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JOMXXX10.1177/0149206316683778Journal of ManagementLeiblein et al. / Resource Allocation in Strategic Factor Markets

Journal of Management
Special Issue:
Vol. 43 No. 8, November 2017 2588­–2608
Resource Allocation and Strategy
DOI: 10.1177/0149206316683778
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Resource Allocation in Strategic

Factor Markets: A Realistic Real Options
Approach to Generating Competitive Advantage
Michael J. Leiblein
Ohio State University
John S. Chen
University of Florida
Hart E. Posen
University of Wisconsin–Madison

This paper develops a realistic real option theory of resource allocation decisions in strategic
factor markets. Competitive advantage in factor markets is underpinned by market failures that
allow firms to acquire assets at less than their value in use. We recognize that market failure
may result from uncertainty regarding the current and/or future value of an asset, which map,
respectively, to uncertainty as modeled in the feedback learning and real options literatures. The
realistic real option framework we develop grafts insights from the strategic factor market,
feedback learning, and real option valuation literatures. We argue that competitive advantage
may emerge not only from luck, or ex ante differences in information or complementary assets,
but also because firms differ in a specific type of learning ability—the ability to integrate new
information to exercise a contingent claim on an asset in a factor market. We dimensionalize
these differences in terms of information processing and belief updating, argue that these differ-
ences lead to different resource allocation decisions, and suggest how these decisions may
generate competitive advantage.

Acknowledgments: All authors contributed equally to this project and author order is randomly determined. We
thank the associate editors, Cathy Maritan and Gwen Lee, and two anonymous reviewers for providing con-
structive and useful feedback on earlier versions of this manuscript. This paper has benefitted from comments
on related work presented in seminars at Bocconi University, USI Lugano, Temple University, the University of
Pennsylvania, the BYU–University of Utah Winter Strategy Conference, Hebrew University, Tel Aviv University,
University of Southern Denmark, Seoul National University, and Yonsei University. In addition, we have ben-
efitted from specific comments and suggestions provided by Jay Barney, Russ Coff, Jeff Dyer, David Hoopes,
Thomas Keil, Thorborn Knudsen, Dovev Lavie, Marvin Lieberman, Jay Wellman, and Sid Winter. Of course, any
errors or omissions are our own.

Corresponding author: Michael J. Leiblein, Ohio State University, 2100 Neil Avenue, Columbus, OH 43220,
USA.

E-mail: leiblein.1@osu.edu
2588
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2589

Keywords: real option logic; decision making under uncertainty; competitive advantage;
competitive heterogeneity; sequential decision making; strategic decision making

Introduction
A fundamental issue facing strategy scholars is the identification of sources of competi-
tive advantage (Rumelt, Schendel, & Teece, 1991). Existing theories of competitive advan-
tage, which are based on assumptions of interfirm heterogeneity in productive resource
endowments (e.g., Barney, 1991; Peteraf, 1993; Peteraf & Barney, 2003), have been criti-
cized because of their limited ability to explain how managerial actions generate competitive
heterogeneity (e.g., Cockburn, Henderson, & Stern, 2000). Indeed, substantial scholarly
effort reflects the ongoing need to build and refine a “clear conceptual model that includes an
explanation of how . . . heterogeneity arises” (Helfat & Peteraf, 2003: 997). Scholars ranging
from Bower (1970) and Burgelman (1983) to Levinthal (2011) and Gavetti (2012) have
argued for a more realistic description of how behavioral and organizational processes link
to the emergence of competitive advantage. In this paper, we argue that competitive hetero-
geneity and advantage may arise because firms are differentially effective at executing real
options to acquire assets in strategic factor markets.
A large body of research has sought to understand the sources of competitive advantage.
An important class of answers relates to preferential acquisition of productive resources—
that is, resources that reduce cost or increase willingness to pay—in strategic factor markets
(Barney, 1986). One of the oldest arguments in this stream is that some firms get lucky
(Barney, 1986; Lippman & Rumelt, 1982). Serendipity shines on fortunate firms, enabling
them to acquire resources in strategic factor markets at a cost lower than their true economic
value. While this answer is convenient, and sometimes even true, it is theoretically and prac-
tically unsatisfying. In an effort to identify a more actionable foundation, subsequent work
has argued that firms may be differentially endowed with information (Barney, 1986;
Makadok, 2001) or complementary assets (e.g., Adegbesan, 2009; Lieberman, Lee, & Folta,
in press; Lippman & Rumelt, 2003). Yet the “infinite regress” highlighted by Collis (1994)
still binds, leaving unanswered why some firms are endowed with superior information or
complementary assets.
Our paper takes a different approach. It suggests the process of learning about asset value
may lead to competitive advantage when exercising options in strategic factor markets. A
central activity of the firm is to allocate scarce capital (Bower, 1970; Burgelman, 1983)
across alternative investment opportunities by acquiring productive assets in factor markets.
There is often substantial uncertainty about the future value of these assets (Felin, Kauffman,
Mastrogiorgio, & Mastrogiorgio, 2016). Resource allocation decisions may be viewed as
exercising real options when (a) prior investments provide preferential claims on subsequent
asset acquisitions and (b) the arrival of new information reduces uncertainty (Bowman &
Hurry, 1987, 1993; Dixit & Pindyck, 1994; Kogut, 1991; Myers, 1977). We follow prior
research in assuming firms are endowed with bundles of real options on productive assets
(e.g., Kogut & Kulatilaka, 2001; Maritan & Alessandri, 2007). In conceiving of resource
allocation as executing real options to acquire assets in factor markets, we take seriously the
possibility that competitive advantage may emerge not only from luck, or ex ante differences
in information or complementary assets, but also because firms differ in a specific type of
2590   Journal of Management / November 2017

learning ability—the ability to integrate new information to exercise a contingent claim on

