Capacity Investment under Demand Uncertainty: Price vs. Quantity Competition

Jan A. Miegham and Maqbool Dada

No 1204, Discussion Papers from Northwestern University, Center for Mathematical Studies in Economics and Management Science

Abstract: This article shows that under uncertainty, a firm's capacity investment decision crucially depends on the mode of market approach (price-setting vs. quantity-setting) and competition that follows investment. We model an industry in which firms have to make capacity investment decisions when demand is uncertain. First each firm must decide on its capacity investment level. Then, industry capacity levels are observed and firms engage in quantity or price competition. Finally, demand and revenues are realized. We begin by considering a monopoly and show that the monopoly price given an uncertain demand curve can be higher or lower than the reference price when the demand curve is known at the start. Moreover price and firm value may fall or rise with increasing uncertainty. We compare thses results with a setting where a monopolist sets quantity instead of price. The resulting investment fundamentally differs from the price-setting investment. Moreover, the investment strategy under quantity-setting is significantly less sensitive to variability and more profitable than under price-setting. Under quantity competition, these results extend to a duopoly, oligopoly and perfect competition. In addition, entry dettering investments are possible yet more difficult as variability increases and credible only at low investment costs. Under price competition, no pure equilibria exist if there is demand uncertainty. Key Words: pricing, quantity, capacity, competition, strategy, game theory, demand uncertainty.

Date: 1997-11
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