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What is not a real option: identifying boundaries for the application of real options to business strategy

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The concept of real options has generated considerable interest within the management literature in recent years. The appeal of the framework is natural given the high degree of uncertainty that firms face in their investment decisions. Little attention, however, has been paid to what distinguishes a real option from other path-dependent investment processes. The authors argue that the critical distinctions stem from the degree to which the criteria for whether or not to continue with a course of action (i.e., a option) can be specified ex-ante. While the real option framework is designed to address uncertainty, options are structured around particular sets of possible actions. To the extent that choice sets (not only outcome values) evolve as a consequence of prior actions, the real option framework is less applicable. A common violation of this boundary condition occurs when initial efforts that prove unsuccessful with regard to the intended market or technical agenda raise the possibility of success in the context of other markets or different technical agendas. The flexibility associated with the notion of real options stems from the possibility of abandonment. As a result, the boundaries of applicability of real options to business strategy are, in important respects, a function of organizational design and project management. The authors argue that maintaining this flexibility requires an off-setting rigidity in the boundaries of search processes. However, preserving the applicability of real options by imposing rigid criteria for abandonment may result in the underutilization of discoveries made in the course of initial investments and search efforts. The organizational rigidity required to maintain the flexibility of abandonment may therefore cause real options to be an inferior mechanism of resource allocation relative to other search processes (e.g., March and Simon, 1958; Burgelman, 1983; Kanter, 1988; Lynn, Morone, Paulson, 1996) in many strategic settings.

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