Paper: Exit in duopoly under uncertainty

1. Primary target field: industrial organizationSecondary target field: financial economics, game theory Thesis: On investment, uncertainty, and strategic interaction with applications in energy markets Paper: Exit in duopoly under uncertainty Pauli Murto

2. Problem analyzed: • There is uncertainty on the developments of industries; markets fluctuate: demand shifts, technological expectations fail, etc. • When the market declines, it may become optimal for a firm to exit • The problem is related but opposite to the optimal investment problem • When considered in isolation from competition, the optimal timing of exit is straight-forward to solve using the same methodology as investment • However, when there are many firms in the industry, the exit of a given firm affects the profitability of the remaining ones • This results in a strategic interaction, where the firms would typically like to see their competitors exit as early as possible • What is their Nash-equilibrium exit pattern? When do they exit and who exits first? How does uncertainty affect the equilibrium?

3. Background literature: • Literature on real options: • Exit without strategic interaction: uncertainty increases reluctancy to exit • Some new literature on entry games with uncertainty: opposite strategic interaction to exit • Industrial organization literature: • Exit with the focus on strategic interaction, but no uncertainty • Unique sub-game perfect equilibrium exit pattern with asymmetric firms: the large firm exits before the small firm • Stopping game literature: • Some results on specific classes of continuous time stopping games exist, but none directly applicable to the present case • This paper combines these literatures to consider exit under both uncertainty and strategic interaction

4. Results: • The incorporation of uncertainty requires a refined definition of strategies compared to the deterministic IO models: Markov strategies • Some results from the IO literature carry over to the stochastic market: e.g.: unique sub-game perfect equilibrium exit pattern with low degree of uncertainty • However, subgame perfectness criterion may suddenly lose its effect when uncertainty is increased beyond some point! • The contribution can be seen from two angles: • Extension of the real options theory to consider abandonment options in oligopoly • Extension of the theory of industrial organization to consider market stability as one of the factors explaining the firms’ behavior • Also a new result in the theory of stopping games

5. Publication plan: • Under review in the RAND Journal of Economics since 1/2002 • First answer in 5/2002: • Too long and technical for the journal • One of the referees doubts some results • Contribution considered important by both referees and the editor • Thorough and qualified reports • Revision submitted in 8/2002: • Considerably shortened • Presentation of the results simplified • All referees’ comments addressed • Report from the thesis examinors in 11/2002: • Significance of the questions analyzed should be better justified and interpretation of the results should be strengthened • Current plan: • Minor revisions according to the comments of the thesis examinors • Waiting for the answer from the journal