Closure Options in Duopoly: The Case of Second-Mover Advantages

This paper examines exercise policies for capacity reduction options in a duopolistic market that is subject to aggregate shocks. Firms face an inverse demand that exhibits second-mover advantages rather than the complementary property of first-mover advantages commonly assumed in the literature on games of investment timing. We identify a joint-reduction scenario to be the unique equilibrium outcome of the disinvestment timing game with identical firms. With heterogeneous firms one out of three scenarios occurs. Depending on the degree of heterogeneity either firms disinvest jointly or the high-cost firm moves first or a multiplicity of equilibria arises. All optimal exercise policies turn out to be different from the closure rules suggested by the standard real options theory: Identical as well as heterogeneous firms in duopoly should disinvest earlier than price-taking firms but later than a monopolist. A discussion of welfare and policy issues suggests a restrictive approach to the assessment of mergers in declining industries.