Strategic Urban Development Under Uncertainty

Abstract

The aim of this paper is to analyze the equilibrium strategies of two developers in the real estate market, when demands are asymmetric. In particular, the paper considers three key features of the real estate market. First, the cost of redeveloping a building is, at least partially, irreversible. Second, the rent levels for different buildings vary stochastically over time. Third, demand functions for space are interrelated and may produce positive or negative externalities. Using the method of option pricing theory, the paper addresses this issue at three levels. First, it models the investment decision of a firm as a preassigned leader as a dynamic stochastic game. Then, it solves for the non-cooperative case, and for the perfectly cooperative case, in which redevelopment of an area is coordinated between firms. Finally, it analyzes the efficiency/inefficiency of the equilibria of the game. It is found that if one firm has a significantly large comparative advantage, the preemptive threat from the rival will be negligible. In this case, short burst and overbuilding phenomena, as predicted by Grenadier (1996), will occur only as a limiting case.