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Asymmetric Information and Irreversible Investments: an Auction Model

Multinational Finance Journal, 2010, vol. 14, no. 3/4, pp. 255-289

Abstract:
The owner of a real option does not have the necessary expertise to manage the investment project and needs to contract with an expert in order to exercise the real option. The potential managers (the experts) have private information about their respective cost of investing in the project. The project owner organizes an auction in which the experts participate. The winner of the contract is the expert who can exercise the investment project at the lowest cost. The optimal contract is incentive compatible, i.e., it induces the winner to follow the investment strategy preferred by the project owner. It is shown that private information increases the project owner's cost of exercising the option, which may lead to under-investment. The inefficiency due to under-investment decreases in the number of experts participating in the auction.

Keywords : real options; investment strategy; private information; auction
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