Product Life Cycles and Investment: A Real Options Analysis

This paper studies a firm’s investment decision in production capacity where product demand follows a product life cycle (PLC), implying that demand first grows and then declines. The starting point of the decline phase is uncertain. The investment decision involves deciding about the timing and the size of the investment. We make a distinction between the firm being a product life cycle leader and a product life cycle follower. A PLC-leader will always first experience demand growth before the decline kicks in. In case of a PLC-follower, the firm enters an existing product life cycle, implying that the decline can already start before this firm even has invested. It turns out that it makes a major difference whether the firm is a PLC-leader or PLC-follower. To benefit from a period of demand growth, the PLC-follower has an incentive to invest early, thus when the current demand level is still low. This forces the firm to limit the investment size. The PLC-leader, on the contrary, always chooses the investment size corresponding to demand growth throughout, where the probability of demand decline simply delays the moment of investment.