Investment, uncertainty and pre-emption

Abstract

This paper examines irreversible investment in a project with uncertain returns, when there is an advantage to being the first to invest and externalities to investing when others also do so. We show that the possibility of pre-emption can have significant qualitative and quantitative effects on the relationship between uncertainty and investment. In a single-agent real options model, the trigger threshold for investment increases without bound as uncertainty grows. In contrast, the investment trigger of a leader faced with pre-emption is bounded above as uncertainty increases. In fact, we show that under certain parameter values, greater uncertainty can lead the leader to invest earlier. These findings reinforce the importance of extending real options analysis to include strategic interactions between players. Applications to industry situations are also discussed.