an asset in a factor market.
We contribute by offering an explanation for interfirm heterogeneity that grafts strategic
factor market theory to the economic logic of real options and to the behavioral logic of
feedback learning. We recognize that real-world firms face two types of uncertainty when
making capital allocation decisions—uncertainty regarding the current value of an asset and
uncertainty about its future value—which we label as contemporaneous and prospective
uncertainty. These two types of uncertainty underpin distinct sources of market failure in
strategic factor markets and are core to the logic underlying the feedback learning and real
options literatures, respectively.
The realistic real option framework we utilize incorporates both contemporaneous and
prospective uncertainty (Posen, Leiblein, & Chen, 2016). The inclusion of contemporaneous
uncertainty complicates and challenges decision making within real options because firms
may erroneously exercise or terminate an option. We focus on learning under these dual
forms of uncertainty. Our notion of learning is related to, but distinct from, the idea of judg-
ment in the strategy literature (Foss & Klein, 2005; Foss, Klein, Kor, & Mahoney, 2008;
Priem, 1994; Schmidt, 2014; Schmidt & Keil, 2013). While judgment is the process of “mak-
ing a decision after careful thought,” learning is the process of “acquiring knowledge by . . .
experiencing something” (Merriam-Webster.com, s.vv. “judgment,” “learning”).1 We argue
that differences in learning about assets in factor markets, dimensionalized as information
processing and belief updating, may lead to competitive heterogeneity in the exercise of real
options to acquire assets in strategic factor markets.
This paper proceeds as follows. In the next section, we discuss the role of managerial
action in models of resource allocation. We then develop a system of ideas that incorporates
insights from the real option, feedback learning, and factor market literatures. Next, we
develop propositions suggesting how differences in information processing and belief updat-
ing across firms generate competitive advantage through resource allocation. Finally, we
discuss linkages between our theory and other behavioral and organizational decision-mak-
ing research before offering brief concluding remarks.

Roles of Management in Models of Resource Allocation

An influential body of management research, built on the work of Bower (1970) and
Burgelman (1983), emphasizes an organizational view of resource allocation and strategy
making. It highlights that resource allocation decisions are not determined purely by the
financial features of a project. For instance, Bower states,

The procedure summarized [i.e., the net present value, or NPV, model] is indeed a theoretically
correct approach to a class of decisions, but . . . the problem today’s large corporations call
“capital budgeting” has very little to do with that class of decisions. In fact, the set of problems
corporations refer to as capital budgeting are general management problems. (1970: 7)

Influenced by the Carnegie conceptualization of an organization consisting of individuals

and units, levels of hierarchy exhibiting incongruent goals, information asymmetries, and
power differences (Cyert & March, 1963; Simon, 1947), Bower and Burgelman attend to the
process by which resource allocation decisions are made in (large) firms. Bower (1970)
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2591

argues that strategy is made in a series of resource commitments across time; knowledge,
power, and decision rights are dispersed across levels of the organization. The critical insight
is that effective strategy requires managing the resource allocation process. Burgelman
(1983) complements and extends Bower’s model by incorporating evolutionary processes,
Bromiley (1986) incorporates elements of behavioral theory and demonstrates the plausibil-
ity of these behavioral assumptions, Noda and Bower (1996) incorporate cognition, and
Maritan (2001) incorporates process differences across types of investments. Thus, the
resource allocation literature highlights the importance of developing realistic models of
organizational decision-making processes.

NPV and Managerial Discretion

In contrast to the rich view of organizational decision making embodied in the resource
allocation process literature, where managers and organizations are central in determining
resource allocation decisions, financial valuation approaches to resource allocation treat the
firm as a rational actor and, therefore, underemphasize the role of managerial judgment.
Typically, these approaches are based on an assessment of the contribution of a project to
current and future profitability. This idea has long been institutionalized in managerial prac-
tice under the rubric of the NPV of an investment with discounted cash flow (Fisher, 1930).
This tool has become the cornerstone of resource allocation decisions as taught to students
and managers and as reflected in the leading textbooks on corporate finance (e.g., Brealey,
Myers, & Allen, 2010).
A central critique of the NPV approach is that it has little room for managerial discretion
in decision making. It assumes investments are irreversible in the sense that the project can-
not be terminated, prior investments are sunk, and each investment opportunity is a “now or
never” proposition. Thus, management is passive, relegated to mechanically committing to a
particular investment approach at the start of the project on the basis of the output of a model
in terms of expectations of future cash flows for all future times, irrespective of what subse-
quently occurs (e.g., Luehrman, 1998). It is at odds with economic and management research
that argues that decision makers should pursue firm- and industry-specific resources to gen-
erate competitive advantage over time (e.g., Lippman & Rumelt, 1982).

Real Options and Managerial Discretion

The real options literature provides an alternative conceptualization of the role of manage-
ment in resource allocation decisions that contrasts with the passive nature of management
implied in the NPV approach. Brealey et al. assert real options addresses the critique that
NPV “does not reflect the value of management” (2010: 554). Building on the observation
that uncertainty about the value of a project may be resolved over time, real options draws an
analogy to financial options (Black & Scholes, 1973). Real options accounts for a very sim-
ple form of managerial discretion missing in traditional applications of the NPV model:
Managers can take action in response to new information.
In real options, the asset is not a financial stock but, rather, a real asset—for example, a
new production facility or a new technology. An option has three main elements: (1) a small
up-front investment by which the option is obtained, (2) the arrival of uncertainty-reducing
information, and (3) a preferential claim on some future action. The temporal structure of a
real option is as follows. At the time of option initiation, the firm knows the current value of
2592   Journal of Management / November 2017

