Impact of Bayesian Learning and Externalities on Strategic Investment

We investigate the interplay between learning effects and externalities in the problem of competitive investments with uncertain returns. We examine a game theoretic duopoly investment model in which (i) a firm can learn about the profitability of the investment by observing the performance of the first mover and (ii) externalities exist between the investments of two firms. We find a region of a war of attrition between the two firms in which the interplay between externalities and learning gives rise to counterintuitive effects on investment strategies and payoffs. In particular, we find that, contrary to the conventional war of attrition where an increase in benefits for the follower generally delays the first move, an increase in the rate of learning—which tends to benefit the follower—can hasten the first investment.

This paper was accepted by James Smith, decision analysis.