditional on the actions of their rival. 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. while markets with milder information asymmetries may sometimes experience a rapid series of investments or information cascades. A ﬁrm has a prior belief about the distribution of its rivals’ signals. updating its beliefs when new entry triggers are attained.

hoping to enjoy rents in a monopolistic industry structure. The optimal timing game is viewed as a war of attrition or chicken game. 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. The authors examine the learning externality. 13. 1990) or Fudenberg and Tirole (1986). The resulting “war of attrition” results in a unique symmetric equilibrium..5 Exit Strategies Exit decisions in declining markets may also involve strategic interactions among incumbent ﬁrms. by allowing for the stochastic decline of a market. Once again. The authors show that the sequence of exit is not unique due to “jumps” in the demand process. Inversely.Extensions and Other Applications 415 markets with two or more players with asymmetric information about the cost of investment. Firms may wait for their rival to exit ﬁrst. Similar to previous models where investment is considered irreversible. option to invest) the threshold is attained from below.g. Duopolists disinvest or exit later than a monopolist. each ﬁrm tries to convince its rival that its own cost is high so that the rival should invest ﬁrst. 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. Firms have symmetric information about the signal realization but asymmetric information about their rival’s investment cost. such as Ghemawat and Nalebuff (1985. Sparla (2004) analyzes closure or exit options for a duopoly where ﬁrms face a stochastically declining market in continuous time. Fine and Li (1989) complement deterministic duopoly models of exit. 8. in the present case where we deal with a put option the threshold is reached from above. . Each investor knows its own costs but ignores its rival’s cost. In cases involving perpetual American call options (e.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. This may lead to a war of attrition. re-entering the market after having exited is ruled out. In this setting an aggregate shock (modeled as a geometric Brownian motion) affects the proﬁt value received by the two ﬁrms. 9. the decisions made by duopolists may differ from what a monopolist would do.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 proprietary option. By delaying investment.

exit rather than partial closure (as in the original paper). For the sake of comparability between models. We simplify using a single aggregated salvage value S. Π* is a lower cutoff proﬁtability level to be reached at the time of exit. is hit.8).10) 10.. β2 − 1 (13. the high-cost ﬁrm exits ﬁrst and the low-cost ﬁrm stays longer. that is.8) j ˆ with VFj = π F / δ where the “convenience yield” is δ = k − g = r − g. We also simplify the expression for the payoff received upon exiting. 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. . given by equation (13. the low-cost ﬁrm may possibly exit earlier. For identical ﬁrms the unique symmetric strategy proﬁle in equilibrium is for both ﬁrms to exit the ﬁrst time X F . In case of asymmetric ﬁrms with small cost differential. Sparla’s (2004) model was simpliﬁed by assuming full closure. where the j 10 threshold X F is given by j X F VFj = Π* S (13. The deterministic component of the market’s (inverse) demand function is of the constant-elasticity type: π ( X t . layoff costs).416 Chapter 13 j The follower (ﬁrm j) will exit the ﬁrst time X F is attained.3) in the appendix at the end of the book: β2 ≡ ˆ ˆ −α − α 2 + 2rσ 2 σ2 (< 0 ) ˆ ˆ with α ≡ g − (σ 2 2). Murto (2004) considers a similar problem in which duopoly ﬁrms differ in terms of production scale (with ﬁrm i smaller than ﬁrm j). The symmetric equilibrium proﬁle where both ﬁrms exit at TF is the best achievable outcome from the viewpoint of the industry. Here ﬁrms face a multiplicative aggregate demand shock X t following a geometric Brownian motion.g. Qt ) = X t Qt−1 η. Sparla (2004) and Murto (2004) (discussed later) are more explicit. (13. decomposing this value into operating cost savings made upon exiting the market (positive value) and costs incurred to make exit effective (e. If the cost differential is large. however.9) where β 2 is the negative root of the fundamental quadratic given in equation (A2. It is given by Π* ≡ β2 .

Firms can incur a cost of I per unit. To account for time to build. there is a unique exit i sequence where the smaller ﬁrm (i) exits ﬁrst (leads) when threshold X L obtained from equation (13. The resulting exit thresholds. The leader’s willingness to stay in the market increases with volatility because its put option value is increased. K t = Qt + Qt ′ = Qt + D.12) is ﬁrst reached and the largest ﬁrm ( j) j follows suit when X F from equation (13. with ˆ δ = k − g = r − g and Π* as given in equation (13. For low levels of volatility. X L j for the ﬁrst exiting ﬁrm (leader) and X F for the last one (follower). Aguerrevere (2003) relaxes this assumption and obtains a mean-reverting price process exhibiting volatility spikes.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 . The variable cost incurred by a ﬁrm is a function of capacity utilization υ ∈[0.12) j i i where the value functions are VFj = π M / δ and VL = π C / δ . a new (Markov) committed capacity state.12 At each period ﬁrms choose their optimal level of capacity utilization.11) and i i X L VL = Π*. For high volatility levels. S (13.9). 1]. . however. are such that j X F VFj = Π* S (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). and time to build. 13. tracks 11. Aguerrevere’s (2003) model complements this explanation. 12. Firms operate identical production facilities. Q) = X t − bQ. Capacity expansion takes D years to implement (complete). expanding capacity incrementally at any point in time.Extensions and Other Applications 417 i where η ( > 1) is the elasticity of demand. capacity utilization. Such price evolutions have traditionally been explained through the dynamics of storage. the cost function is C (υ ) = c1υ + (c2υ 2 2). this equilibrium is no longer unique and the reverse ordering with the largest ﬁrm exiting ﬁrst may also obtain as industry equilibrium. In his model the price behavior arises from the interplay among installed capacity.11) is reached for the ﬁrst time. even when the (additive) stochastic demand shock or demand intercept X t follows a geometric Brownian motion.

