Uncertainty , Networks and Real Options ∗

Two pervasive features of industries experiencing rapid technological progress are uncertainty (with regard to the technological feasibility and marketabilility of an innovation) and networks (the dense web of research alliances and joint ventures linking firms to each other). This paper connects the two disparate phenomena using the notion of real options. It visualizes firms as nodes and the links connecting them as call options that give each pair of interlinked firms the right, but not the obligation, to sink additional resources into a project at some future date conditional on favorable technical/market information. The formation of networks is endogenous as firms establish links with others by appraising their value using option pricing methods. Our model explains the following: why networks are particularly ubiquitous in industries that are subject to high uncertainty; why networks often display an interconnected “hubs and spokes” architecture; why small (or peripheral spoke) firms often sink resources into relatively higher risk higher return investment projects (and those too with only large, or hub firms); and why so many research alliances are continuously ∗We would like to thank Wally Mullin and Anthony Yezer for many helpful comments and suggestions. We would also like to thank the seminar participants at the International Industrial Organization Conferences (Boston, Arlington), Southern Economic Association Meetings (Washington D.C), Indian School of Business (Hyderabad) and at George Washington University.