IDEAS home Printed from https://ideas.repec.org/a/wly/mgtdec/v30y2009i2p119-133.html
   My bibliography  Save this article

A real-option rationale for investing in excess capacity

Author

Listed:
  • Sudipto Sarkar

    (McMaster University, Hamilton, Ont., Canada)

Abstract

Excess capacity is expensive, yet persistent excess capacity is widely observed in the corporate sector. Using a real-option approach to capacity planning, this paper shows that under certain conditions it is optimal to invest in long-term (even permanent) excess capacity. This results from the asymmetric nature of operating flexibility resulting from excess capacity-the ability to increase output under favorable demand shocks. The model is used to identify conditions under which excess capacity is more likely to be optimal. The implications are generally consistent with existing empirical evidence from studies on excess capacity and capacity utilization. Copyright © 2008 John Wiley & Sons, Ltd.

Suggested Citation

  • Sudipto Sarkar, 2009. "A real-option rationale for investing in excess capacity," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 30(2), pages 119-133.
    • Handle: RePEc:wly:mgtdec:v:30:y:2009:i:2:p:119-133
    DOI: 10.1002/mde.1446
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1002/mde.1446
    File Function: Link to full text; subscription required
    Download Restriction: no
    File URL: https://libkey.io/10.1002/mde.1446?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Coelli, Tim & Grifell-Tatje, Emili & Perelman, Sergio, 2002. "Capacity utilisation and profitability: A decomposition of short-run profit efficiency," International Journal of Production Economics, Elsevier, vol. 79(3), pages 261-278, October.
    2. Bar-Ilan, Avner & Strange, William C., 1999. "The Timing and Intensity of Investment," Journal of Macroeconomics, Elsevier, vol. 21(1), pages 57-77, January.
    3. Lieberman, Marvin B, 1987. "Excess Capacity as a Barrier to Entry: An Empirical Appraisal," Journal of Industrial Economics, Wiley Blackwell, vol. 35(4), pages 607-627, June.
    4. Dixit, Avinash, 1980. "The Role of Investment in Entry-Deterrence," Economic Journal, Royal Economic Society, vol. 90(357), pages 95-106, March.
    5. Winston, Gordon C, 1974. "The Theory of Capital Utilization and Idleness," Journal of Economic Literature, American Economic Association, vol. 12(4), pages 1301-1320, December.
    6. SMITH, Kenneth R., 1969. "The effect of uncertainty on monopoly price, capital stock and utilization of capital," LIDAM Reprints CORE 32, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    7. Fagnart, Jean-Francois & Licandro, Omar & Sneessens, Henri R., 1997. "Capacity utilization and market power," Journal of Economic Dynamics and Control, Elsevier, vol. 22(1), pages 123-140, November.
    8. Guiseppe Bertola & Ricardo J. Caballero, 1994. "Irreversibility and Aggregate Investment," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 61(2), pages 223-246.
    9. Felipe L. Aguerrevere, 2003. "Equilibrium Investment Strategies and Output Price Behavior: A Real-Options Approach," The Review of Financial Studies, Society for Financial Studies, vol. 16(4), pages 1239-1272.
    10. He, Hua & Pindyck, Robert S., 1992. "Investments in flexible production capacity," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 575-599.
    11. Smith, Kenneth R., 1969. "The effect of uncertainty on monopoly price, capital stock and utilization of capital," Journal of Economic Theory, Elsevier, vol. 1(1), pages 48-59, June.
    12. Smiley, Robert, 1988. "Empirical evidence on strategic entry deterrence," International Journal of Industrial Organization, Elsevier, vol. 6(2), pages 167-180.
    13. E. Abdul Azeez, 2002. "Economic reforms and industrial performance: An analysis of capacity utilisation in Indian manufacturing," Centre for Development Studies, Trivendrum Working Papers 334, Centre for Development Studies, Trivendrum, India.
    14. Lieberman, Marvin B., 1989. "Capacity utilization: Theoretical models and empirical tests," European Journal of Operational Research, Elsevier, vol. 40(2), pages 155-168, May.
