"Irreversible Investment in
Stochastically Cyclical Markets",
(co-authored with
Francisco Ruiz-Aliseda) Revise and resubmit to Journal of Economics and Management Strategy
This paper studies entry and exit
decisions in perfectly competitive markets whose demand alternates between
growth and decline phases at uncertain times. We introduce a stochastic process
that captures these features of random market evolution, and we provide key
mathematical results related to first passage times which make the
characterization of entry and exit behavior quite simple and straightforward
(even when the process is subject to an endogenously determined upper or lower
barrier). We characterize entry and exit patterns in a dynamic competitive
equilibrium, and we show why our results differ from those obtained if demand
follows a diffusion process (e.g., a Geometric Brownian Motion). Despite the
stochastic process of the underlying variable has a continuous sample path in
both cases, we demonstrate in our setting that positive rates of entry and exit
discontinuously fall to zero owing to informational overshooting. Another
advantage of our framework is that it can explain discontinuities in stock
prices even if sample paths are continuous or that it can be easily applied to
(dis)investment timing games, as we illustrate.
"Capacity Preemption with
Leadership Contest",
Revise and resubmit to Journal of Economics and Management Strategy
This paper introduces a continuous-time
game to study two ex-ante identical firms' incentives in capacity preemption.
Each firm can choose small or large capacity and investment timing to enter a
new industry whose demand grows until an unknown maturity date. Previous
literature usually predicts that the Stackelberg
leader, whether endogenously or exogenously determined, is better off by
building a larger capacity than its rival. In contrast, this paper proves that
in most cases the first mover's equilibrium strategy is to enter with a smaller
capacity than the follower. If it had chosen the larger capacity, its follower
could, and in fact would use a smaller plant to force it out of the market
through a leadership contest. The large leader lacks incentive to fight for the
market because the small firm can make credible commitment to stay with its
higher option value of waiting to exit.
" The
Impact of Market Structure and Learning on the Tradeoff between R&D
Competition and Cooperation "
(co-authored
with David Besanko) Revise and resubmit to Journal of Industrial Economics
This paper explores the
trade-off between R&D cooperation and competition with learning. We develop
a continuous time, two-armed bandit model in which firms can devote resources
to a "safe" investment in an established market or to a risky R&D
investment aimed at discovering a new product that is characterized by both
"if" and "when" uncertainty. The firm that wins the race
under R&D competition enjoys a period of monopoly profits. But, after this
period, competition in the market for the new product occurs, which may also
impair the profitability of each firm's established product. Post-patent market
structure and the extent of the adverse impact of the new product on the
profitability of established products play a key role in driving the tradeoff
between R&D competition and R&D cooperation. Firms' incentives to
invest in the non-cooperative regime differ from a consortium's investment
incentives. Under non-cooperative R&D, a free rider problem can arise,
which generally results in an equilibrium investment flow that is less than or
equal to that of the research consortium. Expected ex ante undiscounted
investment and welfare under R&D competition can also be shown to be less
than what it would be under R&D cooperation. However, if the gain due to
the oligopoly profit from the new product is less than the loss in profit from
the established product, then the free rider problem does not arise. In this
case, R&D cooperation results in the same or lower level of investment than
arises under non-cooperative R&D. Thus, in contrast to the traditional
literature, we show that technology spillover alone need not lead to higher
R&D investment or higher social welfare under research cooperation. In
fact, significant product market spillovers are necessary if the underlying
R&D project exhibits both "if" and "when" uncertainty.
Government
Subsidies for Research Programs Facing If and When Uncertainty
(co-authored
with David Besanko) This paper is currently under review.
This paper studies the
impact of R&D subsidies in a setting in which there is uncertainty not only
about the timing of a breakthrough ("when" uncertainty), but also
about whether a breakthrough is even possible ("if" uncertainty).
This setting seems particularly applicable to firms engaged in fundamental
scientific research. Our paper makes two broad contributions. First, we show
that the way in which R&D is subsidized matters. Certain types of subsidies
may crowd out private investment while other types of subsidies may stimulate
private investment. Second, we show that simple subsidy mechanisms can be very
effective in dealing with market failures, and under important conditions, it
may be possible to implement the first-best outcome with a minimum of
information. This demonstrates that even in complex dynamic settings R&D
subsidies have the potential to improve social welfare. More specifically, the
paper utilizes a two-armed bandit framework to model the impact of government
subsidies for private R&D investment. We focus on two cases: monopoly and
competitive R&D. We derive an individual firm's optimal R&D investment
decision and noncooperative firms' symmetric Markov
Perfect equilibrium investment strategies. If there is no shadow cost of public
funding, we show that for a monopoly the first-best welfare can be attained
through a pure matching subsidy that does not rely on firm beliefs about
project viability. Under competition, the first-best can be attained using a
combination of a (belief-free) matching subsidy and a (belief-free)
unrestricted subsidy policy. The unrestricted component is needed because of
the free-rider problem that arises under R&D competition. By contrast, if
there is shadow cost of public funding, we show that earmark and unrestricted
subsidies are never optimal for the monopoly case for a large set of
parameters. In fact, numerical examples demonstrate that a pure matching policy
is optimal for all cases under monopoly and when spillovers are sufficiently
small under R&D competition.
Breaking Up a Research
Consortium
(co-authored
with Andras Niedermayer) Revise and resubmit
to International Journal of Industrial
Organization.
Inter-firm R&D collaborations
through contractual arrangements have become increasingly popular, but in many
cases they were broken up at the pre-committed contract expiration date without
any joint discovery. We provide a rationale for pre-committing to a breakup
time in the R&D agreement. Consider a research consortium initiated by a
firm A with a firm B. B has private information about its benefit from a
success, the difficulty of the development process, and the relevance of its
expertise. In first-best, breakup never occurs: a consortium is either
continued until success or never formed in the first place. In second best, a
breakup rule is necessary to elicit the right type of firm B to collaborate
under a fairly general condition. This condition is sufficient not only when A
is restricted to offering a single, type independent contract to B, but also
when A can offer a menu of contracts depending on B's type. If the costs of
separating different types of B are too high, A may prefer partial pooling.
Furthermore, numerical analysis shows that A only
breaks up with B if B has the right type and never breaks up in case of pooling
with a bad type. This stems from breakup being a screening device.
This paper introduces a two-stage model to
study a duopoly competition to retain customers. Conventional wisdom tells us
that competition in markets with switching cost leads to too much switching. We
argue that when consumers are allowed to seek retention benefit from their
existing suppliers, firms cannot refrain from offering discount in equilibrium,
although their profits are lower. Even if retention seeking is costly, consumer
and social welfare are unambiguously improved. As the cost of retention seeking
remains positive but goes to zero, the difference between the discount and full
price goes to zero, but the welfare improvement remains positive throughout.
"Double Auction with a Small
Participation Cost"
This paper studies a simple market with N
potential buyers and N potential sellers where each trader needs to incur a
small participation cost to enter the trading for an indivisible good. In this
case, the realized market might be asymmetric in two senses: first the numbers
of traders in each side are not equal; second, the entering buyers and sellers
will have different supports, either partially overlapped or completely
separated. These two aspects might cause the equilibrium strategies to become
kinked. However, it can be shown that the post entry efficiency loss in this
simple market will be at most O((1/(N²))) even with
the presence of those complexities.