Doctoral Dissertation Abstract

STRATEGIC INVESTMENT IN INFORMATION TECHNOLOGIES:
A REAL-OPTIONS AND GAME-THEORETIC APPROACH

Kevin Zhu
Stanford University
June 1999

Investments in information technologies (IT) constitute more than 50% of all new capital investments by major U.S. companies. Evaluating such investment projects has been recognized as crucial to the efficient allocation of resources. Yet, the existing evaluation models are not capable of capturing the characteristics of technology investments due to the difficulty in handling the real options embedded in such investment projects in an uncertain, competitive environment.

Viewing investment projects as real options, this dissertation develops a methodology for evaluating technology adoption decisions in the joint presence of uncertainty and competition. Using dynamic programming, our methodology integrates the game-theoretic models of strategic market interactions with a real options approach, and provides an improved understanding of the effects of uncertainty and competition on the strategic exercise of real options embedded in technology innovations and adoptions.

Several key features underline the model. First, our study demonstrates how investment strategies depend on competitive interactions. The model shows that firms tend to exercise their options “too early” under the pressure of competition. The resulting “rush equilibrium” substantially erodes the option value of waiting and induces aggressive adoption behavior. Second, we derive optimal investment strategies as specified by critical thresholds. These thresholds provide insights into the optimal timing to exercise real options in a multi-period setting where investment decisions can be deferred but with certain competitive risks. Furthermore, considering different information structures, we extend the conventional full-information models to an asymmetric information context, and demonstrate that information asymmetry leads to asymmetric Nash equilibrium and sequential adoptions (hence endogenous leadership emerges from otherwise identical firms).

Finally, we model price competition and quality differentiation for information products. Our model shows that at equilibrium only a small number of firms can expect to survive in the markets for information goods. We derive a precise formula, in which the number of firms that can survive at equilibrium is largely influenced by consumer heterogeneity. This implies that consolidation would be inevitable in some information product markets.

The model generates some new insights into the forces that shape market behavior as observed in the IT industry. It can be used to determine optimal investment strategies for technology innovations and adoptions, new product introduction, and investment projects in IT infrastructures.