Irreversible Commitment and Price Negotiation under Knightian Uncertainty: A Real Options Perspective

This paper tackles the problem of irreversible investment and price negotiation under Knightian uncertainty using the real options lens. We present a multiple-priors based formulation of utility in continuous-time that permits a distinction between risk and uncertainty in decision-making to study the impact of vagueness/ambiguity on bilateral price negotiation and investment. Specifically, we examine negotiation dynamics between a buyer and a seller in a dual options context (i.e., call for buyer and put for seller) to 1) derive thresholds for optimal commitment, 2) identify conditions under which mutual agreement is warranted (with and without bargaining power), and 3) estimate likelihood of agreement, all in an environment fraught with deep economic uncertainty. Besides generalizing risk uncertainty results found in previous research, our findings highlight the moderating effect of negotiators’ perceived ambiguity (i.e., pessimism and optimism) on the process of negotiation and its related outcomes and provide insights into the formulation of robust optimal (buying/selling) strategies for negotiation under high uncertainty.