Optimal Exit Policy with Uncertain Demand

Entrants often need to make considerable sunk investments whose returns are highlyuncertain. The option to exit the market if returns are low helps to reduce investment risksand can be an important impetus to investment. We examine the interaction between exitpolicy and up-front investment by new market entrants, fi nding an inverted-U relationshipbetween entrants' incentives to invest and exit value. From a consumer welfare standpoint,there is a trade-off between encouraging more fi rms to stay in the market through higherbarriers to exit, and stimulating ex-ante investment through a more permissive exit policy.As uncertainty about future returns increases, an exit policy intended to protect consumersshould entail lower barriers to exit given the positive effect on consumer welfare of additionalinvestment. These insights are then applied to discuss optimal merger policy and bankruptcylaw