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Incumbent monopolists frequently claim that the introduction of competition will reduce future profits and therefore delay future investments. In this paper we show, that not only is this not generally true, but in the oligopolistic industry model of Dixit and Pindyck [Investment under Uncertainty, 1994] this is never the case. We extend this result to situations in which investments have positive externalities and situations in which the monopolist has multiple investment opportunities.

In Investment under Uncertainty, Dixit and Pindyck (1994) document the significance of irreversibility and uncertainty for the investment decisions of the firm. It is shown that irreversibility and uncertainty induce a firm to invest (optimally) only when the value of a completed investment exceeds the value of the option to invest. In an extension of the standard irreversible investment model, Dixit and Pindyck solve this type of investment problem when there are two firms engaged in a strategic investment game. The purpose of this paper is to find the effect of competition on the optimal investment strategy of the firm. We examine this issue by comparing the optimal investment strategy of a monopolist with the optimal investment strategy of two firms. In the process of this comparison, we extend the two-firm model of Dixit and Pindyck to allow for investments with both positive and negative externalities. The effect of competition turns out to be the same for either type of externality, but for very different reasons. In the first case, the introduction of competition has two opposing effects. Firstly, competition lowers the expected profit flow from an investment and this tends to delay investment. Secondly, competition introduces a strategic benefit to investment, namely that it deters the investments of other firms. Our main result is that the strategic effect always dominates and competition thus precipitates investment. In the second case, where investments are mutually beneficial, the optimal investment policy is essentially a question of coordination. In equilibrium, both firms invest early in anticipation that the other firm will invest early as well. The paper is organized as follows. Section 2 briefly recapitulates the model, as it is presented in Dixit and Pindyck. In Section 3, we state and prove the main proposition of this paper namely that competition precipitates investment when entry reduces an incumbent’s profits. In Section 4, we consider the case of investments with positive externalities and show that while the type of equilibrium changes, the result continues to hold. In Section 5, we extend the analysis, by allowing the monopolist to invest twice rather than just once. Finally, Section 6 comments on the literature and Section 7 concludes.

In this paper, we have studied the effect of competition on the investment decisions of the firm. Two different cases have been considered, namely those of negative and positive externalities. The first case corresponds to traditional competitive industries in which the investment decision of one firm lowers the profitability of other firms. In this case, we find that firms invest sequentially as the market develops. Specifically, we have shown that the first firm invests earlier than a firm with no competition would have done. The second case corresponds to industries in which externalities make the investment of one firm increase the profitability of other firms’ investments. In this case, we find that firms invest simultaneously once the industry has developed sufficiently. This type of equilibrium resembles the rapid and sudden development that we have seen in internet investments. While the type of equilibrium changes, we have shown that our result on competition and irreversible investment extends to this case as well. That is, both firms invest before a firm with no competition would have done. These results can be extended to the case in which a monopolist has several investment opportunities. Just as before, the analysis splits up into two cases depending on whether the second investment increases or decreases per unit profit flow. As above, with increased profit flow a monopolist makes both investments simultaneously. They are, however, made earlier than by competitive firms if there are positive synergies from both investments having the same owner. With decreased profit flow, a monopolist always makes its first investment later than the leader among two competitive firms would have done. In the process, we also showed a different result, namely that it makes no difference for the first investment whether the monopolist has access to one or two investment projects. Finally, we found that a monopolist will make its second investment earlier than the follower, if the profit loss due to increased competition is larger than that due to increased supply.