Real Options in an Asymmetric Duopoly: Who Benefits from Your Competitive Disadvantage?

Abstract

This paper analyzes the impact of investment cost asymmetry on the optimal real option exercise strategies and the value of firms in duopoly. Both firms have an opportunity to invest in a project enhancing (ceteris paribus) the profit flow. We show that three types of equilibrium strategies exist. Furthermore, we express the critical levels of cost asymmetry delineating the equilibrium regions as functions of basic economic variables. The presence of strategic interactions among the firms leads to counterintuitive results. First, for a certain range of the asymmetry level, a marginal increase in the investment cost of the firm with the cost disadvantage can enhance this firm's own value. Moreover, such a cost increase can reduce the value of the competitor. Finally, we discuss the welfare implications of the optimal exercise strategies and show that the presence of identical firms can result in a socially less desirable outcome than if one of the competitors has a significant cost (dis)advantage.

Real options in strategic investment games between two asymmetric firms

“…(2004) and Pawlina and Kort (2006) examine the effect of first mover advantage in combination with cost asymmetry. They find that when asymmetry is relatively small and first-mover advantage is not significant, simultaneous entry may be favored.…”

Strategic Technology Switching Under Risk Aversion and Uncertainty

“…The impact of γ and σ on the relative loss in the value of the proprietary and non-proprietary leader is indicated in the left-and the right-hand side expression of (35), respectively, and is illustrated in Figure 10.…”

“…Real options models often address the problem of optimal investment timing without considering strategic interactions Siegel, 1985 and1986), while the ones that do, either ignore the sequential nature of investment opportunities (Pawlina & Kort, 2006;Siddiqui & Takashima, 2012) or attitudes towards risk (Huisman & Kort, 2015). In the area of competition, Spatt & Sterbenz (1985) analyse how the degree of rivalry impacts the learning process and the decision to invest, and find that increasing the number of players hastens investment and that the investment decision resembles the standard NPV rule.…”

Developing real option game models

“…9), Huisman (2001), Paxson and Pinto (2005), and Pawlina and Kort (2006), among others, developed ROG models for leader-follower competition settings. With few exceptions, it is assumed that firms can observe all the parameters of the model (drift, volatility, etc) and the evolution of the random variable dz given in equation (2).…”