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The effect of first-mover’s advantages in the strategic exercise of real options

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Abstract

Real-world competitive investment situations do not allow firms to choose exercise strategies in isolation. Optimal investment policies have to take into account the threat of pre-emption and the advantages that may accrue to the first entrant in the new market. These calculations cannot be conducted separately, but must be done as part of a strategic equilibrium. This chapter provides a model of strategic entry option exercise where the threat of pre-emption is severe. In the model, two competing firms have the option to enter a market with uncertain profitability. The option to enter is an American-style call option with an exercise price equal to the investment cost, and the underlying security is the profitability derived from operating in the market. However, the exercise of the option to enter by one firm has repercussions on the value of both competing firms' options. The firm to enter first has to sink the investment cost earlier, but can benefit from securing a higher market share than the competitor. The other firm (the follower) must then decide when it is optimal to sink the cost of investment so as to claim a share of the market lower than that of the first entrant. When the follower decides to enter, the underlying game ends and the resulting market structure is a duopoly where market sharing is an explicit function of the degree of pre-emption parameter.