Competitive Strategy

Competitive Strategy: Options and Games

Benoît Chevalier-Roignant
Lenos Trigeorgis
WITH A FOREWORD BY AVINASH K. DIXIT
Copyright Date: 2011
Published by: MIT Press
Pages: 520
https://www.jstor.org/stable/j.ctt5hhbmq
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  • Book Info
    Competitive Strategy
    Book Description:

    Corporate managers who face both strategic uncertainty and market uncertainty confront a classic trade-off between commitment and flexibility. They can stake a claim by making a large capital investment today, influencing their rivals' behavior; or they can take a "wait and see" approach to avoid adverse market consequences tomorrow. In Competitive Strategy, Benoit Chevalier-Roignant and Lenos Trigeorgis describe an emerging paradigm that can quantify and balance commitment and flexibility, "option games," by which the decision-making approaches of real options and game theory can be combined. The authors first discuss prerequisite concepts and tools from basic game theory, industrial organization, and real options analysis, bringing important materials and ideas together into a unified framework. They then present the new approach in discrete time and later in continuous time, beginning with the building blocks of the basic ideas and tools and culminating in richer theoretical analyses. Their presentation of continuous-time option games is the first systematic coverage of the topic and fills a significant gap in the existing literature. Competitive Strategy provides a rigorous yet pragmatic and intuitive approach to strategy formulation. It synthesizes research in the areas of strategy, economics, and finance in a way that is accessible to readers not necessarily expert in the various fields involved. The book will be of interest to scholars, students, and academically trained practicing managers interested in applying these ideas.

    eISBN: 978-0-262-29871-1
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-x)
  3. Glossary
    (pp. xi-xviii)
  4. Symbols
    (pp. xix-xxii)
  5. Foreword
    (pp. xxiii-xxiv)
    Avinash Dixit

    President Truman once said: “Give me a one-handed economist. All of my economic advisers say ‘On the one hand this, on the other hand that.’” Economists do indeed recognize that there are multiple forces at work in most situations, and it takes quite subtle analysis to understand their interaction and balance. This book is an admirable effort at such an economic analysis.

    When facing an uncertain future, remaining flexible until more information arrives has value, because one can cherry-pick to make investments only when the prospects are relatively favorable. This is the starting intuition of real option theory. But in...

  6. Preface
    (pp. xxv-xxviii)
  7. 1 The Strategy Challenge
    (pp. 1-44)

    At a time when national monopolies have been losing their secular well-protected positions owing to market liberalization in the European Union and elsewhere across the globe, strategic interdependencies and interactions have become a key challenge for managers in many corporations. Strategic questions abound: How should a firm sustain or gain market share? How to differentiate oneself from others in the grueling global marketplace? When precisely should a firm enter or exit an industry when it faces uncertainty and significant entry and exit costs?

    Recent developments in economics, finance, and strategy equip management facing such challenges with a concrete framework and...

  8. I STRATEGY, GAMES, AND OPTIONS
    • 2 Strategic Management and Competitive Advantage
      (pp. 47-74)

      Managing an enterprise in an uncertain competitive environment is not an easy task. Strategic management attempts to explain why some firms are more successful than others in the marketplace. At the core of strategy is a dilemma between flexibility and commitment. Flexibility to adapt strategy and operations is clearly valuable when the environment changes unexpectedly. An early investment commitment may yet have strategic value because it can influence the behavior of rivals in equilibrium, potentially creating a future competitive advantage for the firm. The flexibility perspective partly draws on the resource-based view of the firm and core-competence arguments: a firm...

    • 3 Market Structure Games: Static Approaches
      (pp. 75-108)

      Studying industrial organization is useful to deduce managerial insights to help explain how firms should behave strategically when faced with competition. In this chapter and the following one, we review some basic principles and models in this area, discuss industry structures, and examine information asymmetry, commitment, and collaboration. Basic ideas developed in these chapters serve as building blocks in subsequent discussions. In this chapter we deal mainly with static models that help explain the modus vivendi in competitive situations when firms focus on the short-run impact of their decisions. We discuss simple economic models that characterize optimal firm behavior under...

    • 4 Market Structure Games: Dynamic Approaches
      (pp. 109-152)

      In chapter 3 we dealt with benchmark models of market structure from a static perspective. These static games allow predicting the short-run impact of a firm’s actions on its rivals. The current chapter extends this discussion to dynamic approaches. These allow the inclusion of long-term strategy formulations and discussion of phenomena that require more dynamic thinking such as commitment and collaboration.

      Dynamic games make explicit how today’s decisions may affect or induce distinct future strategic situations. For example, if one adopts today an aggressive stance toward a rival, this behavior might induce the rival to act aggressively in the future....

    • 5 Uncertainty, Flexibility, and Real Options
      (pp. 153-192)

      Up to now we have mainly focused on industrial organization models in a certain or deterministic world. Before discussing further how to combine game theory with real options under uncertainty, we review in this chapter the basics and insights of real options analysis to improve our understanding of flexible real investment decisions.¹ The real options approach to analyzing investment under uncertainty has by now gained standard corporate finance textbook status. Real options analysis involves the application of methods utilized to price financial options and other derivatives to real assets; that is, it is an extension of option-pricing theory or contingent-claim...

