Competitive Investment Under Uncertainty: Real Options And Game Theroy

Until now, various investors all the time intend to develop useful quantitative tools to analyze the feasibility of various project investments. However, traditional investment project valuation methods, such as Net Present Value (NPV) and Internal Rate of Return (IRR), cannot be effectively applied to complex investment problems due to their mechanical investment strategies and assumptions of certain technology and environments. In market-based economies, market competition can be characterized by high uncertainty and unpredictability. An option game method, which is the combination of real options and game theory and therefore provides a scientific and theoretic foundation for project assessment and investment strategies analysis, is suitable for the problem of competition and investment under uncertainty. Therefore, this dissertation attempts to develop multiple option game models to study the strategic investment problems under uncertainty.In my models, investor can make flexible adjustments to complex investment environments allowing not only for external uncertainty but also for other competitors’investment decisions. The payoff of any firm is the result of multiple investors’competition. These option game models can overcome the shortcomings of static models and incorporate the advantage of management flexibility in dynamic models. The option game models attempt to integrate game theory into real options, because investment strategies are usually influenced and restrained mutually in competitive environments. The value of investment projects depends not only on a company’s own decision-making but also on investment choices of its competitors. Therefore, the application of the option game method to the valuation of real options and the analysis of investment strategies has gradually attracted much attention in various investment analyses.This dissertation is composed of seven chapters, which cover a basic introduction to option game models, literature review, theoretical analyses and models, and a final summary. More details regarding these chapters are described as follows:The first chapter provides a detailed description concerning my research background and motivation. I also address the major features of option-based models and highlight the significant contributions of this study to the relevant literature.The second chapter carries out a review for relevant literature by summarizing the literature about strategic investment problems investigated by the real options models and game theories. These problems are usually explored by allowing for symmetric duopoly, asymmetric duopoly, and oligopoly markets.The third chapter takes into account competitive investment problems under uncertainty. It introduces real options theory and compares real options with financial options. It also investigates the difference and similarity between the traditional NPV and the strategic NPV, so that strategic investment problems can be solved by combining real options models with game theories.The fourth chapter looks at competitive investment choices in a duopoly, while considers product differentiation. In the environment of product differentiation, consumers’preferences for differentiated products will be different with one another, so are their pricing advantages. This chapter discusses the competitive investment problems of heterogeneous firms under both the stochastic market demand and the stochastic pricing advantage. It deduces the existence conditions of preemptive investment thresholds and finds out subgame Nash equilibrium strategies. Furthermore, it addresses reasons for recession-induced construction boom from two aspects.The fifth chapter examines competitive investment problems in an oligopoly, under product differentiation. Based on the model framework developed in chapter four, this chapter extends the investment background from duopoly market to oligopoly market to analyze competitive investment behaviors of several firms. It derives the value functions and investment thresholds of these firms firstly, and then carries out quantitative analysis and numerical simulation based on the proposed model.The sixth chapter investigates investment timing and capacity choice problems under uncertainty. These investment problems are discussed in a monopoly context. Optimal investment timing and capacity choices are derived and their model implications are elaborated. This chapter also analyzes the value functions, investment timing and capacity choices of the dominant leader, the preemptive leader and the follower, respectively. In the end, it makes a comparison about the optimal capacities under uncertain and certain environments. Equilibrium strategies in fixed capacity model and in flexible capacity model are also considered.Chapter seven summarizes this thesis, draws relevant conclusions, and proposes further research.Finally, I also summarize those new ideas given by the dissertation as follows:First, in the traditional real options theory, investors will wait and delay investment when facing greater uncertainty. However, this study shows that if a firm’s pricing advantage and the market demand for its products have negative correlation, the firm could rush instead of postponing the investment when facing greater uncertainty of pricing advantage or market demand. This conclusion is supported by existing empirical findings.Second, the higher correlation between market demand and pricing advantage will bring about a positive impact on investment thresholds. That is, larger correlation could delay an investment. When the other parameter values are kept unchanged, the rising expected change rate of market demand and pricing advantage will affect investment triggers positively, and deferred investments will happen again.Third, three kinds of investment triggers are identified to respond differently to the correlation, the expected change rate and the volatility of pricing advantage or market demand, respectively. Preemptive triggers are most sensitive to the expected change rate and the volatility while being most insensitive to the correlation.Fourth, the irrational phenomenon of recession induced construction boom is interpreted from two aspects in this study. On the one hand, to obtain the first-mover advantage, a firm must enter the market at its preemptive trigger, which is a low demand state corresponding to market supply, so over-production happens. On the other hand, even if the market demand declines, the pricing advantage will increase faster than the decrease of the market demand. Fifth, in an oligopoly market with product differentiation, investment thresholds obtained by my option game theory must be higher than Marshallian thresholds by the net present value. Furthermore, by numerical simulation I find that the investment triggers of any firm will vary in a trend that decreases firstly and then increases when the number of investors increases gradually.Sixth, in a monopoly market, a firm can be optimal to choose its investment timing and capacity. When both the volatility and the expected change rate of market demand increase, this firm will provide more goods in a later time, which shows that capacity choices cannot change the impact of uncertainty on investment triggers. In general, the more sensitivity of price to capacity, the higher price of product.Seventh, in a duopoly market, it has a significant impact on investment thresholds and optimal capacity whether the leader is dominant in the game or not. However, in any case, an increase in uncertainty will delay this investment while increasing its size. At the same time, the investment threshold (optimal capacity) of a follower increases faster than that of a leader. Most important of all, in Stackelberg model under certain enviornment, the leader will choose a larger capacity than its competitor, which is contrary to the conclusion under uncertainty. The reason why the firm is prone to lead the game to obtain a lower profit can be expressed as follows. On the one hand, only the firm with a lower capacity can preempt the leadership successfully. On the other hand, the leader can occupy a better market position during the period of monopoly, and thus provide better facilities or services to increase the number of consumers during the period of duopoly.Eighth, after comparing fixed capacity model with flexible capacity model, it is shown that investment thresholds (or optimal capacities) will be lower under flexible capacity model when there is little uncertainty, while at other times they will be lower under fixed capacity model.