The Strategic Value of Flexible Quality Choice: a Real Options Analysis∗

This paper analyzes the value of flexibility in quality choice using a dynamic real-option framework. Firms decide about quality of their products when they enter the market upon incurring a sunk cost. Flexibility in quality choice induces (ceteris paribus) earlier investment, and the value of flexible quality increases with demand uncertainty. We find that a possibility of competitive entry more than doubles the relative value of flexibility. Moreover, we show that flexible quality serves as an entry deterrent control, while it can still be set at the optimal monopoly level. Furthermore, we extend the theory of strategic real options from which it is known that the follower’s investment timing is irrelevant for the decision of the leader. The addition of a second control (quality) results in the leader’s investment timing being influenced by the follower’s entry. It also holds that introducing the second control variable in combination with strategic interaction results in the option value of the leader decreasing in uncertainty. Finally, we show that the follower can be driven out of the market due to ”aggressive” quality choice of the leader in high states