15. For an n-ﬁrm oligopoly. completion of capacity expansion is preceded by a phase of high utilization and high prices.14 Surprisingly. Whenever the current demand level X t exceeds X M (K ). Without time-tobuild delays. capacity units under construction can effectively be considered as a set of European call options (with maturities t + D) on the net proﬁt from an extra unit of capacity. This arises from the trade-off between the increased risk of capacity underutilization and the higher uncertainty increasing the value of capacity under construction. but the timing of expansion and the utilization rate are independent. the value of growth options decreases with the number of ﬁrms and approaches zero when n tends to inﬁnity (as in 13. However.15 The output price paths exhibit mean reversion and signiﬁcant spikes in times of full capacity utilization. Aguerrevere (2009) relaxes the assumption of time to build and uses linear operating costs. both the committed and operational oligopoly capacity are strictly greater. Capacity under construction is analogous to a set of European call options whose value is strictly increasing in volatility.13 The trigger demand level X M (Kt ) for exercising an expansion option given the currently committed capacity is obtained. Weights are determined based on the present values of assets in place and of growth options.16 In line with Grenadier (2002). ﬁrms may provide more capacity if faced with greater uncertainty. aggregate committed capacity Kt is decreasing in the underlying volatility. If an extra unit of capacity always at least breaks even (as it can be shut down at no cost). a monopolist ﬁrm will commit additional capacity. the partial differential equation describing the value evolution of the monopolist’s option to invest in an extra unit of capacity can be derived. Industry capacity increases with the number of ﬁrms. oligopolistic ﬁrms will add capacity at the exact same time as a monopolist would. with time to build. The option to launch the construction of a unit of capacity is thus analogous to an American call on this set of European calls. as all committed capacity will be operational prior to the earliest maturity t + D. 16. Due to time-to-build delays. utilization of operational capacity is independent of the number of ﬁrms. 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. 14. a symmetric equilibrium results such that the expansion threshold is identical to the monopoly case.418 Chapter 13 the sum of capacity units currently operational Qt and units currently under construction Qt ′ (“in the pipeline”). However. That is. He examines the ﬁrm’s systematic risk (beta) in a competitive setting. . The value of each European call option depends only on X t and K t. Given this relationship. The oligopoly quantities can be expressed as the corresponding monopoly capacity times a constant multiplier.

but this disadvantage is compensated by a lower outlay per unit of capacity added. the level of market demand and the current time. Under intensiﬁed competition. In case of geometric Brownian motion.Extensions and Other Applications 419 perfect competition).17 Once the infrastructure (transmission capacity) is installed. . Investment decisions are sequential. The authors examine the asymmetric case where ﬁrm j must invest in large lumps compared to its rival. n. 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. Starting with zero initial capacity. demand level or the number of ﬁrms. and Keppo (2004) consider multiple investment opportunities available to ﬁrms. enabling derivation of the optimal expansion (Markov) strategies via dynamic programming. ﬁrm i (symmetrically ﬁrm j) can decide at any time to invest I i (I j) to increase capacity by a lump sum ΔQi (ΔQj). the ﬁrm’s beta decreases with the number of rivals. Consider a data bandwidth market with two incumbent ﬁrms. For high demand. with the ﬁrst mover being randomly chosen. Regardless of the number of ﬁrms. assets in place are generally less risky when demand is high as capacity utilization is increased. Any single investment subgame is fully described by current ﬁrm capacities. The outcome in this asymmetric case stands in sharp contrast to the case 17. meaning it is independent of industry capacity. ﬁrms also decide on whether to expand capacity. Investment-inducing demand thresholds characterize these expansion strategies. the growth option’s beta is constant.10). providing bandwidth is effectively costless. As these thresholds are increasing in a ﬁrm’s installed capacity. the capacity held in the industry is utilized more in response to demand increases. but for low demand it increases. the smallest ﬁrm is more likely to respond to small demand shocks by expanding capacity. While this quantity choice constitutes a tactical decision. The ﬁrms’ continuation values in the ﬁnal period are determined as perpetuities assuming steady state for future capacity.7 Lumpy Capacity Expansion (Repeated) Previous models typically assumed that each ﬁrm has only one investment option. 13. Suppose that the demand function is of the constant-elasticity type as in equation (13. Näsäkkälä. In any given state ﬁrms maximize current proﬁts by selling the Cournot–Nash quantity under capacity constraints. The GBM is discretized in a CRR binomial lattice. In each period the ﬁrms set their output and earn the market-clearing price for each unit sold. Murto.

Firm i beneﬁts from the asymmetry although it has higher costs per unit of capacity because it can react quicker to changes in demand. Boyer. and Moreaux (2010) reﬁne previous contributions on strategic investment developed in a deterministic setting. Compared to the payoffs of a monopolist. 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.18 Firm i’s payoff distribution has distinctly more probability mass at higher payoff levels than ﬁrm j’s. effectively investing more often than its rival. whereas Boyer. The ﬁrm roles are endogenously determined and commitment to a rigid long-term development program is not credible. Later if ﬁrms hold capacity.19 Initially. this is compatible with joint-proﬁt maximization. This distortion implies riskier entry and lower expected returns. notably Gilbert and Harris (1984). Lasserre. the aggregate duopoly payoff in the asymmetric case is lower and more skewed to the left. two types of equilibria may arise. but higher volatility may cause the ﬁrst industry investment to occur earlier. (2004) assume that reduced-form stage proﬁts are the outcome of Bertrand price competition. . Such equilibria are more likely to exist in highly volatile or fast-growing markets. Lasserre. and Mills (1988). 19. Boyer et al. This timing rivalry causes the ﬁrst industrywide investment to occur earlier than what would be socially optimal from the viewpoint of industry participants. However. In the symmetric case the ﬁrms’ payoffs are distributed identically. When ﬁrms do not hold any existing capacity. and Moreaux (2010) consider Cournot quantity competition. two ﬁrms have low capacities. The threat of preemption is real and may lead to the complete dissipation of any ﬁrst-mover advantage as in a preemptive sequential equilibrium. The only possible equilibrium in such burgeoning industries is the preemptive sequential (closed-loop) equilibrium. When ﬁrms are of equal size. both the lower market power in duopoly and the threat of preemption (hastened increased capacity buildup) drive this result.420 Chapter 13 involving symmetric ﬁrms. tacit-collusion equilibria are ruled out because ﬁrms are not threatened by the loss of existing rents. 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 possibility of collusion or cooperation is more attractive to symmetric ﬁrms than to (sufﬁciently) asymmetric 18. Fudenberg and Tirole (1985). Rent equalization occurs irrespective of the volatility or the speed of market development. when ﬁrm asymmetry is large the joint investment threshold is beyond the level that maximizes value for the disadvantaged ﬁrm. This response ﬂexibility advantage exceeds the cost disadvantage regarding the necessary investment outlay.

