Dynamic investment strategies with demand-side and cost-side risks

Investments in cost reductions are critical for the long run success of companies that operate in dynamic and stochastic market environments. This paper studies optimal investment in cost reductions as a real option under the assumption that a single firm faces two different sources of risk, stochastic demand and input prices. We derive optimal investment strategies for a monopoly as well as a firm in a perfectly competitive market and show that in case of high marginal costs, cost reductions take place earlier in competitive than in monopoly markets. While the existence of an option to invest in cost reductions increases firm value it also increases a firm’s systematic risk. Risk can be smaller in a monopolistic than in a competitive industry.