    15. Carol Corrado & Joe Mattey, 1997. "Capacity Utilization," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 151-167, Winter.
    16. Subhash C. Ray & Kankana Mukherjee & Yanna Wu, 2006. "Direct And Indirect Measures Of Capacity Utilization: A Non‐Parametric Analysis Of Us Manufacturing," Manchester School, University of Manchester, vol. 74(4), pages 526-548, July.
    17. Esposito, Frances Ferguson & Esposito, Louis, 1974. "Excess Capacity and Market Structure," The Review of Economics and Statistics, MIT Press, vol. 56(2), pages 188-194, May.
    18. H. Kim, 1999. "Economic Capacity Utilization and its Determinants: Theory and Evidence," Review of Industrial Organization, Springer;The Industrial Organization Society, vol. 15(4), pages 321-339, December.
    19. Ciaran Driver, 2000. "Capacity Utilisation and Excess Capacity: Theory, Evidence, and Policy," Review of Industrial Organization, Springer;The Industrial Organization Society, vol. 16(1), pages 69-87, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Di Corato, Luca & Moretto, Michele & Vergalli, Sergio, 2014. "Long-run investment under uncertain demand," Economic Modelling, Elsevier, vol. 41(C), pages 80-89.
    2. G. Guthrie, 2021. "Adapting to Rising Sea Levels: How Short-Term Responses Complement Long-Term Investment," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 78(4), pages 635-668, April.
    3. Liu, Zugang & Wang, Jia, 2019. "Supply chain network equilibrium with strategic supplier investment: A real options perspective," International Journal of Production Economics, Elsevier, vol. 208(C), pages 184-198.
    4. Li, Xishu & Zuidwijk, Rob & de Koster, M.B.M, 2023. "Optimal competitive capacity strategies: Evidence from the container shipping market," Omega, Elsevier, vol. 115(C).
    5. Dale Squires & Kathleen Segerson, 2022. "Capacity and Capacity Utilization in Production Economics," Springer Books, in: Subhash C. Ray & Robert G. Chambers & Subal C. Kumbhakar (ed.), Handbook of Production Economics, chapter 24, pages 1001-1037, Springer.
    6. Kamoto, Shinsuke, 2015. "Strategic capacity expansion under a potential entry threat," International Review of Economics & Finance, Elsevier, vol. 38(C), pages 157-177.
    7. Koussis, Nicos & Silaghi, Florina, 2023. "Revenue-sharing and volume flexibility in the supply chain," International Journal of Production Economics, Elsevier, vol. 261(C).
    8. Sarkar, Sudipto, 2021. "The uncertainty-investment relationship with endogenous capacity," Omega, Elsevier, vol. 98(C).
    9. Sarkar, Sudipto, 2014. "Product–market flexibility and capital structure," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(1), pages 111-122.
    10. Sarkar, Sudipto, 2018. "Optimal DOL (degree of operating leverage) with investment and production flexibility," International Journal of Production Economics, Elsevier, vol. 202(C), pages 172-181.
    11. Shaton, Katerina, 2015. "Value of Flexibility in Gas Pipeline Investments," Chapters from the Proceedings of the Hamburg International Conference of Logistics (HICL), in: Kersten, Wolfgang & Blecker, Thorsten & Ringle, Christian M. (ed.), Innovations and Strategies for Logistics and Supply Chains: Technologies, Business Models and Risk Management. Proceedings of the Hamburg Internationa, volume 20, pages 333-357, Hamburg University of Technology (TUHH), Institute of Business Logistics and General Management.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Dale Squires & Kathleen Segerson, 2022. "Capacity and Capacity Utilization in Production Economics," Springer Books, in: Subhash C. Ray & Robert G. Chambers & Subal C. Kumbhakar (ed.), Handbook of Production Economics, chapter 24, pages 1001-1037, Springer.
    2. Santiago J. Gahn, 2022. "Towards an explanation of a declining trend in capacity utilisation in the US economy," Working Papers PKWP2214, Post Keynesian Economics Society (PKES).