They also examine the effect of ﬁrst vs. 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. At later stages of development. The . They examine the sensitivity of the ﬁrms’ value to changes in market shares. Kulatilaka and Perotti (1998) discuss growth options under uncertainty and imperfect competition. increased volatility fosters investment in growth options. the authors show that followers may have important advantages as well. A ﬁrst-mover advantage may lead to capture a greater market share. Cottrell and Sick (2002) examine competitive value erosion arising when decision makers anticipate preemptive entry by rivals. process parameters and volatility. Although market pioneers may gain ﬁrst-mover advantage. either by deterring entry or by inducing rivals to leave more room for a stronger competitor. Kong and Kwok (2007) examine a duopoly involving asymmetric ﬁrms in terms of investment costs and uncertain revenue ﬂows. the authors show how efﬁcient implementation programs affect the adoption-timing decisions in a duopoly. when ﬁrms hold substantial capacity. both the unit price and demand (number of units sold) are random. while lower volatility might reduce the incentive to do so. second-mover advantages and adoption costs on adoption timing. Nielsen (2002) considers positive externalities and scenarios where a ﬁrm has multiple investment opportunities. Boyer and Clamens (2001) examine why in the US reengineering projects often fail due to internal resistance to corporate changes or lack of commitment from management. In the second. 13. determining the follower’s and leader’s values. This challenges the common result that higher volatility delays investment. returns and investment costs are subject to economic shocks. With decreasing proﬁt ﬂow.8 Other Extensions and Applications In this section we provide more breadth of application covering other related literature. When the strategic advantage is strong. Extending a model proposed by Stenbacka and Tombak (1994). a monopolist invests later than a leader in a preemption scenario. competition is weaker and tacit-collusion equilibria may persist.Extensions and Other Applications 421 ones. Paxson and Pinto (2003a) consider a duopoly where the leader’s market share follows a birth and death process. In the ﬁrst. Paxson and Pinto (2003b) discuss two distinct duopoly models. In such a context.

Wu (2006) analyzes capacity expansion in an optiongame setting where two symmetric ﬁrms choose both investment timing and capacity levels. Williams (1993) considers the option to develop an asset under stochastic demand uncertainty. focusing on Airbus’s A380 lunch and Boeing’s best strategic response. tacit collusion may sustain whereby ﬁrms delay investment more than a monopolist. ﬁrms face hysteresis or delay effects. Firms may enter or exit depending on demand realization. Baba (2001) considers a duopoly option game to examine a bank’s entry decisions into the Japanese loan market. Weyant and Yao (2005) study the sustainability of tacit collusion equilibrium in case of information time lags. For a longer time lag. Botteron. Inversely. shedding light on the prolonged slump in this market over the 1990s. symmetric developers build at the maximum feasible rate whenever income rises above a critical value. Chesney. They determine the expected entry time and the probability that both ﬁrms enter within a given time interval. the range of which is decreasing in the correlation parameter. A monopolist will make its second investment earlier than the follower. The author assesses the impact of development capacity. They identify the degree of suboptimality and propose measures to reduce the discrepancy. Odening et al. Demand grows until an unknown date and declines thereafter. The optimal building rate depends on a stochastic exogenous factor and affects aggregate demand. (2007) show that myopic planning may lead to suboptimal investment strategies.422 Chapter 13 number of available investment projects does not affect the timing of the ﬁrst investment. for a sufﬁciently short time lag. and Gibson-Asner (2003) model production and sales delocalization ﬂexibility for multinational ﬁrms under exchangerate risk. and the concentration of developers. Tsekrekos. Shackleton. preemptive equilibrium is more likely to arise. and Wojakowski (2004) analyze the entry decisions of competing ﬁrms in a duopoly when rival ﬁrms earn distinct but correlated economic proﬁts. They illustrate their model in the duopoly situation faced by Boeing and Airbus. Pineau and Murto (2004) apply similar thinking to the deregulated Finnish electricity market subject to stochastic demand growth. of the supply of underdeveloped assets. deriving the optimal investment strategies and resulting ﬁrm values under perfect equilibrium. In Nash equilibrium. ﬁrms may act strategically and exercise their delocalization options preemptively at an endogenously set exchange rate. . Depending on industry structure. In the presence of sunk entry costs. determining ﬁrm strategies in terms of investment and production levels for base and peak-load periods.

g.. economics and strategy in both the academic and managerial realms. such as why there may be strategic delays in patent races while in other situations (e. These new insights help us understand puzzling phenomena. involving positive externalities) investment might be expedited. 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. The option games approach developed herein considers optimal investment strategies as part of an industry equilibrium.Extensions and Other Applications 423 Conclusion In this chapter we synthesized and discussed new developments and applications concerning option games. (2011) discuss a number of research contributions and the managerial insights derived. Gravel. We also glimpsed at important extensions and applications with thought-provoking implications for ﬁrm competitive strategy and public policy. Selected References Boyer. Huisman et al. Asymmetric models are more involved but provide a more natural ordering of ﬁrst and second-investor timing in sequential decisions. delayed implementation (sleeping patents) or real-estate market quirks. 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. Sequential investment in case of cost asymmetry involves substantial option value erosion due to competitive entry. We considered both symmetric and asymmetric ﬁrm conditions. Option games are at the forefront of developments in corporate ﬁnance. and Grenadier (1999) discusses informational asymmetry. 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. They also help us understand industry phenomena like delayed exit. (2004) give an overview of continuous-time models dealing with lumpy investments in a competitive setting. and Lasserre (2004) discuss a set of option games contributions. Grenadier (1996) develops a general approach for dealing with time lags with application to the real estate market. Chevalier-Roignant et al. .

Flath. 2004. Strategic investment under uncertainty: Merging real options with game theory. . Journal of Finance 51 (5): 1653–79. 1996. Steven R. Peter M. 1999. Information revelation through option exercise. European Journal of Operational Research 215 (3): 639–50. CIRANO. Eric Gravel. Grenadier. Real options and strategic competition: A survey. 2004. Strategic investment under uncertainty: A synthesis. Chevalier-Roignant. Kort. Marcel. Steven R. Review of Financial Studies 12 (1): 95–129. M. 2011. Montreal. Huisman.424 Chapter 13 Boyer. Benoît. Arnd Huchzermeier. Grenadier. Kuno J. and Lenos Trigeorgis. and Pierre Lasserre. Mimeo.. Jacco J. Thijssen.. Gregorcz Pawlina. Zeitschrift für Betriebswirtschaft 67 (3): 97–123. The strategic exercise of options: Development cascades and overbuilding in real estate markets. Christoph M. J.

