Real Options in a Duopoly with Jump Diffusion Prices

Abstract

This paper analyzes irreversible investments in technology under asymmetric duopoly. Asset prices are defined by a diffusion with Poisson jumps. Assuming negative externalityfor profit flows, we develop a real options and game theoretic valuation model to evaluate the optimal investment strategies under interaction. Three types of equilibrium, i.e., simultaneous equilibrium, preemptive equilibrium, and sequential equilibrium, are attainable depending on the firms’ competitive advantageand first-mover advantage. The role of a firm, as “leader”, “follower”, or “simultaneous entrant”, is analyzed both exogenously and endogenously. We find that preemptive competition lowers both firms’ profits from the investments in the technology. Numerical examples illustrate the key results.