the asset, the strike price at which the option can be exercised, and the time over which this
claim may be exercised. At the time of the exercise/terminate decision, new information is
received and then the decision maker observes the value of the asset and compares it to the
strike price on the option to determine whether the option is “in the money.” If so, the firm
exercises its preferential claim to acquire the asset.
The ramifications of this characterization of the investment decision are straightforward
yet profound. There is real value inherent in managerial flexibility (e.g., Amram & Kulatilaka,
1999; Copeland & Antikarov, 2001; Dixit, 1989) when there is prospective uncertainty and
investments are at least partially reversible. In such situations, a significant portion of the
value associated with a resource allocation decision resides in the option component of total
value.
Two streams of literature that leverage real options logic have been developed. The real
options “reasoning” approach provides managerial intuition regarding the value of flexibility
(e.g., Adner & Levinthal, 2004a, 2004b; Klingebiel & Adner, 2015; McGrath, 1997). The
reasoning approach highlights the merits of undertaking uncertain projects and staging
investments (Trigeorgis & Reuer, in press).
The real options “valuation” approach, largely developed in economics and finance, for-
mally assigns a value to the flexibility inherent in waiting for prospective uncertainty to be
resolved (e.g., Dixit & Pindyck, 1994; Trigeorgis, 1996). In the strong form of this approach,
firms are assumed to be rational and markets are assumed to function perfectly. This version
of the valuation literature, in employing the math of financial options, implicitly suggests the
assumptions associated with a theory of financial options also hold for options on real assets.
That said, this work is quite nuanced and often (verbally) recognizes these assumptions may
not hold (e.g., Dixit & Pindyck, 1994; McDonald & Siegel, 1986; Sakhartov & Folta, 2014,
2015; Trigeorgis & Ioulianou, 2013). In the semistrong form of the real options valuation
approach, it is assumed firms receive informative market signals via the use of proxy assets
and tracking portfolios that substitute for well-functioning spot markets (Amran & Kulatilaka,
1999; Lander & Pinches, 1998; Merton, 1998; Trigeorgis, 1996). Borison (2005) reviews the
main arguments in real options employed to circumvent this limitation in formal models of
real options.
In the strong form of the real options valuation approach, markets are assumed to provide
complete and accurate estimates of current asset prices. Even in the semistrong form, in
which markets are not assumed to function perfectly, the use of tracking portfolios and proxy
assets is viewed as sufficient to generate good estimates of current asset prices. The analogy
to a financial option is traders with Reuters terminals that provision perfectly accurate prices
from ever-present spot markets. Therefore, at the time of option exercise, the role of manage-
ment is to make a simple comparison between the current asset price and the strike price and
exercise if the option is in the money. Managerial decision making is trivial, and there is no
mechanism for heterogeneity to emerge. In sum, while there is a role for managerial discre-
tion in the real options valuation approach to resource allocation, this role is algorithmic.
Our interest is to develop a theory of resource allocation in strategic factor markets that
embraces the role of management and provides a basis for the emergence of competitive
heterogeneity and, possibly, competitive advantage. Neither the real options valuation
approach nor the real options reasoning approach currently is sufficient for this purpose. In
the real options valuation approach, stringent informational assumptions run counter to
prominent descriptions of the resource allocation process (Bower, 1970). If markets are
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2593

efficient, they provide accurate asset prices at all times, and, as such, the opportunity to
acquire an asset in factor markets at less than its value in use is ruled out by assumption.
While the real options reasoning approach relaxes these informational and behavioral
assumptions, it cannot articulate conditions when investments are likely to be more or less
valuable. It is not possible to generate a formal valuation of alternative investments or to rank
order the payoffs associated with a set of alternative projects. In the next section, we lay the
foundation for a real options theory of competitive advantage.

Real Options, Factor Markets, and Feedback Learning

In this section, we provide a summary of the factor market literature that highlights the
role of market imperfections in generating competitive advantage. We then take a grafting
approach wherein we assess how each of the constituent “theories has a limitation that can be
addressed by the other” (Harris, Johnson, & Souder, 2013: 448). In particular, we first graft
real options theory with strategic factor market theory and, second, with feedback learning
theory. In doing so, we recognize that firms face uncertainty regarding the current and future
value of an asset, contemporaneous and prospective uncertainty (Posen et al., 2016), and that
these types of uncertainty have implications for the emergence of competitive advantage.

Factor Markets and Competitive Advantage

The strategic factor market theory of competitive advantage explores mechanisms by
which competitive heterogeneity results from firm behavior and market conditions. Our con-
ception of competitive advantage is the relative difference between willingness to pay and
cost (e.g., Hoopes, Madsen, & Walker, 2003: 892). That is, the ability to create more eco-
nomic value than close competitors in a given transaction (Peteraf & Barney, 2003: 314). The
factor market literature acknowledges three approaches to generating heterogeneity in factor
markets compatible with a real options model.
First, firms may be differentially endowed with productive assets (e.g., Barney, 1991;
Peteraf, 1993). This idea has been extended into the real options literature by work that
assumes firms are differentially endowed with real options to acquire productive assets in
factor markets (Kogut & Kulatilaka, 2001; Maritan & Alessandri, 2007; Myers, 1977). Kogut
and Kulatilaka, for example, argue, “A core competence is a scarce factor as Barney (1986)
defines it, that embeds complex options on future opportunities” (2001: 747). Firms with
different competencies possess different sets of real options.
Second, firms may be differentially endowed with productive complementarities (e.g.,
Adegbesan, 2009; Lieberman et al., in press; Lippman & Rumelt, 2003). In the context of an
option, the presence of the complementary asset increases the value of the focal asset at the
time of option execution. Adegbesan argues, “Those with greater complementarity can outbid
firms with lesser complementarity, and at least some of the acquiring firms will retain part of
the surplus they help create” (2009: 463). For instance, it is possible the option to enter into
the smartphone industry during the late 2000s was more valuable to Samsung than rivals, such
as Nokia, as a result of Samsung’s complementary (and superior) LCD display technology.
Finally, firms may be differentially endowed with information about the value of assets
traded in strategic factor markets (Barney, 1986; Makadok & Barney, 2001). For example,
Cisco has superior information about the future value of new technologies as compared to
2594   Journal of Management / November 2017

Table 1
Existing Approaches to Generating Heterogeneity in Factor Markets
That Are Compatible With Real Options Theory

Differential Endowments in Real Options How Performance Heterogeneity Emerges

Endowments in options (Barney, 1991; Kogut &
Kulatilaka, 2001; Myers, 1977)
Productive complementarities (Adegbesan,
2009; Lieberman, Lee, & Folta, in press;
Lippman & Rumelt, 2003)
Information (Barney, 1986; Makadok & Barney,
2001; Maritan & Florence, 2008)
Differential access to options allows a focal firm to acquire
assets in factor markets that other firms cannot acquire.
Unique complementarities allow the firm to acquire assets
in factor markets because those assets are more valuable
to the focal firm than to other firms.
Superior information allows the firm to more accurately
price an option on an asset and to generate advantage
in an otherwise complete market through bidding or
exercise.

rivals, in part, because their status as an industry leader exposes them to new technology,
creating opportunities to interact and to share technological information with many start-up
firms. Armed with more information than its rivals, Cisco is able to bid more intelligently for
patents. When this sort of differential information endowment is extended to real options,
one may consider why, at the time an option is initiated, some firms have better insight into
the future value of the asset. In such situations, Maritan and Florence (2008) assert that an
auction process will enable firms to acquire assets at less than their value in use.
These three approaches, summarized in Table 1, highlight factor market theories of competi-
tive advantage compatible with real options theory. However, there is nothing inherent in the
option itself that generates competitive advantage. The arguments underlying these approaches
emphasize market failures that arise from factors external to resource allocation decisions: dif-
ferential access to options, differential complementary assets, or differential information. In
these existing approaches, firms are assumed to be equally effective at executing real options or
acquiring assets in factor markets (see Leiblein, 2011, for a discussion concerning the focus on
a priori resource endowments in resource-based views of competitive advantage).
In the discussion below, we begin to outline mechanisms by which firms may be differen-
tially effective at executing real options on productive assets in factor markets. An important
critique of strategic factor market theory is that it “reduces the role of managers in creating het-
erogeneous resource positions to gathering information . . . and downplays the complex relation-
ship between managers and resources” (Maritan & Peteraf, 2011: 1382). For real options to
address issues of competitive advantage, we must bring managers and organizational processes
underlying decision making back into the discussion of option execution decisions. The consid-
eration of organizational decision-making processes, moreover, implies an opportunity to
explore how nontradable resources (Dierickx & Cool, 1989), such as organizational processes
that are built rather than bought, foster the development of heterogeneity and advantage.

