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

Authors


  • This research was undertaken with support from the European Union's Phare ACE Programme 1997. The content of the publication is the sole responsibility of the authors and in no way represents the views of the Commission or its services. The authors thank three anonymous referees, Ronald Anderson, Jan Bouckaert, Ulrich Hege, Mark Shackleton, participants of EFA 2001 Doctoral Tutorial in Barcelona, EFMA 2002 in London, and EFA 2002 in Berlin for helpful comments. All remaining errors are ours.

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.

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