Real Option Games with R&D and Learning Spillovers

Martzoukos, Spiros H and Zacharias, Eleftherios (2008): Real Option Games with R&D and Learning Spillovers.

Abstract

We model pre-investment R&D decisions in the presence of spillover effects in an option pricing framework with analytic tractability. Two firms face two decisions that are solved for interdependently in a two-stage game. The first-stage decision is: what is the optimal level of coordination (optimal policy/technology choice)? The second-stage decision is: what is the optimal effort for a given level of the spillover effects and the cost of information acquisition? The framework is extended to a two-period stochastic game with (path-dependency inducing) switching costs that make strategy revisions harder. Strategy shifts are easier to observe in more volatile environments.

• Item Type: MPRA Paper
• Language: English
• Keywords: Benefit Analysis; Real Options; Coordination Games; R&D
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

Bernstein, J. I., and M. I. Nadiri, 1988. “Interindustry R&D spillovers, rates of return, and production in high-tech industries.” American Economic Review 78, 429-434.

Black, F., and M. Scholes, 1973. “The pricing of options and corporate liabilities.” Journal of Political Economy 81, 637-659.

Brennan, M.J., 1991. “The price of convenience and the valuation of commodity contingent claims.” In Lund D., and Øksendal, B. (Eds.), Stochastic Models and Option Values. North-Holland, 33-72.

Brod, A., and R. Shivakumar, 1999. “Advantageous semi-collusion.” Journal of Industrial Economics XLVII, 221-230.

Carey, C., and D. L. Bolton, 1996. “Brand versus generic advertising and the decision to advertise collectively.” Review of Industrial Organization 11, 93-105.

Chan, L. K. C., J. Lakonishok, and T. Sougiannis, 2001. “The stock market valuation of research and development expenditures.” Journal of Finance 56, 2431-2456.

Childs, P. D., S. H. Ott, and T. J. Riddiough, 2001. “Valuation and information acquisition policy for claims written on noisy real assets.” Financial Management 30, 45-75.

d´Aspremont, C., and A. Jacquemin, 1988. “Cooperative and noncooperative R&D in duopoly with spillovers.” American Economic Review 78, 1133-1137.

Davis, G. A., and M. Samis, 2006. “Using real options to value and manage exploration.” Society of Economic Geologists Special Publication 12, Ch. 14, 273-294.

Dixit, A.K., and R.S. Pindyck, 1994. Investment Under Uncertainty. Princeton University Press, Princeton: New Jersey.

Eberhart, C. A., W. F. Maxwell, and A. R. Siddique, 2004. “An examination of long-term abnormal stock returns and operating performance following R&D increases.” Journal of Finance LIX, 623-650.

Epstein, D., N. Mayor, P. Schonbucher, E. Whaley, and P. Wilmott, 1999. The value of market research when a firm is learning: Real option pricing and optimal filtering. In Real Options and Business Strategy. Applications to Decision Making, L. Trigeorgis (ed.). Risk Books, London, UK.

Foster, A. D., and M. R. Rosenzweig, 1995. “Learning by doing and learning from others: Human capital and technical change in agriculture.” Journal of Political Economy 103, 1176-1209.

Grabowski, H., and J. Vernon, 1990. “A new look at the returns and risks to pharmaceutical R&D.” Management Science 36, 804-821.

Hall, B. H., and R. Oriani, 2004. Does the market value R&D investment by European firms? Evidence from a panel of manufacturing firms in France, Germany, and Italy. National Bureau of Economic Research Working Paper 10408, Cambridge, MA.

Huchzermeier, A, and C. H. Loch, 2001. “Project management under risk: Using the real options approach to evaluate flexibility in R&D.” Management Science 47, 85-101.

Hull, J. C., 2006. Options, Futures, and Other Derivatives. Upper Saddle River, N.J.: Pearson – Prentice Hall.

Kamien, M. I., E. Muller, and I. Zang, 1992. “Research joint ventures and R&D cartels.” American Economic Review 82, 1293-1306.

Kaufman, G. M., 1963. Statistical Decision and Related techniques in Oil and Gas Exploration. Englewood Cliffs, N. J.: Prentice-Hall.

Korn, R., 1997. “Optimal impulse control when actions have random consequences.” Mathematics of Operations Research 22, 639-667.

Kothari, S. P., T. E. Laguerre, and A. J. Leone, 2002. “Capitalization versus expensing: Evidence on the uncertainty of future earnings from capital expenditures versus R&D outlays.” Review of Accounting Studies 7, 355-382.

Lambrecht, B., and W. Perraudin, 2003. “Real options and preemption under incomplete information.” Journal of Economic Dynamics and Control 27, 619-643.

Majd, S., and R. Pindyck, 1989. “The learning curve and optimal production under uncertainty.” RAND Journal of Economics 20, 331-343.

Martzoukos, S.H., 2000. “Real options and the value of learning.” Annals of Operations Research 99, 305-323.

McDonald, R., and D. Siegel, 1984. “Option pricing when the underlying asset earns a below-equilibrium rate of return: A note.” Journal of Finance 39, 261-265.

Merton, R. C., 1973. “An intertemporal capital asset pricing model.” Econometrica 41, 867-887.

Merton, R. C., 1976. “Option pricing when underlying stock returns are discontinuous.” Journal of Financial Economics 3, 125-144.

Paddock, J. L., D. Siegel, and J.L. Smith, 1988. “Option valuation of claims on real assets: The case of offshore petroleum leases.” Quarterly Journal of Economics 103, 479-508.

Paxson, D. A. (ed), 2003. Real R&D Options. Butterworth-Heinemann.

Pennings, E., and Lint, O., 1997. “The option value of advanced R&D.” European Journal of Operational Research 103, 83-94.

Pindyck, R., 1993. “Investments of uncertain cost.” Journal of Financial Economics 34, 53-76.

Pratt, J. W., H. Raiffa, and R. O. Schlaifer, 1961. Introduction to Statistical Decision Theory. The MIT Press.

Roberts, K., and M. Weitzman, 1981. “Funding criteria for research, development and exploration projects.” Econometrica 49, 1261-1288.

Seade, J. K., 1980. “The stability of Cournot revisited.” Journal of Economic Theory 23, 15-27.

Shackleton, M., A. Tsekrekos, and R. Wojakowski, 2003. “Strategic entry and market leadership in a two-player real options game.” Journal of Banking and Finance 28, 179-201.

Smit, H. T. J., and L. A. Ankum, 1993. “A real options and game-theoretic approach to corporate investment strategy under competition.” Financial Management 22, 241-250.

Smit, H. T. J., and L. Trigeorgis, 2004. Strategic Investment. Princeton: Princeton University Press.

Tao, Z., and C. Wu, 1997. “On the organization of cooperative research and development: theory and evidence.” International Journal of Industrial Organization 15, 573-596.

Trigeorgis, L., 1996. Real Options: Managerial Flexibility and Strategy in Resource Allocation. The MIT Press.

Weeds, H., 2002. “Strategic delay in a real options model of R&D competition.” Review of Economic Studies 69, 729-747.