DP3674 Time-to-Build and Strategic Investment Under Uncertainty

Author(s): Goncalo Pacheco de Almeida, Peter Zemsky
Publication Date: December 2002
Keyword(s): endogenous investment timing, real options, strategic commitment
JEL(s): L13
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3674

We show that time-to-build, which creates a lag between the decision to invest and production, is an important element of industry structure. We study a multi-period investment game where there is demand uncertainty. Allowing for time-to-build alters, non-monotonically, the classic trade-off between making strategic commitments and exploiting the option to wait. At first, increases in time-to-build make commitment more likely as the committing firm has the market to itself for longer after the resolution of uncertainty. As time-to-build becomes more substantial, however, the likelihood of commitment declines as the follower firm increasingly makes its own ex ante investments. Furthermore, time-to-build gives rise to a novel incremental Cournot equilibrium where both firms make small ex ante investments, which they then scale up if uncertainty is positively resolved. This behaviour contrasts with most prior work on multi-period investment games where firms invest only once. We show how time-to-build affects firm heterogeneity, investment timing, the option value of waiting, the evolution of prices and social welfare.