Strategic capacity investment under demand ambiguity with creative destruction

This paper investigates the joint effects of creative destruction, competition, and ambiguity aversion on firms’ optimal investment timing and capacity choices within a real options game framework. The market demand for the underlying product evolves over time according to a jump-diffusion process, and at least one of the firms exhibits ambiguity aversion regarding both diffusion risk and jump risk. Under the assumption of stochastic project lifetime, we obtain the following results: (1) In a monopoly market, the investment timing is a U-shaped function of the volatility of market demand and ambiguity aversion to diffusion risk. Meanwhile, the higher the ambiguity aversion to jump risk, the later the firm invests with less capacity. (2) In the sequential equilibrium, the leader’s decision to deter or allow the follower’s entry is significantly influenced by the volatility of market demand and the leader’s aversion to diffusion risk. (3) In the preemptive equilibrium, the ambiguity aversion towards diffusion and jump risks increases the incentive to preempt the opponent’s investment when only the follower is ambiguity-averse, while the opposite result occurs when two firms have the same ambiguity aversion preference or when only the leader is ambiguity-averse.