Strategic Commitment Versus Flexibility in a Duopoly With Entry and Exit

CMS-EMS Working Paper No. 1378

48 Pages Posted: 10 Feb 2004

Date Written: September 2006

Abstract

We present a continuous-time real options game in which two firms must decide at each instant of time whether to be in or out of a market that expands up to a random maturity date and contracts thereafter. Firms differ only in the opportunity costs of usage of the assets they employ (e.g., owing to different redeployment or resale values), so their investments are not equally recoverable. The paper disentangles the numerous aspects that affect the order of entry and exit, and it challenges the common wisdom that a firm with a sunk cost higher than that of its sole competitor is credibly committed to fight for the market (if necessary) and is worse shielded against the adverse effects of uncertainty. Our analysis also shows that the destructive effect of the threat of preemption on option values may be softened if the rival's commitment to remain active after investing is not credible.

Keywords: Opportunity costs of usage of assets, war of attrition, preemption, Bayesian real options, Markov perfect equilibrium, industry dynamics

JEL Classification: C73, D92, G31, L13, M21

Suggested Citation

Ruiz-Aliseda, Francisco, Strategic Commitment Versus Flexibility in a Duopoly With Entry and Exit (September 2006). CMS-EMS Working Paper No. 1378. Available at SSRN: https://ssrn.com/abstract=498582 or http://dx.doi.org/10.2139/ssrn.498582

Francisco Ruiz-Aliseda (Contact Author)

Pontifical Catholic University of Chile ( email )

Vicuna Mackenna 4860
Santiago, 99999
Chile

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