Strategic Entry and Market Leadership in a Two-Player Real Options Game

Abstract

We analyse the entry decisions of competing firms in a two-player stochastic real option game, when rivals can exert different but correlated uncertain profitabilities from operating. In the presence of entry costs, decision thresholds exhibit hysteresis, the range of which is decreasing in the correlation between competing firms. The expected time of each firm being active in the market and the probability of both rivals entering in finite time are explicitly calculated. The former (latter) is found to decrease (increase) with the volatility of relative firm profitabilities implying that market leadership is shorter-lived the more uncertain the industry environment. In an application of the model to the aircraft industry, we find that Boeing's optimal response to Airbus' launch of the A3XX super carrier is to accommodate entry and supplement its current product line, as opposed to the riskier alternative of committing to the development of a corresponding super jumbo.

Keywords: Real options, Intertemporal optimal exchange, Two-player stochastic game, Expected active times and probabilities

JEL Classification: D81, L13, G13, G31