Resource Allocation in Strategic Factor Markets: A Realistic Real Options Approach to Generating Competitive Advantage

Abstract

This paper develops a realistic real option theory of resource allocation decisions in strategic factor markets. Competitive advantage in factor markets is underpinned by market failures that allow firms to acquire assets at less than their value in use. We recognize that market failure may result from uncertainty regarding the current and/or future value of an asset, which map, respectively, to uncertainty as modeled in the feedback learning and real options literatures. The realistic real option framework we develop grafts insights from the strategic factor market, feedback learning, and real option valuation literatures. We argue that competitive advantage may emerge not only from luck, or ex ante differences in information or complementary assets, but also because firms differ in a specific type of learning ability — the ability to integrate new information to exercise a contingent claim on an asset in a factor market. We dimensionalize these differences in terms of information processing and belief updating, argue that these differences lead to different resource allocation decisions, and suggest how these decisions may generate competitive advantage.