    3. Huberts, Nick F.D. & Rossi Silveira, Rafael, 2023. "How economic depreciation shapes the relationship of uncertainty with investments’ size & timing," International Journal of Production Economics, Elsevier, vol. 260(C).
    4. Kuno J.M. Huisman & Peter M. Kort, 2015. "Strategic capacity investment under uncertainty," RAND Journal of Economics, RAND Corporation, vol. 46(2), pages 376-408, June.
    5. Arrieta Paredes, Mary-Paz, 2004. "Capacity Expansions timing patterns in the United Kingdom’s petroleum refining industry between 1948 and 1998," MPRA Paper 32239, University Library of Munich, Germany.
    6. Mohieddine Rahmouni, 2021. "Determinants of capacity utilisation by firms in developing countries: evidence from Tunisia," International Journal of Technological Learning, Innovation and Development, Inderscience Enterprises Ltd, vol. 13(3), pages 212-245.
    7. Arrieta Paredes, Mary-Paz, 2004. "The timing of capacity expansions as barriers to mobility in the United Kingdom’s petroleum refining industry between 1948 and 1998," MPRA Paper 32231, University Library of Munich, Germany.
    8. Xingang Wen & Peter M. Kort & Dolf Talman, 2017. "Volume flexibility and capacity investment: a real options approach," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 68(12), pages 1633-1646, December.
    9. Ciaran Driver, 2000. "Capacity Utilisation and Excess Capacity: Theory, Evidence, and Policy," Review of Industrial Organization, Springer;The Industrial Organization Society, vol. 16(1), pages 69-87, February.
    10. Yamawaki, Hideki, 2002. "Price reactions to new competition: A study of US luxury car market, 1986-1997," International Journal of Industrial Organization, Elsevier, vol. 20(1), pages 19-39, January.
    11. E. Abdul Azeez, 2002. "Economic reforms and industrial performance: An analysis of capacity utilisation in Indian manufacturing," Centre for Development Studies, Trivendrum Working Papers 334, Centre for Development Studies, Trivendrum, India.
    12. Joachim Gahungu and Yves Smeers, 2012. "A Real Options Model for Electricity Capacity Expansion," RSCAS Working Papers 2012/08, European University Institute.
    13. Sarkar, Sudipto, 2014. "Product–market flexibility and capital structure," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(1), pages 111-122.
    14. Singh, Satwinder & Utton, Michael & Waterson, Michael, 1998. "Strategic behaviour of incumbent firms in the UK," International Journal of Industrial Organization, Elsevier, vol. 16(2), pages 229-251, March.
    15. Briec, Walter & Kerstens, Kristiaan & Prior, Diego & Van de Woestyne, Ignace, 2010. "Tangency capacity notions based upon the profit and cost functions: A non-parametric approach and a general comparison," Economic Modelling, Elsevier, vol. 27(5), pages 1156-1166, September.
    16. Lutz, Clemens & Kemp, Ron & Dijkstra, S. Gerhard, 2007. "SME's perceptions regarding strategic and structural entry barriers," Research Report 07009, University of Groningen, Research Institute SOM (Systems, Organisations and Management).
    17. Jyh-Bang Jou & Charlene Tan Lee, 2023. "Design of the contingent royalty rate as related to the type of investment," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 9(1), pages 1-25, December.
    18. Trezzini, Attilio & Pignalosa, Daria, 2021. "The Normal Degree of Capacity Utilization: The History of a Controversial Concept," Centro Sraffa Working Papers CSWP49, Centro di Ricerche e Documentazione "Piero Sraffa".
    19. repec:dgr:rugsom:07009 is not listed on IDEAS
    20. V Ghosal, 2004. "Pre-Emptive Investment Behaviour and Industry Structure," Economic Issues Journal Articles, Economic Issues, vol. 9(1), pages 47-68, March.
    21. Sarkar, Sudipto, 2015. "Price limits and corporate investment: The consumers' perspective," Economic Modelling, Elsevier, vol. 50(C), pages 168-178.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wly:mgtdec:v:30:y:2009:i:2:p:119-133. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley Content Delivery (email available below). General contact details of provider: http://www3.interscience.wiley.com/cgi-bin/jhome/7976 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.