Volume flexibility and capacity investment: a real options approach

Abstract

This paper considers the investment decision of a firm where it has to decide about the timing and capacity. We obtain that in a fast-growing market, right after investment the firm produces below capacity, where the utilization rate (the proportion of capacity that is used for production right after the investment) increases with market uncertainty for a very big market trend, and shows no monotonicity for a moderately large market trend. On the other hand, we get that, for a slowly growing or shrinking market, the firm produces up to capacity right after investment. In the intermediate case, the firm produces up to capacity right after investment when uncertainty is low and below capacity when uncertainty is high, whereas the utilization rate decreases with the market uncertainty.

Keywords:

• investment under uncertainty
• monopoly
• capacity choice
• volume flexibility

Acknowledgements

The authors would like to thank the anonymous referee and Verena Hagspiel for their valuable comments.

Notes

1 The definitions of small, intermediate and large market trend, and examples of very large and moderately large market trends can be found in Section 4.2.

2 Note that we allow for .

3 Note that with this demand function, the optimal capacity size is always below .

4 From “Proof of ” section, , , and .