Distortions in Investment Timing and Quantity in Real Options with Asymmetric Information

Abstract

We analyze real options investment under asymmetric information on investment costs, where decisions not only involve investment timing, but also investment quantity. A principal, the regulator, offers a menu of contracts to the agent (the regulated firm). The regulated firm has better information on costs than the regulator, and the optimal regulation trades off distortions in investment decisions and informational rents left to the firm. In a non-dynamic situation, it is well known that optimal contracts involve downward distortions on investment quantity. In the dynamic, real options situation, distortions also occur in investment timing: a high-cost firm’s investment will be delayed beyond the optimal time, until revenues reach a higher investment threshold. We explore the effect on investment quantity in this real option regulation under various assumptions on the stochastic process for revenues. On the one hand, the higher investment threshold tends to increase investment quantities, whereas screening of high-cost firms would favour reducing their investment quantity. We find a simple sufficient condition for the latter, quantity-reducing, effect to dominate, and show that it is satisfied for a wide range of commonly used stochastic processes.