Flexibility and Commitment in Strategic Investment

The paper deals with the tradeoffs between the option value of managerial flexibility and the strategic value of early commitment in a dynamic competitive environment. It departs from the standard real options optimization problem (game against nature) to model strategic games against competition. It thus provides an integration of real options valuation with game-theoretic principles that enable the determination of different market structure equilibrium outcomes (e.g., Nash, Stackelberg leader/follower, or monopoly) in the various states of demand (nodes) within a binomial option valuation tree, as well as proper accounting for the interdependencies among the early strategic commitment and subsequent investment decisions in a competitive interactive setting. The optimal investment strategy of a pioneer firm depends not only on its own stance vis-a-vis its competitor (tough or accommodating) and the type of investment (proprietary or shared), but also on the nature of competitive reaction (reciprocating or contrarian).