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

Abstract

This paper considers the impact of uncertainty and investment cost asymmetry on the value and optimal real option exercise strategies of firms under imperfect competition. Both firms have an opportunity to invest in a project enhancing (ceteris paribus) the profit flow. We show that three types of equilibria exist and derive critical levels of cost asymmetry separating the regions in which they prevail. The presence of strategic interactions leads to counter-intuitive results. First, we prove that profit uncertainty always delays investment, even in the presence of a strategic option of becoming the first investor. Second, depending on the level of asymmetry, a marginal increase in the investment cost of the firm with the cost disadvantage can increase his firm's own value. Moreover, such a cost increase can result in a decrease in 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 investment cost disadvantage.