Optimal Risk Adoption and Capacity Investment in Disruptive Innovations

33 Pages Posted: 2 Nov 2020

See all articles by Lars H. Sendstad

Lars H. Sendstad

Norwegian University of Science and Technology (NTNU) - Department of Industrial Economics and Technology

Michail Chronopoulos

City University London - Sir John Cass Business School; Norwegian School of Economics (NHH) - Department of Business and Management Science

Verena Hagspiel

Norwegian University of Science and Technology (NTNU) - Department of Industrial Economics and Technology

Date Written: September 1, 2020

Abstract

Disruptive innovations often formulate new market regimes and create incentives to abandon existing, less attractive ones. However, this decision depends not only on market forces, such as economic and technological uncertainty, but also on attitudes towards risk. Although greater risk aversion typically raises the incentive to postpone investment, the impact of risk aversion becomes more complex when a firm has discretion over both the timing and the size of a project. We develop a utility-based, regime-switching framework in order to analyse how a firm with discretion over investment timing and project scale may choose to abandon an existing market regime to enter a new one. Results indicate that greater risk aversion hastens investment in an existing regime by decreasing the amount of installed capacity, but delays its abandonment, thereby hindering the transition to a new one. In contrast, greater demand uncertainty in the new market regime raises the value of the investment opportunity, and, in turn, the incentive to abandon the existing regime. Furthermore, we find that uncertainty over the arrival of a disruptive innovation may accelerate investment in the existing regime and reduce the relative loss in project value in the absence of managerial discretion over project scale.

Keywords: investment analysis, regime switching, risk aversion, disruptive innovation, real options

Suggested Citation

Sendstad, Lars H. and Chronopoulos, Michail and Chronopoulos, Michail and Hagspiel, Verena, Optimal Risk Adoption and Capacity Investment in Disruptive Innovations (September 1, 2020). Available at SSRN: https://ssrn.com/abstract=3684461 or http://dx.doi.org/10.2139/ssrn.3684461

Lars H. Sendstad (Contact Author)

Norwegian University of Science and Technology (NTNU) - Department of Industrial Economics and Technology ( email )

NO-7491 Trondheim
Norway

HOME PAGE: http://www.sendstad.com

Michail Chronopoulos

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

HOME PAGE: http://https://www.cass.city.ac.uk/

Norwegian School of Economics (NHH) - Department of Business and Management Science ( email )

Helleveien 30
Bergen, NO-5045
Norway

Verena Hagspiel

Norwegian University of Science and Technology (NTNU) - Department of Industrial Economics and Technology ( email )

NO-7491 Trondheim
Norway

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