  9. II OPTION GAMES:: DISCRETE-TIME ANALYSIS
    • [II Introduction]
      (pp. 193-194)

      In the first part of the book, we introduced basic principles of strategic management and real options, and discussed how an industrial organization perspective may provide useful insights to managers about how to behave vis-à-vis rivals under certain business conditions. Our belief is that these separate approaches should be combined, leveraging the strengths of each discipline to provide enhanced managerial guidance, dealing concomitantly with both market and strategic uncertainties. In part II of the book, we put these perspectives together, discussing some useful models at the interface between game theory and real options as part of a unified, discrete-time analysis....

    • 6 An Integrative Approach to Strategy: Option Games
      (pp. 195-218)

      In part I we discussed basic approaches providing insights about how to behave in an uncertain competitive environment. We reviewed strategic management, industrial organization, and real options as separate, stand-alone disciplines. Each approach can separately bring about useful insights in analyzing business situations. Nonetheless, each discipline, taken separately, also has drawbacks. Standard game theory has not dealt so far with stochastic dynamics; static games by their very nature do not involve such a problem, while dynamic games are mostly cast in a steady or deterministically evolving environment. Real options analysis, while suitable to account for stochastic uncertainty, often makes the...

    • 7 Option to Invest
      (pp. 219-242)

      This chapter describes a simple framework—based on the combined insights from real options and game theory—that enables managers to analyze strategic investment and quantify flexibility in a competitive setting in relatively simple terms. Encompassing more aspects of reality would involve more complications to the modeling of option games. The simple models presented herein offer pedagogical value and make easier the understanding of subsequent chapters.

      The chapter is organized as follows. In section 7.1, we present a benchmark model for later analysis, focusing on a monopolist’s option to invest. In section 7.2, we discuss quantity competition models and examine...

    • 8 Innovation Investment in Two-Stage Games
      (pp. 243-274)

      R&D investments are typically made under uncertainty. Firms cannot safely predict the state of demand when the resulting product offering will be launched in the marketplace, nor what the competitive situation will be. Box 8.1 discusses how real options analysis can provide intuitive insights regarding R&D investment. Here we complement such analysis with game-theoretic thinking.

      Strategic investments are often made under conditions of uncertainty about key market factors (e.g., demand, costs, or competitors’ strategies). When moves are hard or costly to reverse, the value of preserving flexibility must be explicitly assessed and traded off against the strategic benefits gained from...

  10. III OPTION GAMES:: CONTINUOUS-TIME MODELS
    • 9 Monopoly: Investment and Expansion Options
      (pp. 277-310)

      We argued previously that the firm’s ability to delay investment invalidates the common “NPV rule” that asserts firms should “invest when the value of a project exceeds the cost of investment.”¹ This static investment rule effectively turns a blind eye to the opportunity cost of investing now when firms can wait for more accurate information. The real options paradigm explicitly takes into consideration this opportunity cost, revising the investment rule as follows: “invest when the project value exceeds the opportunity cost of waiting.” This raises the following implementation issues: When exactly should a firm invest? When does the value of...

    • 10 Oligopoly: Simultaneous Investment
      (pp. 311-330)

      In the previous chapter we discussed optimal investment timing under uncertainty for a monopolist. We considered two types of options: invest (defer) and expand. The models developed in the monopoly case help pave the way and set a benchmark for analyzing investment-timing problems under uncertainty involving competition among two or more firms. This last extension requires the use of game theory. Here we will deal with simple cases of option games involving symmetric firms. Suppose, for simplicity and pedagogical usefulness, that simultaneous investment occurs at the same trigger value because firms agree to do so or tacitly collude.¹ A social...

    • 11 Leadership and Early-Mover Advantage
      (pp. 331-358)

      In the previous chapter, models of simultaneous investment among oligopolists were discussed. These models assumed that investment timing was decided collectively (or by a social planner able to enforce its investment-timing decision). Here we consider strategic interactions among firms, so collusive simultaneous investment is ruled out as a Nash equilibrium of the investment game. Investment may occur sequentially, particularly if the leader has distinctive capabilities with sufficiently high competitive advantage that makes it possible to disregard the competitor’s investment decision.¹ Section 11.1 discusses the basic deterministic game-theoretic framework of Reinganum (1981a) that shows why sequential, rather than simultaneous, investment emerges...

    • 12 Preemption versus Collaboration in a Duopoly
      (pp. 359-402)

      In the previous chapter we analyzed oligopoly models involving sufficient competitive advantage or asymmetry such that firm roles (who is the leader and who the follower) were arguably rather clear and determinable a priori. When firms are nearly identical, however, there are multiple Nash equilibria in pure strategies and the more likely outcome of the game cannot be readily determined.¹ When no firm has a clear competitive (e.g., cost) advantage, there appears to be a “coordination problem” in determining who acts first and becomes the leader. Mixed strategies may give further insights and help determine what might happen when firms...

    • 13 Extensions and Other Applications
      (pp. 403-424)

      In the previous chapters we discussed how to analyze option games and discussed how they can provide powerful insights into how firms (should) behave when they face an option to defer investment as well as strategic interactions, potentially leading to early preemptive investment. We restricted the discussion primarily to models of complete information and ignored potential time lags between the investment decision and effective entry in the market. In this chapter we discuss extensions of the option games framework that allow for a time lag or time to build, for technological uncertainty and for information asymmetry. This chapter also serves...

  11. Appendix: Basics of Stochastic Processes
    (pp. 425-460)
  12. References
    (pp. 461-472)
  13. Index
    (pp. 473-488)