Capacity investment under uncertainty: The effect of volume flexibility
Domenico De Giovanni and
International Journal of Production Economics, 2018, vol. 198, issue C, 165-176
Real option theory is a central tool in today's investment theory as it integrates uncertainty and managerial flexibility in the analysis and valuation of investment projects. This paper studies the optimal time and size of investment for a monopolistic firm under demand uncertainty and volume flexibility. In our modeling framework, demand is random and the firm first decides the optimal time and size of the production process. After entry, the firm adjusts continuously production volume to match the observed demand. Volume flexibility comes at a cost which depends on both the current output and the established capacity. We study two different models of volume flexibility: Downside volume flexibility allows the firms to produce any quantity below the installed capacity; Upside volume flexibility allows to expand production above the firm's capacity size. In both cases, the option to temporary suspend production is not given a priori, but it is part of the firm's optimal choice. With this feature, the model provides conclusions that contrast some of the most recent theoretical findings on the same subject. We find that an increase of the degree of downside volume flexibility makes the firm willing to invest earlier in a larger plant. We also show that downside volume flexibility reduces the utilization rates, especially in highly uncertain markets. Upside volume flexibility has the joint effect of reducing the size of the investment and the investment threshold at which the firm installs capacity. The utilization rates are significantly higher compared to the case of downside volume flexibility only, and there is an increasing relationship between increased upside flexibility and utilization rates.
Keywords: Real options; Capacity investments; Volume flexibility (search for similar items in EconPapers)
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1) Track citations by RSS feed
Downloads: (external link)
Full text for ScienceDirect subscribers only
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:eee:proeco:v:198:y:2018:i:c:p:165-176
Access Statistics for this article
International Journal of Production Economics is currently edited by R. W. GrubbstrÃ¶m
More articles in International Journal of Production Economics from Elsevier
Bibliographic data for series maintained by Dana Niculescu ().