Strategic Investment Under Uncertainty: Merging Real Options with Game Theory

Abstract

As becomes apparent from the standard text books in industrial organization (cf. Tirole, 1988, The Theory of Industrial Organization), the analysis of the effects of uncertainty within this field is yet underdeveloped. This paper shows that the new theory of strategic real options can be used to fill this empty hole. Based on the work by Smets (1991) standard models are identified, and they are analyzed by applying a method involving symmetric mixed strategies. As an illustration, extensions regarding asymmetry, technology adoption and decreasing uncertainty over time are reviewed. Among others, it is found that the value of a high cost firm can increase in its own cost. Furthermore, it is established to what extent investments are delayed when technologial progress is anticipated, and it is found that competition can be bad for welfare.