Entry and Exit Decisions under Uncertainty

TLDR

An idle firm and an active firm are treated as call options on each other. The study examines a firm's entry and exit decisions under a random‑walk output price and derives trigger prices for entry and exit. The authors solve for a pair of trigger prices that dictate when a firm should enter or exit the market. The entry trigger exceeds variable cost plus interest on entry cost, the exit trigger falls below variable cost minus interest on exit cost, producing significant hysteresis even with small sunk costs.

Abstract

A firm's entry and exit decisions when the output price follows a random walk are examined. An idle firm and an active firm are viewed as assets that are call options on each other. The solution is a pair of trigger prices for entry and exit. The entry trigger exceeds the variable cost plus the interest on the entry cost, and the exit trigger is less than the variable cost minus the interest on the exit cost. These gaps produce "hysteresis." Numerical solutions are obtained for several parameter values; hysteresis is found to be significant even with small sunk costs.