we take care to interpret the assumptions and provide a compendium of key properties. 2. market developments. Since the payoff function f (⋅) of a call option is convex in the underlying factor X . An alternative approach— sketched in Øksendal (2007)—is based on the Stratonovitch integral rather than the Itô integral. We here concentrate primarily on Itô’s theory of integration. so we refer to the dedicated literature. ﬁnance. 327–28n. and economics. such as physics. topics in advanced mathematics that have many applications in applied sciences. For a put option whose payoff function is concave in the underlying factor. he considered Itô calculus a more appropriate tool for economics since it precludes foresight.1 the main stochastic processes that admit “nice” mathematical properties useful for applications in economics and ﬁnance.2 Nevertheless.1 As noted.” . This difference can be seen from Jensen’s inequality applied to convex or concave functions. not expected. The raison d’être of this appendix is to ﬁll prerequisite gaps and help smooth the exposition in previous chapters. When Merton identiﬁed stochastic calculus as a useful tool for the continuous-time analysis of capital markets. Merton (1998. the opposite inequality holds. In this appendix we brieﬂy describe in section A. real options analysis allows for the determination of such optimal strategies. These stochastic processes are made up 1. At places we refer to the following results from this appendix to avoid having lengthy demonstrations in the chapters. 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 development) and an equivalent model based on expected values.Appendix: Basics of Stochastic Processes The strategy of a ﬁrm must generally be adapted to actual. pp. Jensen’s inequality states that E [ f ( X )] ≥ f ( E [ X ]). 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. 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. The underlying theories are often mathematically involved. This is enabled by using stochastic calculus and control theory.

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. of real options analysis.. we sketch the mathematical theory of optimal stopping/timing under uncertainty in section A.3 Alternatively. 4. noise or error term that reﬂects deviation from the expectation. Finally. They are also essential as a building block for the evaluation of real options in a competitive setting.4). by extension. A stochastic process is a collection of random variables such that the value of the process at each time t is random but determined via a known probability distribution. proxying for uncertainty. stock price or project value) is assumed to follow a speciﬁc stochastic process. or in continuous time if they are subject to change at any time (continuous time set).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.2 that follows we discuss the notion of “forward net present value” and provide analytical solutions in a number of interesting situations. for instance.4 Stochastic processes can be classiﬁed in two categories. In section A.3 we discuss the concept of ﬁrst-hitting time. The Brownian motion discussed below.1 Continuous-Time Stochastic Processes Stochastic processes represent a mathematical cornerstone of optionpricing theory and. stochastic processes. . is characterized by stationary. The study of multidimensional processes allows the analysis of economic problems where value functions may depend on several. possibly correlated. They can be formulated in discrete time if they change only over certain discrete time intervals (countable time set). normally distributed increments.4. In the following discussion we focus on one-dimensional stochastic processes of the Itô family.g. Stochastic processes are often classiﬁed based on the assumed probabilistic law of motion governing their increments. prop 12. that is. In such models the underlying asset or factor (e. individually independent. the changes in the value of the asset evolve over time in an uncertain or unpredictable manner. providing explicit solutions for expected discount factors for certain Itô processes. Any continuous-path process whose increments share these three properties is a (drifted) Brownian motion (see proof in Breiman 1968. A. 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 following a certain probability law. In section A. Here we primarily focus on Itô processes. which are continuous-time stochastic processes with 3.

F. .Appendix: Basics of Stochastic Processes 427 continuous sample paths. owing to Lévy characterization theorem. this property is consistent with the weak form of the efﬁcientmarket hypothesis (EMH). 177–78). the most common being arithmetic and geometric Brownian motions. The EMH challenges the foundation of technical analysis. pp. Poisson and jump-diffusion processes are not a primary subject of examination here since they have discontinuous sample paths. F. 47) A standard one-dimensional Brownian motion is a continuous. unpredictable information—which is unrelated to past unexpected information that drove past price movements.6 Technically we assume the following (ﬁltered) probability space (Ω.7 A. conditional expectations are written E ⎡⋅⏐Ft ⎤ or Et[⋅]. Deﬁnition (adapted from Karatzas and Shreve 1988. 7. To prevent foresight. corresponds to the increment of a standard Brownian motion.1. ⎣ ⎦ 8. This process has been formulated in physics to study the motion of small particles in liquids or gas. where F ≡ {Ft }t ≥ 0 is a ﬁltration. The tribe Ft corresponds to the information set on which the decision maker bases her decision at time t. The origin of the concept explains why still today the graph of the values taken by the process is referred to as a “path. Asset price changes are thus independent over time. P ) such that:9 5.8 A multitude of continuous-path Markov processes can be represented in terms of a standard Brownian motion. Bachelier’s (1901) treatise provides the ﬁrst known application of the Brownian motion to describe ﬁnancial or economic phenomena. See Neftci (2000. The efﬁcient market hypothesis (EMH) asserts that competition among hundreds of competent. meaning that all relevant information governing future increments are summarized in the latest state of the process. adapted process z = {zt } deﬁned on a given probability space (Ω.5 Itô processes are memoryless or Markov. If the current price already reﬂects all the information contained in past prices. When applied to traded assets. rational investors ensures that the latest information is immediately incorporated into the current price. 6. The standard Brownian motion and Wiener processes differ in their deﬁnitions. Our discussion is based on the premise that stochastic processes and their functions are adapted to the ﬁltration. Standard Brownian Motion The term dzt . expectations formed at time t are conditional on the information revealed up to now. often entering the description of Itô processes. p. It has been mathematically formulated by Louis Bachelier (1901) and Albert Einstein (1905). P ). 9.1 Brownian Motion A cornerstone stochastic process is the standard Brownian motion or Wiener process. but the mathematical object is essentially the same. Ft . namely a family of tribes (or σ algebra) such that Fs ⊆ Ft for all s ≤ t . prices will change only in response to new. namely that decision makers cannot make decisions based on information that is not yet revealed.” The physical phenomenon has been discovered by the English botanist Robert Brown in 1827.

