Markov-Perfect Nash Equilibria in Models with a Single Capital Stock

We examine a model in which two firms strategically compete in a duopolistic product market. Firms produce a homogenous product and face stochastic industry demand. Each firm has a single option either to expand or contract capacity, and hence output. In this setup we analyze the risk characteristics of industries as well as single firms and look at corresponding asset price dynamics. We focus on sequential exercise of options. We find that strategic competition in the product market is risk reducing. Irrespective of expansion or contraction the presence of strategically interacting rivals causes firm's risk to decline. This is the consequence of a simple hedging argument. Moreover, we find that own firm and industry characteristics have opposite risk implications in case of expansion and contraction. Empirical evidence, however, is that a strong negative relationship exists between firm and rival risk measures