Optimal Exit Policy with Uncertain Demand

Abstract

Entrants often need to make considerable sunk investments with highly uncertain returns. The option to exit if returns are low reduces investment risks and stimulates innovation. We examine the interaction between exit policy and up-front investment by entrants, finding an inverted U-shaped relationship between innovation and exit value. Consumer welfare is shaped by a trade-off between encouraging firms to stay in the market through higher exit barriers, and stimulating investment through a more permissive exit policy. As future returns become more uncertain, consumer welfare maximization requires lower exit barriers. These insights are applied to optimal merger policy and bankruptcy law.