g. Formally E [ zt + h | Ft ] = zt for all h > 0. that is. In the present case the expected value is zero since the starting value of the process is zero (by deﬁnition). Martingales are not discussed at length here but they are regarded essential for a mathematical understanding of continuous-time ﬁnance (e.11 One can also (informally) state that dzt 2 = dt over any inﬁnitesimal increment (h → dt ) and var (zt ) = t. 11. • 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). This feature is of cardinal signiﬁcance for stochastic calculus. Under certain conditions one can deﬁne an integral with respect to a standard Brownian motion (Itô integral) rather than with respect to time. and all processes based on it. sufﬁcing to use a loose deﬁnition of it.428 Appendix: Basics of Stochastic Processes • • the starting value z0 = 0 almost surely. 10. E ⎡zt + h ⏐Ft ⎤ = E ⎡zt + h ⏐zt ⎤ ⎣ ⎦ ⎣ ⎦ • A measure of dispersion or variation over a time interval h is var(zt + h − zt )2 = h. 12. do not admit a time derivative. We do not intend to discuss this measure of dispersion in detail. the value increment zt + h − zt is normally distributed with mean zero and variance h. . Such integrals have zero expected value. as standard differentiation techniques cannot be readily employed. The equation here relates to the Markov property. • It is a Markov process. not the strong Markov property that involves stopping times.12 Unfortunately. It is a martingale. the standard Brownian motion. risk-neutral valuation). 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. The quadratic variation drives much of the differences between deterministic and stochastic processes. the value increment zt + h − zt is independent of information revealed up to time t. The Itô integral captures the noise of the phenomenon around its expected trend.. It relates to the quadratic variation of the Brownian motion. meaning that the best estimate (expectation) of its future value is its present value. so that10 ∀h > 0 . The mathematical subject underlying this property is more complex than implied here.

namely var (zt ) = t.1 depicts a sample realization or sample path of an arithmetic Brownian motion.13 One may alternatively think of drifted Brownian motion as the accumulation of independent. This representation of the arithmetic Brownian motion permits a description as a stochastic differential equation (SDE) of the form dxt = α dt + σ dzt . stationary. Since the mean of the drifted Brownian motion grows with t and the standard deviation with t . and σ is its volatility or standard deviation. Since the standard Brownian motion is a martingale with starting value zero. The parameter α. For a large time horizon. (A. can be constructed based on the standard Brownian motion described above. the random variable xt 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 ). A linear function with slope α represents the expected growth trend. called the “drift parameter. given its initial value x0. Formally this process is of the form xt = x0 + α t + σ zt .” measures the growth (expected) trend of the process. or xt as shorthand. The “variance” of the arithmetic Brownian motion comes from the “variance” of the standardized Brownian motion. (A.1) where zt is a standard Brownian motion as deﬁned previously. 14. The actual sample path moves around the expected (long-term) trend due to volatility σ . The arithmetic Brownian motion (ABM) is a continuous-time Markov process such that.14 When applied to ﬁnancial assets. whereas in the short term volatility is what really matters. It admits a nonzero starting value and an expected trend. 13.2) Figure A. . Most economic variables can be reasonably described by their drift and volatility.Appendix: Basics of Stochastic Processes 429 Arithmetic Brownian Motion The drifted or arithmetic Brownian motion x = {xt }t ≥0 . this property is in line with the common saying that in the long term. and identical normally distributed increments dxt over many nonoverlapping small time intervals of length dt . the third right-hand term disappears in the expectation. but in the short run they may ﬂuctuate due to random factors or volatile capital markets. with each increment having mean α dt and “variance” σ ²dt. stock prices are driven by expected real growth trends. the growth trend is the dominant determinant. 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).

1) and the deﬁnition of the standard Brownian motion. where ε is a standard normal random variable generated by a computer program. we have θ t = Pt ⎡vt + ατ + σ τ ε ≥ I ⎤ . It follows that θ t = Pt [ ε ≥ −d2 ] with d2 ≡ vt − I + ατ (A. (A. A European call option on this stock may be exercised at maturity (time T ) by paying an exercise price I . x0 = 1 ( t0 = 0 ). From equation (A.19685.1 Sample path of an arithmetic Brownian motion ABM is discretized by xt + h = xt + α h + σ h × ε .4) . Example A. θ t ≡ Pt [ vT ≥ I ]? Here Pt [·] stands for the probability conditional on time-t information.430 Appendix: Basics of Stochastic Processes 5 4 3 Expected growth trend (linear) 2 Sample path 1 0 t Figure A.3) σ τ . α = 4 percent.2) above. What is the probability that the option will end up “in the money” at maturity T .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. ⎣ ⎦ where τ ≡ T − t and ε is a random variable with standard normal distribution. We assume h = 0. σ = 30 percent.

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. This different angle calls for the modeling of prices as a geometric Brownian motion.g.1) is ill-advised. commonly used for modeling asset prices. The double exponential underlies Laplace’s (as well as Poisson’s) ﬁrst law of random measurement error with the most-likely estimate being . 16. this process has a severe ﬂaw for modeling ﬁnancial assets since prices may possibly become negative (owing to the normally distributed diffusion term). the normal and the uniform distributions as special cases. metal and gold prices) exhibit signiﬁcant skewness and kurtosis. As pointed out by Samuelson (1965). a feature hardly descriptive of real price dynamics. (A. For positively skewed growth or distress stocks. the (natural) logarithm of price is assumed to follow a (drifted or arithmetic) Brownian motion. β may be less than 1 (leading to lower average returns). (A. If prices were negative.Appendix: Basics of Stochastic Processes 431 Since the cumulative standard normal distribution N (⋅) is symmetric (at zero). When log-return errors are normally distributed. One can 15.5) The modeling of stock prices as an arithmetic Brownian motion (as in example A. 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 . θ t = Pt [ ε ≥ −d2 ] = Pt [ ε ≤ d2 ] = N(d2 ). is an exponential form of Brownian motions. The symmetric case of the GED includes the double exponential.1). β = 1.6) where xt follows the arithmetic Brownian motion of equation (A. If returns exhibit higher moments (skewness and leptokurtosis). foreign exchange rates.. the power exponential or generalized error distribution (GED).15 Stock prices X t are instead typically assumed to be log-normally distributed to avoid this ﬂaw exhibited by the arithmetic Brownian motion. 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. ⎝ Xt ⎠ Log-returns are normally distributed. β may differ from 1. The daily log-returns of most ﬁnancial assets or indexes (e. Subbotin (1923) proposed a more general error distribution than the normal. That is. 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 ⎟ . Such exponentials are characterized by X t = f ( xt ) = exp (β xt ) = e β xt . stock market indexes. Geometric Brownian Motion and Other Exponentials The geometric Brownian motion (GBM). for negatively skewed indexes. β may exceed 1.