Grafting Strategic Factor Markets and Real Options

Grafting real options theory and strategic factor market theory suggests we must recog-
nize that firms face not one but two types of uncertainty. Prospective uncertainty, which
relates to the future value of an asset, is fundamental to a real option. Contemporaneous
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2595

Table 2
Extant Theories That Are Grafted Onto Our Behavioral Real Option Theory

Real Options

Valuation Reasoning Strategic Factor Markets Feedback Learning

Primary Quantifies the value Highlights the value Information imperfections A behaviorally realistic
Contribution of managerial of managerial can lead to competitive model of decision
flexibility. flexibility. heterogeneity. making.
Central Newly arrived Newly arrived Imperfect nature of The ability to learn
Mechanism information information information regarding (resolve uncertainty)
resolves prospective resolves prospective the current value of as information
uncertainty that uncertainty that assets. arrives that updates
existed in the past. existed in the past. asset value.
Existing Assumption of perfect Inability to compare Does not explicitly Does not (formally)
Limitation information on the or ordinally recognize the arrival of model changes in
contemporaneous rank the payoffs new information over asset value.
value of an asset. to alternative time, and learning is
projects. assumed to be trivial.

uncertainty, which relates to the current value of an asset, arises because most real assets are
not traded in complete markets, and, as such, there is no guaranteed ability to sell an asset at
a known market price (Posen, Leiblein, & Chen, 2016).
Recognizing these two forms of uncertainty requires confronting the tension between
strategic factor market theory and real options theory. Factor market theory claims that firms
“can only obtain greater than normal returns” when they “create or exploit competitive
imperfections in strategic factor markets” (Barney, 1986: 1232). An implication of market
incompleteness is that markets may poorly provision information on asset values (Denrell,
Fang, & Winter, 2003; Lippman & Rumelt, 2003). The real options valuation approach, how-
ever, is premised on the assumption that markets are complete: “There is a market for every
good” (Flood, 1991: 32). The real options literature recognizes that most real assets are not
traded in spot markets (Trigeorgis, 1996). While the literature points to the use of proxy
assets and tracking portfolios as a substitute for spot markets (Amram & Kulatilaka, 1999;
Lander & Pinches, 1998; Merton, 1998; Trigeorgis, 1996), even these alternatives assume the
firm perfectly knows the current value of the asset. The lack of complete information about
contemporaneous asset values and the existence of contemporaneous uncertainty are two
sides of the same coin—the existence of one implies the presence of the other.2
The primary contribution, central mechanisms, and existing limitations of the strategic fac-
tor market and real options theories are highlighted in Table 2. As noted in the table, real options
and strategic factor market theory have complementary contributions and limitations.

Grafting Feedback Learning and Real Options

Above, we argue that the incomplete markets assumption inherent in strategic factor mar-
ket theory can be incorporated into real options by assuming the existence of contemporane-
ous uncertainty. A key implication is that the exercise/termination decision in the context of
a real option is not as simple as comparing a known asset value to its exercise price. Instead,
undertaking a real option may require substantial learning—the ability to integrate new
2596   Journal of Management / November 2017

information to exercise a contingent claim on an asset in a factor market. In this section, we

graft feedback learning and real option theories. We begin by discussing the relationship
between contemporaneous uncertainty and information processing and then discuss belief
updating.

Contemporaneous uncertainty and information processing. Contemporaneous uncer-

tainty exists in a real option because the firm is provisioned with data rather than infor-
mation. When spot markets do not exist, or do not function effectively, firms must fill the
resulting information void (Posen et al., 2016). The term data reflects “things known or
assumed as facts” (Oxforddictionaries.com, s.v. “data”). Data are something given but raw.
“Information equals data plus meaning” (Checkland & Scholes, 1990: 303). That is, the data
have “been processed into a form that is meaningful” (G. B. Davis & Olson, 1985: 200).
Simon (1973) alludes to a similar distinction when differentiating between well-structured
and poorly structured problems. Likewise, Levinthal notes, “Any but the most trivial prob-
lems require a behavioral act of representation” (2011: 1517).
Consider the difference between a financial option and a real option in terms of the nature of
the execution/termination decision. In a financial option, data and information are equivalent;
available data provision unambiguous information about the value of the stock. When a finan-
cial option is purchased, there is prospective uncertainty about the future value of the stock, but
there is no uncertainty about current tradable price. Prospective uncertainty is resolved when
new information arrives at the time of the exercise decision. The spot market aggregates the
views of a large number of individuals and provides a guarantee that the stock can be sold at the
market price (this information is available to all on a Reuters terminal). The exercise price is
compared to the stock price, and the option is exercised if it is in the money. There are addi-
tional dilemmas when exercising options on knowledge, however (e.g., Coff & Laverty, 2001).
The firm faces an additional challenge when managing a real option as opposed to a finan-
cial one, that of transforming data into information with which it can make its option exer-
cise or terminate decision. In a real option, the existence of contemporaneous uncertainty
means the option provisions data rather than information. The firm does not know an objec-
tive asset value at the time of the exercise decision. For example, consider a real option to
experiment with new battery technology for hybrid cars. The battery research produces data
regarding parameters such as the rate of discharge and recharge time. The firm must then
transform these data into information in the form of a good estimate of the commercial value
of the technology. This implies making causal inferences about how these features of the
technology will influence human and firm behavior (e.g., market size, willingness to pay,
technological feasibility and cost, competitor responses) and distilling them into a number
representing future expected cash flows that can be compared to the cost of commercializa-
tion to make the exercise/terminate decision.

