Competition and Irreversible Investments under Uncertainty

We examine the effect of competition on investment decisions in an industry in which each firm has a completely irreversible investment opportunity and the product market has positive externalities for a small market size and negative externalities for a large market size. In the latter case, which corresponds to the traditional competitive industries, firms invest sequentially as market profitability develops. In the former case, which corresponds to industries in which investment is mutually beneficial, firms invest simultaneously after the market's profitability has developed sufficiently to gain all network benefits and to recover the option value of waiting. These extensions of a real options analysis may help explain rapid and sudden developments such as recent Internet investment, or explain the late take-off phenomenon of prolonged start-up problems, such as the case of fax machine production.Irreversible Investments, Real Options, Network Effects

Opting-out in profit-sharing regulation

To avoid the extremely high profit levels found in recent experiences with price cap regulation, some regulators have proposed a profit- sharing mechanism that revises prices to the benefit of consumers. This paper investigates the conditions under which a regulator can implement such a profit-sharing scheme, having the option to revoke the contract if the firm's profits are excessive. When this option is included in the regulator's objective function and the cost of exercising it is not too high, a long-term equilibrium arises with a state-contingent sharing rule that guarantees and appropriate level of profits. The model determines both the level of profits that triggers the profit-sharing mechanism and the consequent price adjustment endogenously. There is an endogenous regulatory lag initially characterized by a price cap regulation, followed by a period of profit-sharing regime where the firm is motivated to cut prices to avoid revocation.public utilities, price cap regulation, profit-sharing, stochastic games

Firm Regulation and Profit-Sharing: A Real Option Approach

To avoid the extremely high profit levels found in recent experience of public utilities’ regulation, some regulators have introduced a profit-sharing (PS) rule that revises prices to the benefit of consumers. However, in order to be successful, a PS rule should satisfy appropriate incentive conditions. In this paper, we study the incentive properties of a second best PS mechanism designed by the regulator to induce a regulated monopolist to divert its "excessive" profits to the customers. In a real option model where a regulated monopolist manages a long-term franchise contract and the regulator has the option to revoke the contract if there is serious welfare loss, we first endogenously derive the welfare maximising PS rule under the verifiability of profits. We then explore the dynamic efficiency of this PS rule under non-verifiability of profits and study the firm’s incentive to comply with it in an infinite-horizon game. Finally, we derive the price adjustment path which follows the adoption of a PS rule in a price cap regulation. We show that the riskiness of the distribution of the firm’s future profits and the regulator’s cost in revoking the franchise contract are key factors in determining the equilibrium properties of a dynamic PS rule.

Investment in Hospital Care Technology under Different Purchasing Rules: A Real Option Approach

In this article, we analyse the optimal investment decision in a new health care technology of a representative hospital that maximises its surplus in an uncertain environment. The new technology allows the hospital to increase the quality level of the care provided, but the investment is irreversible. The article uses the framework of the real option literature to show how the purchasing rules might influence the level of investment. We show that the investment in new technology is best incentivate within a long term contract where the number of treatments reimbursed depends on the level of investment made in the period when the technology is new. In this way, asymmetry of information does not affect the outcome of the contract. In our model in fact the purchaser can verify the level of the investment only at the end of each period but the purchasing rule has an anticipating effect on the decision to invest.Health care technologies, Medical quality, Irreversible investments, Real options

Are Workers. Enterprises Entry Policies Conventional

One of the main reasons why workers’ enterprises (WE) still represent a relevant chunk of the economy may lie in some affinities with conventional profit maximizing firms. To prove this, we compare the entry policies of WEs and conventional firms when they can decide size at entry while having to stick to it afterwards. Even though short run differences remain, a long run coincidence appears besides that under certainty. Endogenizing size and time of entry in an uncertain dynamic environment we see that WEs enter at the same trigger and size of conventional firms. Both of them wait less and choose a dimension larger than the minimum efficient scale. This may be another way to explain why WE are still an important share of the economy (Hesse and Cihàk, 2007) despite the ongoing mantra of their imminent demise.Workers’ Enterprises, Entry, Uncertainty, Rigidity

