The Effect of Stochastic Demand on Entry and Exit of Firms: Applying Real Option Theory

Abstract

Market demand uncertainty is a significant factor behind the variety of industry evolution. To quantify such affect and understand the mechanism behind, I consider 3 types of stochastic market demand (growing expectation, shrinking expectation, and fluctuating expectation around a fixed level), construct a dynamic market equilibrium in Nash-Cournot competition, and apply real option theory to find the optimal entry and exit strategies of firms and evaluate their values and systematic risk loadings. I not only review the geometric Brownian market setting specified in previous work but also model a mean-reverting market which is closer to reality. Comparative static results for the number of firms show that apart from the "incumbent effect" that also exists in geometric Brownian markets, there is another effect, namely the dilution effect, in mean-reverting markets, which distinguishes entry-exit strategies, firm values and risk loadings in mean-reverting markets from those in geometric Brownian markets. I also provide comparative statics for sunk costs and fixed costs of firms; they serve as indicators and tools for regulators to prevent industries from distortions.

Keywords: real option, entry an exit, market uncertainty, mean-reverting process, Nash-Cournot Equilibrium