Real options and belief updating. In a real option, exercise decisions are premised on
subjective beliefs about the value of the asset rather than its true latent value. A firm must
engage in learning in order to produce an informative estimate of asset values based on data
obtained from experiments. The effectiveness of this learning process faces multiple chal-
lenges: The initial belief about the value of an asset is noisy, the data collection and aggre-
gation process is noisy, and the process of transforming data into information is noisy. As
a result, a firm’s subjective belief about the value of the asset may differ from the true but
latent value of the asset at any point in time—that is, there is contemporaneous uncertainty.
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2597

A model of feedback learning under uncertainty describes a process through which firms
form subjective beliefs about the value of an asset and update those beliefs when there is new
feedback (in the management literature, see, e.g., Denrell & March, 2001; Posen & Levinthal,
2012). A firm has a prior belief about the value of the asset, receives noisy feedback (noisy
new information) about the true latent value of the asset, and then updates its belief on the
basis of that noisy feedback. The resulting posterior belief is then the estimate of the asset
value. Models of feedback learning can account for a wide range of adaptive rationality,
including fully Bayesian rational learning.
A key idea underlying the notion of Bayesian learning is that the extent to which new
information updates the prior belief is a function of the extent of uncertainty; the noisier the
information, the less one updates beliefs. In the extreme, when the information is mostly
noise, it should be ignored and beliefs should not be updated (so that posterior and prior
beliefs remain the same).
When grafting feedback learning and real options theory, we recognize an important sym-
metry between the two. An option provisions new information about the value of the asset
that may be used in deciding to exercise or terminate. This information is analogous to the
noisy new information (i.e., feedback) in a feedback learning model. Consider a real option
from a learning perspective: The prior is the value of the asset at the time the option is initi-
ated. Feedback is provided by the (potentially noisy) new information on the asset value that
arrives at the time of the option execution/termination decision. If new information is noise
free, as is assumed in the real option valuation approach, there is no contemporaneous uncer-
tainty, and effective learning (being Bayesian rational) is easy. At the time of exercise, the
firm observes the (true) asset value, updates beliefs fully to that (true) value, and makes the
appropriate option exercise or terminate decision. If, however, the information at the time of
exercise is noisy (i.e., there is contemporaneous uncertainty), then the notion of Bayesian
learning implies partial updating of beliefs. The posterior is intermediate between prior
beliefs and the new feedback.
Learning under contemporaneous uncertainty is not easy. Effective learning implies
understanding how much of the new information is subject to contemporaneous uncertainty
and updating beliefs at the appropriate partial updating rate. In what has become known as
“Simon’s Scissors,” Simon (1990) draws an analogy in which one blade of the scissor reflects
the decision-making challenges of the environment and the other blade reflects the cognitive
abilities of firms and managers. If the informational environment is sufficiently simple, then
so too is learning and decision making. In the context of a real option, however, the existence
of contemporaneous uncertainty leads to a much more demanding informational environ-
ment that potentially makes information processing and belief updating challenging.
Referring to Table 2, we have now highlighted the primary contribution, central mecha-
nisms, and existing limitations of feedback learning and real options theories. As noted in the
table, feedback learning and real options theories have complementary contributions and
limitations.

A Realistic Real Options Theory of Competitive Advantage

In this section, we argue that firms may be differentially effective at executing real options
in factor markets. In the earliest reference to real options in the finance literature, Myers
recognizes that part of the “value of a firm is accounted for by the present value of options to
2598   Journal of Management / November 2017

make further investments on possibly favorable terms” (1977: 148). While Myers does not
identify the mechanism by which “favorable terms” accrue, prior research argues that firms
may be differentially endowed with a bundle of proprietary real options on productive assets
that can be acquired in factor markets (e.g., Kogut & Kulatilaka, 2001; Maritan & Alessandri,
2007). For instance, Reuer and Leiblein (2000) explore whether and how differences in inter-
national joint ventures affect downside risk. In this and related work, options may arise from
previous investments and capabilities that have uncertain future uses.
Whereas prior work assumes that firm heterogeneity may arise from proprietary options
(e.g., Kogut & Kulatilaka, 2001), the theory we develop is amenable to a situation where
multiple firms are equally endowed with shared options—that is, “jointly held opportunities
of a number of competing firms” that “can be exercised by any one of their collective own-
ers” (Trigeorgis, 1996: 143).3 A real option provides access to feedback in the form of new
data about the value of the asset (as well as the ability to act in a contingent fashion). This
new data affords the firm the opportunity to perceive and enact new uses and functions for an
asset (Felin et al., 2016).
Our claim is that firms differ in a specific type of learning ability—the ability to integrate
new data (i.e., feedback) to exercise a contingent claim on an asset in a factor market. We
dimensionalize this learning ability as information processing and belief updating. The con-
cept of information processing reflects a core task in undertaking a real option. Once endowed
with a real option, the firm receives feedback in the form of raw data that must be trans-
formed into usable information. The concept of belief updating is consistent with extant work
in feedback learning (e.g., Posen & Levinthal, 2012). Belief updating reflects the task of
integrating new (noisy) information at the time of the option execution decision with the
firm’s prior beliefs about the value of the asset. The existence of noisy feedback and differ-
ential learning concerning these data suggests competitive heterogeneity may emerge through
another mechanism.

Realistic Real Options—A Link to Competitive Advantage

Our argument begins by defining a realistic real option as the right but not the obligation
to acquire an asset when there is both prospective and contemporaneous uncertainty. Thus,
realistic real options may differ in the magnitude of total uncertainty as well as the ratio of
contemporaneous to prospective uncertainty. As with traditional options logic, the existence
of prospective uncertainty implies that managerial flexibility is valuable. Our addition of
contemporaneous uncertainty implies managerial decision making within a realistic option is
nontrivial. Firms may be differentially effective in executing realistic real options in factor
markets—they may differ in the number and magnitude of the errors they experience, execut-
ing options that should have been terminated or terminating options that should have been
executed. Our argument proceeds in three steps.
One, firms differ in the accuracy of their subjective beliefs about the value of the asset at
the time of the option exercise decision. As noted in our discussion grafting feedback learn-
ing to real options, at least two classes of mechanisms exist by which firms endowed with
identical options and receiving the same data may differ in their subjective beliefs. First, they
may differ in their ability to transform data into information—to manage the information
processing activity demanded by realistic real options. Second, given contemporaneous
uncertainty, firms may differ in their ability to manage the belief updating process on the
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2599

