Optimal Exit Policy with Uncertain Demand*

Abstract

In a framework where entrants must make sunk investment decisions with uncertain returns and have private demand information, we show that the relationship between innovation and exit value is non‐monotone and features an inverted U‐shaped pattern. Consumer surplus is maximised at the lowest exit value that incentivises the investment. These insights are applied to optimal merger policy. An entrant is more willing to innovate to be acquired afterwards, even if it has no bargaining power. This innovation‐for‐buyout effect implies that an entrant is less likely to leave the market under a lenient than a strict merger policy.