The drift parameter g of X t is the drift of the corresponding Brownian motion incremented by β 2σ 2 2. obtaining xt = 1 ln ( X t ).9) with β = 1 establishes the relationship between the drift of the geometric Brownian motion and that of ABM or its logarithm.2 in box A. where g is given by g ≡ g (β ) = αβ + β 2σ 2. h (⋅) solves the differential equation h′ (t ) = gh (t ) with initial boundary condition h (0 ) = X 0.9) The term gX t is the drift of the process X t and βσ X t is its diffusion term. Here β > 1 corresponds to skewness and kurtosis being present in ﬁnancial asset return errors. In other words. Hence. 2 1 (A. as in (A. h (t ) = X 0 e gt . xt = ln ( X t ): the median of observations. Theodossiou and Trigeorgis (2010) extended this to the “skewed GED.10) A special case of exponentials of Brownian motion is the geometric Brownian motion. Subbotin (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. 18. 17. Equation (A.8) expressed in the stochastic integral form and Fubini’s ⎣ ⎦ theorem that t allow for permutation of time and state integrals. .10).1) to the exponential function and Brownian motion xt yields17 dX t = ( gX t ) dt + (βσ X t ) dzt . Let h ( s ) ≡ E0 ⎡ X s ⎤ .6). 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). The drift parameter g is increasing in the volatility (σ ). it obtains h (t ) = h (0 ) + g ∫ 0 h ( s ) ds .7) Applying Itô’s lemma (see equation A1. It is the special case obtained for β = 1. From (A. while its volatility term is simply a multiple (β ) of the volatility of the arithmetic Brownian motion (σ).” Two additional parameters control the degree of skewness and leptokurtosis. When the arithmetic mean is used instead (as the most probable value for a number of separate and similar observations in a symmetric distribution). which is more accurate for real-world asset prices. f : x exp ( x ) is smooth. The special case β = 1 corresponds to the theoretical assumption that log-return distribution errors are normally distributed as per the efﬁcient market hypothesis. ⎣ ⎦ (A. which assumes that log-return errors are normally distributed. The expected value of the process at future time t follows an exponential growth path given by18 E0 ⎡ X t ⎤ = X 0 e gt . β (A.432 Appendix: Basics of Stochastic Processes readily associate the exponential X t with its corresponding Brownian motion by inverting (A.8) (A. the normal distribution is obtained instead (Gauss’s law and Laplace’s second law).

t ) = ⎡ ft + gt fX + σ t2 fXX ⎤ dt + σ t f X dzt . . ch. stock price or project value) modeled as an Itô process that follows the stochastic differential equation dX t = gt dt + σ t dzt .. called the inﬁnitesimal generator. t ) and diffusion σ t = σ ( X t .4) This operator is useful henceforth for the understanding of Bellman or HJB equations. although the term “Itô’s lemma” has become standard in ﬁnancial economics. 3) discuss generalization of Itô–Doeblin formula to multidimensional processes (integrand) and to functions having less restrictive “smoothness” conditions (with continuous martingales as integrator).a Suppose an underlying asset (e.2) where ft = ft ( X t . We here state Itô’s lemma in the context of options though it is applicable to a broader range of problems. is given by Γ≡ 1 ∂ ∂ ∂2 + gt + σ t2 . Consider an option on this asset whose payoff function f (⋅. Karatzas and Shreve (1988. Itô’s lemma asserts that the option’s price dynamics { f ( X t . t ) and f XX = f XX ( X t . fX = fX ( X t . Doeblin (1940) and Itô (1951) independently discovered this formula.Appendix: Basics of Stochastic Processes 433 Box A. Protter (2004. t ). ⋅) is twice continuously differentiable in the asset price and continuously differentiable in time. a common approach is to use Itô’s lemma. ⎢ ⎥ 2 ⎣ ⎦ (A1. a.3) = ft + gt fX + σ t2 fXX . ⋅) with respect to their subscript. ∂X 2 ∂X 2 ∂t (A1. t )}t ≥0 also follows an Itô process and that its value increment is described by the stochastic differential equation 1 df ( X t .1 Itô’s lemma To describe the dynamics of functions of stochastic processes. Doeblin’s variant was lost for almost sixty years until the early 2000s. t ) h 1 2 (A1. t ) stand for the ﬁrstorder and second-order derivatives of f (⋅. Since standard differentiation approaches do not apply for stochastic processes. ch.1) with drift gt = g( X t . The operator Γ . This formula should properly be referred to as Itô–Doeblin formula. 2) deﬁnes stochastic integrals with respect to (nonnecessarily continuous) semimartingales.g. t ) ≡ lim h→0 Et [ f ( X t + h . This is analogous to the “chain-rule” of stochastic calculus. one needs a sort of “differentiation” rule. t + h)] − f ( X t . (A1. The expected capital gain of the option over an inﬁnitesimal time interval is given by Γf ( X t . t ).

2 1 (A.12) where zt is a standard 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 continuously compounded nature of growth.0 Expected growth trend (exponential) 1. σ . h = 0.0 t Figure A.5 1.2 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).2 depicts a realized sample path for the geometric Brownian motion. The geometric Brownian motion is also referred to as a proportional Brownian motion since the expected change per time interval h.19 Figure A.5 2. The stochastic differential equation for the geometric Brownian motion can be written (from equation A. ε t is (standard) normally distributed.” . (A. Et ⎡ X t + h − X t ⎤ X t .5 0. σ = 20 percent.434 Appendix: Basics of Stochastic Processes 2. equal to gh .8 with β = 1) as dX t = ( g X t ) dt + (σ X t ) dzt. and X 0 = 1 ( t0 = 0 ). ( ) g ≡ g (1) = α + σ 2 .11) The volatilities are the same. is propor⎣ ⎦ tional to the time interval considered.0 Sample path 0. The actual sample path moves 19. g = 9 percent. Dixit (1993) employs the term “proportional Brownian motion.039526.