basis of noisy new information. Taken together, these mechanisms underlie a learning ability
in the context of a realistic real option—the ability to integrate new information to exercise a
contingent claim on an asset.
Two, differences in the accuracy of subjective beliefs lead to differences in option execu-
tion decisions and, therefore, option execution errors. Heterogeneity in option exercise deci-
sions emerge when subjective beliefs deviate (1) across firms and (2) from the (true) latent
value of an asset. For instance, consider a firm that exercises a realistic real option to acquire
an asset in a factor market when, in fact, it should have terminated the option. This occurs
when a firm’s subjective belief exceeds the exercise price while the true value of the asset
does not. Alternatively, the firm might terminate the option and forego asset acquisition in the
factor market when it should have exercised the option.4
Three, in the resource allocation process, option execution errors lead to the emergence of
competitive heterogeneity and, possibly, competitive advantage. The logic is as follows.
Consider two firms, Alpha and Beta, that are equally endowed with shared realistic real
options to acquire productive assets in factor markets. In each period, managers make deci-
sions on exercising some of these options. The assets reduce a firm’s cost by a fixed amount.
A firm should exercise its option only if the exercise price is less than the cost reduction from
owning a particular asset. Exercise errors in realistic options can thus give rise to competitive
advantage. For example, because they hold different beliefs on asset value, Alpha might exer-
cise its realistic option to acquire the asset in the factor market when it should have terminated,
while Beta terminates. In this case, Beta would have a competitive advantage over Alpha.

Propositions Derived From Realistic Real Options

These differences in information processing and belief updating give rise to differences in
option execution decisions in strategic factor markets. These differences in option execution
in turn may lead to competitive advantage. We state this basic logic as a series of general
propositions that result from our realistic real options theory.
First, realistic real options are subject to not only prospective but also contemporaneous
uncertainty. The latter arises because a realistic real option provisions data about the value of
the asset rather than unambiguous information. A firm must engage in an information process-
ing task to transform the data provisioned by the option into actionable information. For a given
body of data, more effective information processing leads to lower contemporaneous uncer-
tainty. That is, the information about the value of the asset at the time of the option execution
decision is less noisy. It is likely that firms vary in their information processing capacity in the
context of a realistic real option as a result of differences in top management team (TMT) char-
acteristics, organizational structure, problem formulation routines, or problem solving routines,
for example. Thus, a firm with superior information processing capacity will realize compara-
tively low contemporaneous uncertainty, which suggests the following proposition.

Proposition 1: Superior information processing reduces contemporaneous uncertainty, increasing a

firm’s ability to generate competitive advantage by more effectively executing real options in
factor markets.

Second, firms are intendedly rational (in an adaptive sense). They transform their new
data into information and seek to effectively employ the new information to make their exer-
cise/terminate decision. A key idea underlying the notion of Bayesian learning, as we noted
2600   Journal of Management / November 2017

earlier, is that the firm updates its beliefs about the value of the asset in a proportional man-
ner. Its posterior belief about the value of the asset is intermediate to its prior belief and the
noisy new information. The optimal rate (i.e., extent) of belief updating is a function of the
noisiness of the new information (i.e., level of contemporaneous uncertainty).
The organizational challenge is three-fold. First, the organization must assess the level of
contemporaneous uncertainty. Second, the organization must align its belief updating rate to
match the level of contemporaneous uncertainty. Third, the organization must form an
updated belief that appropriately accounts for the extent of contemporaneous uncertainty.
These challenges are likely to be a function of factors including managerial confidence, over-
optimism, self-efficacy, and locus of control. Consequently, firms are likely to differ in the
rate at which they update their current beliefs to the new information in a real option.
Deviations from the Bayesian rate of updating will lead to greater errors in the execution of
real options in factor markets, which suggests the following proposition.

Proposition 2: Superior ability to implement a belief updating rate matching that required by the
level of contemporaneous uncertainty increases a firm’s ability to generate competitive advan-
tage by more effectively executing real options in factor markets.

Finally, we suggest an interaction between the challenges of information processing and

belief updating. When contemporaneous uncertainty is at either extreme, low or high, the
decision as to the appropriate rate of belief updating is trivial. With no contemporaneous
uncertainty (e.g., as in a financial option), decision makers have a noise-free metric of the
asset value (e.g., a Reuters terminal that lists the current market price). Therefore, the optimal
rate of belief updating is full updating, and regardless of one’s prior belief, the posterior
belief should be the observed asset value at the time of option exercise. At the other extreme,
with very high contemporaneous uncertainty, the signal at the time of the exercise decision is
pure noise; there is no information in the signal, and the optimal rate of belief updating is no
updating. New information should be ignored, and the posterior belief about asset value,
which is used to make the option execution/termination decision, should be unchanged from
the prior belief. At an intermediate level of contemporaneous uncertainty, which results when
firms are moderately effective at information processing, belief updating will be most chal-
lenging, which suggests the following proposition.

Proposition 3: The extent of contemporaneous uncertainty will moderate the relationship between
the ability to implement a belief updating rate matching that required by the extent of contempo-
raneous uncertainty and a firm’s ability to generate competitive advantage by more effectively
executing real options in factor markets.

Broader Implications of Realistic Real Options

Recognition of the role that contemporaneous uncertainty, information processing, and
belief updating play in exercise decisions in realistic real options suggests opportunities to
strengthen linkages between behavioral approaches to understanding the resource allocation
process and economic approaches to understanding the factors that lead to competitive
advantage. In this section, we suggest promising linkages between our theory and extant
research on cognition, organization structure, problem formulation, and problem solving.
Consistent with the core premise underlying Bower (1970) and Burgelman (1983), our
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2601

