Capacity switching options under rivalry and uncertainty

Abstract

Deregulated infrastructure industries exhibit stiff competition for market share. Firms may be able to limit the effects of competition by launching new projects in stages. Using a two-stage real options model, we explore the value of such flexibility. We first demonstrate that the value of investing in a sequential manner for a monopolist is positive but decreases with uncertainty. Next, we find that a typical duopoly firm’s value relative to a monopolist’s decreases with uncertainty as long as the loss in market share is high. Intriguingly, this result is reversed for a low loss in market share. We finally show that this loss in value is reduced if a firm invests in a sequential manner and specify the conditions under which sequential capacity expansion is more valuable for a duopolist firm than for a monopolist.