Migration Dynamics

This paper look at why most migration flows include observable jumps, a phenomenon that is in line with migration irreversibility. We have presented a real option model where the migration choice depends on both the wage differential between the host country and the country of origin, and on the probability of full integration into the host country. The optimal migration decision of an individual consists of waiting to migrate in a (coordinated) mass of individuals. The size of the migration flow depends on the behavioural characteristics of the ethnic groups: the more "sociable" they are, the larger the wave and the lower the wage differential required. The second part of the paper is devoted to calibrating the model and simulating migration flows into Italy over the last decade. The calibration can replicate the migration jumps in the short term. In particular, the calibrated model is able to project the induced labour demand elasticity level of the host country and the behavioural rationale of the migrants.Migration, Real Option, Labour Market, Network Effect

Start-up Entry Strategies: Employer vs. Nonemployer firms

From 1997 to 2001 we observe in the Usa a faster growth in the number of Nonemployer firms (NF) vis à vis Employer firms (EF). The diverse speed of net entry may be due to particular internal organisation of the two types of firms and the effect that this has on the reactions to market uncertainty. However, the set of internal organizations of firms is larger than that made up simply by EFs and NFs, in particular among newborn firms, since we observe corporate start-ups with employees, firms owned and managed by their founders who are simultaneously the employees and, finally, non corporate enterprises. The second class of firms mostly belongs to the category of NFs, according to US nomenclature, while non corporate firms may belong to either category. Our curiosity is attracted by different entry patterns of NFs and EFs and our aim is to interpret them. According to recent literature, firms carry out an irreversible investment, such as entry, only if market prices are strictly larger than average total costs (Marshallian point). However, the trigger price that makes firms become active is affected by institutional rules, the existence of profit sharing, efficiency wages, exit options - i.e. partial reversibility -, financial constraints. Then, the internal organization of a newborn firm may make the difference. In a continuous time stochastic environment, where firms bear a sunk cost, we model entry as a growth option. On the trace of distinct objective functions we show that NFs and EFs have specific entry patterns in terms of output price and/or size. Why? Simply because they react in diverse fashions to market price volatility. In this sense we are able to show that, in most cases, the NF is locally less risky. This makes the NF better suited to enter under conditions of higher volatility. This exactly corresponds to what happened during the years between 1997-2001.Entry strategies, Uncertainty, Nonemployer, Employer firms

Licences, "Use or Lose" Provisions and the Time of Investment

Exclusive rights granted by public authorities, like concessions to develop natural resources or electromagnetic spectrum licences, often have option-like features. However, to avoid licences being unused for lengthy periods, regulators sometimes set time limits, after which the exclusive right of exercise may be revoked. In this paper we analyse the impact of use or lose ("UOL") provisions upon the private time of investment. We find that the risk of losing the licence because of inaction generally increases the probability of early investment. However, when capital costs are expected to decline over time, UOL provisions may involve a "perverse effect", by increasing, rather than reducing, the expected time of investment, with respect to a situation where the date of investment is left entirely to the licencee’s discretion.Licences, Real Options, Use or Lose Provisions, Time of Investment

Partnerships vs. Firms Entry Strategies

From 1997 to 2001 we observe a faster growth in the number of Nonemployer businesses (mostly Partnerships) vis-à-vis Firms in the USA, a country with the mildest asymmetries between the two types of enterprise with respect to taxation, administrative entry barriers and other institutional aspects. The different speed of net entry may be due to the internal organisation of the two types of enterprise and its relation to some market features. In a continuous time stochastic environment, with sunk costs, we model entry as a growth option. Partnerships and Firms display speci…c entry patterns in terms of output price and size since they react in diverse fashions to market uncertainty. In most cases, the Partnership is less risky and better suited to enter under conditions of high volatility, as during the years between 1997 and 2001.Entry Strategies, Uncertainty, Partnership, Firm