approach highlights how competitive advantage arises out of managerial and organizational
processes.
The opportunity to link our propositions to extant behavioral work is evident in literature
emphasizing the role of TMTs in organizational decision making. This literature discusses
how TMT cognition and values affect attention to, perception of, and processing of data
(Hambrick & Mason, 1984: 195). Early work argues that TMT demographics proxy for
underlying cognitive processes and documented associations between TMT characteristics,
such as age, education, and organizational tenure, and the propensity to enact discrete strate-
gic changes (e.g., Bantel & Jackson, 1989; Tihanyi, Ellstrand, Daily, & Dalton, 2000;
Wiersema & Bantel, 1992, 1993). Related work identified associations between measures of
variance in these TMT characteristics and decision making (e.g., Lant, Milliken, & Batra,
1992; Wiersema & Bantel, 1992).
Our realistic real options theory suggests an opportunity to leverage this early work on
cognition by exploring whether TMT demographics affect a firm’s ability to convert data into
information, manage the belief updating process, and generate competitive advantage
through option execution in strategic factor markets. For instance, future fieldwork may
explore whether and how educational differences, such as whether one is educated in the
fields of business, design, or engineering, affect the breadth and depth of information consid-
ered when determining to exercise or terminate an option. If educational fields that engender
broader thinking are better suited to processing information in noisy environments, our work
suggests that individuals educated in those fields will make fewer option execution errors as
contemporaneous uncertainty increases. Similarly, if demographic factors such as age or
organizational tenure are associated with inertial tendencies, older and longer tenured TMTs
will be slower to update their beliefs and will make fewer option execution errors in noisy
environments (where a slower updating rate is predicted to be preferred). In a laboratory set-
ting, similar propositions may be tested more directly, for instance, by associating individual
or group demographic characteristics with the outcomes of experiments aimed to evaluate
information processing or belief updating.
While the use of TMT characteristics as proxies for cognitive processes is prevalent in
early work, more recent studies recognize the benefit of more direct approaches to examining
cognition within TMTs. Consider, for example, differences in the cognitive ability (e.g., J. P.
Davis, Eisenhardt, & Bingham, 2009; Felin & Foss, 2005; Foss, 2011; Gavetti & Levinthal,
2000) of the decision-making team and whether these differences affect a firm’s ability to
enact better decisions or lead to “behavioral failures.” Gavetti (2012: 270-271) defines
“behavioral failures” as factors affecting firms’ ability to compete for opportunities and
argues that these failures are driven by TMT members’ rationality, mental plasticity, and
shaping ability.
When the insights from these behavioral and cognitive approaches are linked to our prop-
ositions, it is possible to derive associations between scores on various mental tests, option
execution errors, and the emergence of advantage. For instance, work in behavioral econom-
ics links calculative skills to the cognitive reflection test (Frederick, 2005). If TMT members
who score higher on the cognitive reflection test (Frederick, 2005) are better able to “see
through the mist” surrounding ambiguous and uncertain decisions, they may make more
informed decisions, experience fewer option execution errors, and generate advantage. More
generally, our work provides a circumstance-contingent explanation for observed differences
between individual TMT members and firm value (e.g., Mackey, 2008).
2602   Journal of Management / November 2017

Also consider how cognitive biases affect decisions regarding option execution in strate-
gic factor markets. One research stream where these biases are particularly salient is the
entrepreneurial confidence literature (Astebro, Herz, Nanda, & Weber, 2014; Busenitz &
Barney, 1997; Camerer & Lovallo, 1999; Lowe & Ziedonis, 2006). A key finding in this lit-
erature is that confidence is positively associated with decisions such as investment, entry,
and delayed exit after controlling for ability and context. This research suggests that cogni-
tive biases, such as overconfidence, and the extent to which managers learn to overcome
these biases, may have important effects on resource allocation and competitive advantage.
If personality characteristics, such as one’s degree of confidence, affect belief updating, then
our propositions imply that over- and underconfident managers should generate different
types of option execution errors. This suggests an opportunity for experimental work to link
responses to various surveys regarding individual bias (e.g., Cooper, Woo, & Dunkelberg,
1988) and to examine whether individuals prone to particular biases are more or less likely
to make errors when deciding to exercise options in factor markets.
It has long been recognized that organizational structures vary in their ability to focus
effort and process information. This work emphasizes how tasks and decision rights are allo-
cated, incentives are aligned, and communications are structured jointly and interactively
affect information processing (Daft & Lengel, 1986; Galbraith, 1974; Siggelkow & Rivkin,
2005; Tushman & Nadler, 1978). The effectiveness of a given organizational configuration is
contingent on the task environment (Galbraith, 1974; Tushman & Nadler, 1978). Research
suggests that the size, breadth, and depth of a hierarchical organization affect the nature and
effectiveness of decisions (e.g., Christensen & Knudsen, 2010; Sah & Stiglitz, 1986).
Likewise, structured processes that reduce biases may affect belief updating. For instance,
Milkman, Chugh, and Bazerman discuss how a “System 2” strategy “involves taking an
outsider’s perspective: trying to remove oneself mentally from a specific situation or to con-
sider the class of decisions to which the current problem belongs (Kahneman & Lovallo,
1993)” (2009: 381).
Applying insights from work on organization structure to our theory suggests a number of
promising avenues for future research. For instance, if delegation of decision making and
splits in authority adversely affect information processing, then organizations exhibiting
these characteristics should be more prone to make errors when deciding to exercise or ter-
minate options in factor markets and, therefore, be less likely to generate competitive advan-
tage through the exercise of real options. The efficacy of information processing may also be
related to the number of levels or the number of distinct actors that data must traverse before
a decision is made. Alternatively, if factors such as an organization’s vertical span of control
reduce the rate of belief updating (so that it is less than optimal), our propositions suggest an
interaction between the number of vertical levels in a hierarchy and the level of contempora-
neous uncertainty would be positively related to the propensity to make errors in the execu-
tion of options in factor markets.
Finally, our work also has implications for the burgeoning problem formulation and prob-
lem solving literature. As noted by Nickerson and colleagues, problem framing skills have
implications for how firms formulate (e.g., Baer, Dirks, & Nickerson, 2013; Nickerson, Yen,
& Mahoney, 2012) and attempt to solve (e.g., Nickerson & Zenger, 2004) problems. The
problem solving perspective emphasizes that organizations differ in their incentive intensity,
communication codes, and dispute resolution regimes. These organizational dimensions
affect the hazards of knowledge appropriation and strategic knowledge accumulation, with
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2603

implications for the optimal form of search (Nickerson & Zenger, 2004). Our theory provides
a means to leverage these concepts by testing associations between the use of different prob-
lem formulating processes, elements of organization structure, and execution errors in real
options. For instance, the use of open, consensus-based problem frames may affect hazards
of knowledge appropriation and accumulation and, thus, errors in option execution. Similarly,
the nature of communication within a team may affect the transformation of data into infor-
mation and, thus, decisions to execute or terminate real options.

