Strategic Real Option Exercising and Second-Mover Advantage

Many business opportunities feature second-mover advantages as there are often positive spillovers and externalities from early entrants to followers. We develop a tractable stochastic duopoly entry game with a second-mover advantage. We show that firms engage in a war-of-attrition game with the hope of becoming the follower, resulting in excessively delayed entry opposite to the predictions that competition causes firms to equalize rents (Fudenberg and Tirole, 1985) by exercising their entry options too soon (Grenadier, 1996). We obtain closed-form value functions and entry strategies for both mixed-strategy and pure-strategy equilibria. We develop a separation principle that a.) decomposes the duopoly game into a monopolist's problem and a generalized war-of-attrition game with stochastic payoffs; and b.) connects the mixed-strategy and pure-strategy equilibria. Quantitatively, our model predicts substantial option value erosion caused by inefficiently delayed firm entry