by these cash flows. The greater the potential for excess
returnsonthesecondinvestment,thegreaterthevalueofthe
expansionoption in the first investment.The potential for
excessreturnsiscloselytiedtohowmuchofacompetitive
advantagethefirstinvestmentprovidesthefirmwhenittakes
subsequent investments.
At one extreme, again, consider investing in research and
developmentto acquirea patent.Thepatent givesthefirm
thatownsittheexclusiverightstoproducethatproductand,
ifthemarketpotentialislarge,therighttotheexcessreturns
fromtheproject.Attheotherextreme,thefirmmightgetno
competitiveadvantagesonsubsequentinvestments,inwhich
caseitisquestionableastowhethertherecanbeanyexcess
returnsontheseinvestments.Inreality,mostinvestmentswill
fall in the continuum between these two extremes, with
greatercompetitiveadvantagesbeingassociatedwithhigher
excess returns and larger option values.
- How sustainable are the competitive advantages? In a
competitivemarketplace,excessreturnsattractcompetitors,
and competition drives out excess returns. The more
sustainablethecompetitiveadvantagespossessedbyafirm,
thegreaterwillbethevalueoftheoptionsembeddedinthe
initial investment. The sustainability of competitive
advantagesisafunctionoftwoforces.Thefirstisthenature
ofthecompetition;otherthingsremainingequal,competitive
advantagesfademuchmorequicklyinsectorswherethereare
aggressive competitors. The second is the nature of the
competitiveadvantage.Iftheresourcecontrolledbythefirm
is finite and scarce (as is the case with natural resource
reservesandvacantland),thecompetitiveadvantageislikely
to be sustainable for longer periods. Alternatively, if the