Conclusions
This paper develops a theory of realistic real options and competitive advantage. We apply
the theory to resource allocation decisions in strategic factor markets. We recognize that real
options embody uncertainty not only about the future value of an asset (prospective uncer-
tainty) but also about its current value (contemporaneous uncertainty). By stressing the role
of contemporaneous uncertainty, we can examine how firms, and the managers within them,
may generate competitive heterogeneity and advantage through resource allocation decisions
associated with the exercise or termination of options in factor markets.
Our theory is premised on the assertion that competitive heterogeneity results from behav-
ioral, organizational, and structural differences in the resource allocation process (Bower,
1970; Bromiley, 1986; Burgelman, 1983; Maritan, 2001). In particular, we argue that firms
differ in a specific type of learning ability—the ability to integrate new information to exer-
cise a contingent claim on an asset in a factor market. This differential learning ability leads
to competitive heterogeneity in the exercise of real options in factor markets. In the spirit of
Bower, Burgelman, and other management scholars, we argue firms differ in their ability to
manage the uncertainty that surrounds investments in real options as a result of differences in
knowledge, power, and the allocation of decision rights.
In addition, we contribute by suggesting a means to extend real options valuation and real
options reasoning approaches to the study of competitive advantage. Grafting the strategic
factor market and feedback learning theories to real options provides a new way to consider
the emergence of heterogeneity, the evolution of heterogeneity, and the changes in asset val-
ues over time. We emphasize the importance of internal organizational differences in infor-
mation processing and belief updating, which may be contrasted with prior research
emphasizing differences in external endowments, including options, productive complemen-
tarities, or information.
This paper provides a starting point for discussion and is not without limitations. First, we
recognize the real options lens is not always the most fruitful perspective to view resource
allocation decisions. In settings where there is limited prospective uncertainty or it is difficult
to sequence a series of investments, real options may not be appropriate. Moreover, in set-
tings where the firm is managing a portfolio of projects, it may be more suitable to use other
valuation approaches, including portfolio theory. Second, we assume away many of the
resource constraints facing real-world firms. For example, Bromiley’s behavioral approach
to capital investment highlights constraints including the “level of internal cash generation
and liquidity, planned acquisitions, the desire for investment, and willingness to change debt
levels” (1986: 167). As these constraints restrict firms from exploring all potentially lucrative
investment opportunities, they force firms to choose between alternative potentially promis-
ing projects of uncertain value. While our theory imparts realism by recognizing the role of
2604   Journal of Management / November 2017

informational imperfections and its implications for cognition and learning in the resource
allocation process, the limitations in our approach point to potentially productive opportuni-
ties for future research.
We also suggest an important caveat to standard applications of real options logic. Even
when there is prospective uncertainty, a resource allocation decision may not embody substan-
tial option value if contemporaneous uncertainty is high (option execution errors are likely to
erode such value). At very high levels of contemporaneous uncertainty, prospective uncer-
tainty is, practically speaking, irrelevant. This offers a plausible explanation for the limited
adoption of real options in practice (Teach, 2003). Managers’ unwillingness to adopt the real
options toolkit may be due to a rational avoidance of a tool that is functional in the world of
financial options, where there is no contemporaneous uncertainty, but is significantly less
functional in the real world. Indeed, proponents of real options advise managers of the need to
flee from projects where there are very high levels of uncertainty (van Putten & MacMillan,
2004). We expect that it is not necessarily the high level of prospective uncertainty per se that
leads to the recommendation to “flee” but the high level of contemporaneous uncertainty that
leads to this conclusion. A deeper understanding of the sources of uncertainty, and their impli-
cations for the value of flexibility, may affect the use of real options as a managerial tool.
This paper develops a realistic theory of real options in a manner that sheds light on how the
resource allocation process leads to competitive heterogeneity and advantage. The paper pro-
poses plausible behavioral and organizational factors that may affect information processing,
belief updating, and, ultimately, resource allocation decisions. We believe that this approach
represents a fruitful avenue for future research by strategy and organization scholars.

Notes
1. Learning and judgment are related. Firms may learn in a manner that enhances their judgment (e.g., Schmidt,
2014), but better judgment may not necessarily lead to learning.
2. It may be helpful to articulate the distinction between prospective and contemporaneous uncertainty with an
example of an option on a financial asset, a stock. At option initiation, there is uncertainty about the future value of
the stock (prospective uncertainty). At the time of the option execution/termination decision, uncertainty remains
about the future value of the stock. However, this uncertainty about the future is not relevant for the exercise/ter-
minate decision because we know the current price at which the stock can be bought and sold—this information is
available in the spot market. We can make an execution/termination decision on the current market price and, if the
option is in the money, lock in the gain (by selling the stock). By invoking the idea of contemporaneous uncertainty,
we relax the assumption about the certainty of the current market price at the time of the option exercise/terminate
decision. What if, at the time of the option exercise decision, the ability to sell the stock at the market price could
not be guaranteed and, thus, gains from exercising the option could not, with certainty, be locked in? The firm then
faces contemporaneous uncertainty about the value of the asset at exercise time. For instance, the firm might have
knowledge regarding the range of tradeable values of the stock rather than a precise and current point estimate of
the market price.
3. This quotation suggests interesting extensions. One might consider the degree to which an option is shared, ex
ante. An option may be shared broadly, in that it is shared by all close competitors, or narrowly, in that it is shared
with only one (or a few) close competitors. One may also consider the degree to which the shared option is nonrival.
That is, if two parties have a shared option, and one party exercises, is the second party also able to exercise its
option?
4. More formally, consider a firm holding an initial prior on the value of an asset available in the factor market,
Bt = 0 = St = 0, where Bt = 0 is the posterior belief and St = 0 is the value of the asset at the time the option is initiated.
Following the standard real options structure, the firm pays C at t = 0 for the option with an exercise price K exer-
cisable after the new data arrive, at t = 1, that resolves prospective uncertainty. Contemporaneous uncertainty is
embodied in the precision of the asset value the firm recognizes at t = 1. The firm does not observe the true latent
 Leiblein et al. / Resource Allocation in Strategic Factor Markets   2605

asset value at the time of the exercise decision St = 1 but, rather, observes noisy information I = St = 1 + vc, where vc is
the realization of a noise parameter. The information is noisy because the firm must transform the data into informa-
tion about the future value of the asset. The firm then uses this noisy information to update its prior, Bt = 0, to form
its posterior, Bt = 1. In turn, Bt = 1 is the basis of its exercise or terminate decision, as the firm exercises if Bt = 1 > K.

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