Appendix: Basics of Stochastic Processes 435 around this exponential expected growth trend.2) to f (⋅) and employ the inﬁnitesimal generator notation in (A1.1 equation (A1. so the probability of the option being exercised at 20. ⎣ ⎦ with γ ≡ ng + [ n (n − 1) σ 2 2 ] and n a positive integer. only the expected value matters (as var0 ⎡ X t ⎤ → 0). Example A. The actual realized value of the process at time t. is 1 ⎤ E0 ⎡ X t ⎤ = X 0 exp ⎡⎛ α + σ 2 ⎞ ⎥ t . when volatility is zero. h (t ) = X 0 n + γ ∫ 0 h ( s) ds.13) X 0 ≡ e x0 is the initial (time-0) value of the geometric Brownian motion. obtained by substituting equation (A.15) Uncertainty affects the dispersion around the growth trend. the result follows from equations (A.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. X t . Consider a European call option with maturity T (> t ) and exercise price I .10). Set h ( s ) = E0 ⎡ X s n ⎤. h (⋅) thus solves the ordinary differential n equation h ′ (t ) = γ h (t ) with initial condition h (t ) = X 0 .1 derived the probability of being in the money for a European call option on a stock that follows an arithmetic Brownian motion. . then the instantaneous expected value change is Γf ( X t ) = γ f ( X t ) .. Replace vt by ln (Vt ) and the exercise price I by ln ( I ) in equation (A.13) [ﬁrst moment] by factorization.e.11) in equation (A. 2 ⎡ ⎤ ⎡ ⎤ ⎡ ⎤ 21. From Dynkin’s formula and ⎣ ⎦ t Fubini’s theorem. might differ from the expected ⎡ ⎤ value E0 ⎣ X t ⎦ since the actual value depends on noise or randomness as well. ⎣ ⎦ (A. Growth is compounded since future value is driven by both growth on the initial value X 0 and growth on recent growth.2 Black–Scholes European Call Option Pricing Suppose that stock price Vt follows a geometric Brownian motion as in equation (A.12). The expected future value of X t . ⎣ ⎦ Example A. As var0 ⎣ X t ⎦ = E0 ⎣ X t 2 ⎦ − E0 ⎣ X t ⎦ .14) follows. Apply Itô’s lemma from box A. with the variance of X t increasing with instantaneous volatility σ . 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.4). In the deterministic case (σ → 0). Equation (A.14) ( 2 ) (A. i. 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−2.14) (with n = 2 ) and (A. The expected future value depends on the initial value X 0 increasing exponentially (geometrically) at a constant growth rate g = α + (σ 2 2).4).

g.19) by symmetry (at zero) of the standard normal distribution (ε ′ ). At maturity T the payoff of the European call option on .17) where α = g − (σ 2 2) and τ = T − t. In complete capital markets that preclude arbitrage opportunities. then (A. Since ε ≥ −d2 implies ε ′ ≥ −d1 with d1 ≡ d2 + σ τ . ) } Let ε ′ ≡ ε − σ τ . see Cox and Ross 1976 or Harrison and Kreps 1979)... (A. dN(⋅) is the probability density of the standard normal distribution dN (ε ) ≡ ⎧ ε2 ⎫ exp ⎨− ⎬ dε . 2π ⎩ 2⎭ 1 It follows that ξt = Vt e gτ 2π ∫ ∞ − d2 exp − { 1 2 (ε 2 − 2σ τ ε + σ 2 τ dε . whereby we replace the growth rate g in ˆ equation (A.18) ξt = Vt e gτ 2π ∫ ∞ − d1 ⎧ ε ′2 ⎫ gτ exp ⎨− ⎬dε ′ = Vt e N (d1 ) 2 ⎭ ⎩ (A.19) by (a certainty equivalent growth g analogous to) the risk-free rate r. if ε ≥ −d2) and zero otherwise—and the random variable ε is standard normally distributed. with ε ′ 2 = ε 2 − 2σ τ ε + σ 2 τ .e. we can use the insights from risk-neutral pricing (e. The expected value of the underlying asset conditional on being “in the money” at maturity is ξt ≡ Et ⎡VT ⏐VT ≥ I ⎤ ⎣ ⎦ ∞ ⎛ g − 1 σ2⎞ τ + σ τε χ = ∫ Vt exp ⎜ {VT ≥ I } dN(ε ) .436 Appendix: Basics of Stochastic Processes maturity (ending up in the money) in the case of the geometric Brownian motion obtains as θ t = Pt [VT ≥ I ] = N(d2 ) with d2 ≡ ln (Vt I ) + ατ (A. ⎟ −∞ ⎝ 2 ⎠ { } ⋅ where χ {} is the indicator function— χ {VT ≥ I } is 1 if VT ≥ I (i.16) σ τ .

and other ﬁnancial time series. The geometric Brownian motion is probably the most widely used price process in ﬁnance and economics because it provides a good starting proxy for the dynamics of stock prices. Alternatively. prices of natural resources. Henceforth to avoid any confusion. exchange rates. ln ( X t + h ) ≡ xt + h.Appendix: Basics of Stochastic Processes 437 a (non–dividend-paying) asset is CT = max {VT − I . Market participants naturally form expectations about future developments.19) with discount rate r. Therefore the (time-t) value of a European call option. The total return k consists of the asset price increase or capital gain. this readily results in the Black–Scholes formula given in equation (5. . the logarithm of the asset price. plus any beneﬁt or “dividend yield. the 22. 0}. 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). From equations (A. obtained as the discounted expected future value under risk-neutral expectation.17). log-returns ( xt + h − xt = ln ( X t + h X t )) are normally distributed with mean α h and variance σ 2 h. 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 increasing in the time horizon (h).” δ .18) and (A. while it remains tractable mathematically. Consider a traded asset whose price dynamics can be modeled via geometric Brownian motion.7): Ct = Vt N (d1 ) − Ie − rτ N (d2 ) with d1 and d2 given in equations (A. 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.16) and (A. the actual future value of the process always remains uncertain to them. 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).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. g. is ˆ ˆ Ct = e − rτ Et [CT ] = e − rτ Et [VT − I | VT ≥ I ] ˆ = e − rτ Et [VT | VT ≥ I ] − e − rτ IPt [VT − I ] = e − rτ ξt − e − rτ Iθ t . with α = r − (σ 2 2). Given the relationship between the geometric Brownian motion and the arithmetic Brownian motion. whereas X t refers to the unknown random variable. the value of the process at time t (once realized and observed) is denoted by X t .

