particular, in these models, regulation can restrict the flexibility of the firm through the
introduction of constraints on prices and on costs associated with delay, abandonment, or
shutdown/restart options.
Although investment decisions in the telecommunications industry often involve
both irreversibility and uncertainty, a limited literature exists on the application of real
options to the telecommunications industry12.
In this paper we extend McDonald and Siegel (1986), who initiated the theory of
irreversible investment under uncertainty in a continuous time setting - later extensively
developed by Dixit and Pindyck (1994) -, by considering investments which have finite
lifespan, whose length is known in advance. Also we use a discrete time setting rather than
the continuous one employed by McDonald and Siegel.
In the next sections, we will present an illustrative example of the decision process of
firm according to real option theory; subsequently we will describe our model and apply it
to NGNs; finally we will compare the impact of different regulatory regimes onto
investments.
3 - A real option theory approach to the telecommunication industry
3.1 - A discrete binomial model: an illustrative example
In this section we present an illustrative example with the aim at making the reader
acquainted with the reasoning behind the optimal exercise of an option. We also introduce
the concept of critical values (i.e. prices above which the option holder should rationally
exercise the option) and examine how do these values vary in response to a change in the
12 Hausman (1999) and Pindyck (2003) applied the real options methodology to examine the sunk cost of
assets and the delay option in the context of unbundled network elements, arguing that the regulator has not
considered the impact of investment irreversibility when calculating rates of return of firms’ investment
incentives. Ergas and Small (2000) examined the sunk cost of assets and the regulator’s impact on the
distribution of returns. Small (1998) studied investment under uncertain future demand and costs with the real
options method. Nevertheless, these studies do not address the investment decision, they simply aim at
calculating the real option surcharge to be included in wholesale products prices. Among others see Hausman
(1997; 1999)
10