Irreversible investment with uncertainty and strategic behavior

Abstract

The paper provides a model of technology adoption in the case where adopting alone is more expensive than adopting when others have already done so (network effect). In addition, if each agent gains at the expense of his rivals, he may also have an incentive for ‘preemptive adoption’. We deal with these two issues in a dynamic programing framework, where adoption is seen as a strategic switching time decision problem for agents facing an ongoing stochastic operating benefit plus sunken investment costs. The model defines the option value of investing for a continuous time stochastic game. In the case of network benefits alone, agents follow a stationary bandwagon strategy, representing the effect caused by a war of attrition. Yet, as network benefits reduce adoption costs after an agent has switched, rivals may follow suit. In the opposite case, where going first gives the innovator a higher payoff the bandwagon rule is turned over and the option value of investing first may be lower than that of going second. This gives rise to sequential adoption.