Merton (1973) shows that the option will not be exercised prior to maturity unless the dividend yield is positive (δ > 0).1. An example of a commodity whose price follows a mean-reverting process is copper. such as commodity prices or interest rates. Although such processes may serve as useful approximations in many circumstances. 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 such processes a meanreverting process may be more suitable as a modeling device. modeled as geometric Brownian motion. Certain asset prices.24 A. For the volatility parameter.11) from past data concerning the asset’s log-return. in the long term it tends to revert to a historical mean observable in long-term time series. For American call options. equally sized time intervals of length h.2 Mean-Reversion Process Arithmetic or geometric Brownian motions characterize asset prices whose future value may potentially attain values far away from the starting one and may increase or decline dramatically for long time horizons. it is possible to use a series over a number of days if the number of estimates is high enough. Arithmetic Ornstein–Uhlenbeck Process The simplest and best known mean-reverting process is the simple or arithmetic Ornstein–Uhlenbeck process represented by the following stochastic differential equation: 23. they can be readily determined when one considers the logarithm of the price ( xt = ln( X t )) or the evolution of the log-return (ln ( X t + h X t ) for h small). The latter can be readily assessed as the standard deviation of the asset’s log-returns. tend to move toward a natural long-run equilibrium with actual values evolving randomly up and down around the long-term mean. k = g + δ must hold. The volatility of asset price changes equals the volatility of Δxt or xt . The growth trend g of X t is readily established in equation (A. . Although the actual price is stochastic. The volatility of the geometric Brownian motion is constant whatever the time horizon considered.438 Appendix: Basics of Stochastic Processes asset holder receives over time. It is generally easier to estimate the drift parameter α by taking the average value of the log-returns Δxt ≡ xt + h − xt = ln ( X t + h X t ) over small. X t = exp ( xt ).23 Consider a time series of the asset price. 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. To ensure that there is no arbitrage opportunity. they may not represent adequately equilibrium dynamics in many situations where capacity adjusts to meet demand. 24.

See Dixit and Pindyck (1994. however.20) Here η describes the speed or strength of reversion toward the “natural level” X of the process (the long-term mean). ch.21) with wη (t ) ≡ exp (−ηt ).21) converges to the long-term average X (since wη (t ) → 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 . Given the initial value of the process at time 0. As t goes to inﬁnity.23) The key differentiating feature between the geometric Ornstein–Uhlenbeck process and the geometric Brownian motion discussed previously lies in the drift parameter.21) can be interpreted as a weighted average of the initial value X 0 and the long-term equilibrium mean value X . X might represent the long-run marginal production cost. There is no expected change in the process if the present value exactly equals the long-term mean X . The variance of the mean-reversion process above is given by25 var ( X t − X ) = σ2 (1 − wη(t )2 ). In case of commodities. The diffusion term (σ > 0) here suggests that even 25. For geometric Brownian motion. 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. 2η (A.22) above. .21) and (A.Appendix: Basics of Stochastic Processes 439 dX t = η ( X − X t ) dt + σ dzt. being positive if the current value is below its long-term average and negative otherwise. 3. the expectation in equation (A. with the future value having variance σ 2 t . the process X t becomes a Brownian motion without drift (α = 0). (A. Since wη (t ) ∈ (0. the process tends rapidly to its natural mean level X (since wη (t ) → 0) and the variance around the mean becomes negligible. X 0 . the drift gX t is proportional to the latest value of the process at time t . Its sign is always either positive or negative. In mean-reversion the difference X t − X between the current level at time t ( X t ) and the “natural level” X inﬂuences the drift η ( X − X t ) X t . the expected value in equation (A. app. A) for a derivation of equations (A. ⎣ ⎦ (A. When there is no force toward the long-term mean (η → 0).22) If the speed of mean-reversion gets large (η → ∞). 1).

24) in its differential form dX t = gt dt + σ t dzt . Such processes are also used to derive useful properties and insights applicable to the whole family. t ). Càdlàg processes share the property of being rightcontinuous and admitting left-limits along all sample paths. (A.26) The general Itô process covers a fairly broad family of stochastic processes used in economic analysis and enables the modeling of Markov processes with continuous sample paths.440 Appendix: Basics of Stochastic Processes if the process has reached its long-term average.24) It is common to write the Itô process (A. t ) and σ t ≡ σ ( X t .25) where zt is a standard Brownian motion. and mixed jump-diffusion processes are all Lévy processes.3 General Itô Processes Broader families of processes may sometimes be more appropriate to describe certain price dynamics. Lévy and càdlàg processes are beyond our scope of analysis here. gt ≡ g ( X t . the drift and the diffusion term. called Itô processes. 0 0 t t (A. An Itô process is a stochastic process of the (integral) form X t = X 0 + ∫ g s ds + ∫ σ s dzs . Lévy processes are càdlàg processes with the additional property of having independent. it may still deviate from it. All these belong to a broader class of processes. For such processes. It can be expressed (in its differential form) as dX t = g ( X t ) dt + σ ( X t ) dzt . 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.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. (A. namely arithmetic and geometric Brownian motion and the mean-reverting processes. A. The Itô. 27. Itô processes belong to a larger family of processes. have ﬁnite variations and that they comply with the linear growth and Lipschitz conditions (see Karatzas and Shreve 1988).1. identically distributed increments. So far we have discussed speciﬁc cases of memoryless or Markov processes. are allowed to depend on the latest value of the asset price X t and the time period (t). Poisson.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. The higher the volatility. . the higher is the probability of a deviation from the average. They are subsumed into Lévy processes and càdlàg processes.

For the simple Ornstein–Uhlenbeck process given in equation (A. In assessing the current value of the option. The geometric Brownian motion corrects some of these ﬂaws while maintaining some of the “nice” mathematical properties of the simple Brownian motion.2 Forward Net Present Value In valuing investment timing options. one can follow a backward valuation process. This is the reason why this process is generally preferred in much of real options analysis. Deriving this value rests on a number of equilibrium conditions applied to dynamic problems. where X is the long-term average. the remaining choices constitute an optimal policy with respect to the subproblem starting at the state that results from the initial actions. 10) summarizes some of them. Trigeorgis (1996.12). It asserts that: “An optimal policy has the property that. In such settings one must resort to numerical methods instead.2). the arithmetic Brownian motion is ill-suited to describe such phenomena as equilibrium asset price dynamics. 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). gt = η ( X − X t ) and σ t = σ . It is often desirable to develop models that admit closed-form solutions to help deduce clear-cut investment rules to be followed by analysts or decision makers.Appendix: Basics of Stochastic Processes 441 previously belong to this general class. as noted. Simple models involving the arithmetic Brownian motion generally admit analytical solutions. These methods take advantage of the Markov property of the Itô process. The geometric Ornstein–Uhlenbeck process in equation (A. A.28 28. given in box A. when the underlying factor is mean reverting.” This principle is at the core of dynamic programming and is used to derive optimal behavior when faced with dynamic problems.23) is characterized by gt = η ( X t − X ) X t and σ t = σ X t. η the speed of mean reversion and σ a constant volatility. . The underlying notion is Bellman’s (1957) principle of optimality.2) is obtained for gt = α and σ t = σ (α and σ being constant). The arithmetic Brownian motion described in equation (A.1 equation (A1. This is the case. Nonetheless. it is not always easy or po