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A real-option rationale for investing in excess capacity

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  • Sudipto Sarkar

    (McMaster University, Hamilton, Ont., Canada)

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    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.

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    File URL: http://hdl.handle.net/10.1002/mde.1446
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    Bibliographic Info

    Article provided by John Wiley & Sons, Ltd. in its journal Managerial and Decision Economics.

    Volume (Year): 30 (2009)
    Issue (Month): 2 ()
    Pages: 119-133

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    Handle: RePEc:wly:mgtdec:v:30:y:2009:i:2:p:119-133

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    Web page: http://www3.interscience.wiley.com/cgi-bin/jhome/7976

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    1. Ciaran Driver, 2000. "Capacity Utilisation and Excess Capacity: Theory, Evidence, and Policy," Review of Industrial Organization, Springer, Springer, vol. 16(1), pages 69-87, February.
    2. E. Abdul Azeez, 2002. "Economic reforms and industrial performance: An analysis of capacity utilisation in Indian manufacturing," Centre for Development Studies, Trivendrum Working Papers, Centre for Development Studies, Trivendrum, India 334, Centre for Development Studies, Trivendrum, India.
    3. Bar-Ilan, Avner & Strange, William C., 1999. "The Timing and Intensity of Investment," Journal of Macroeconomics, Elsevier, Elsevier, vol. 21(1), pages 57-77, January.
    4. Fagnart, J.-Fr. & Licandro, O. & Sneessens, H. R., 1995. "Capacity Utilization and Market Power," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales), Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) 1996006, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
    5. Subhash C. Ray & Kankana Mukherjee & Yanna Wu, 2005. "Direct and Indirect Measures of Capacity Utilization: A Nonparametric Analysis of U.S. Manufacturing," Working papers, University of Connecticut, Department of Economics 2005-36, University of Connecticut, Department of Economics.
    6. Giuseppe Bertola & Ricardo J. Caballero, 1991. "Irreversibility and Aggregate Investment," NBER Working Papers 3865, National Bureau of Economic Research, Inc.
    7. COELLI, Tim & GRIFELL-TATJE, Emili & PERELMAN, Sergio, 2001. "Capacity utilisation and profitability: a decomposition of short run profit efficiency," CORE Discussion Papers, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) 2001052, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    8. Lieberman, Marvin B., 1989. "Capacity utilization: Theoretical models and empirical tests," European Journal of Operational Research, Elsevier, Elsevier, vol. 40(2), pages 155-168, May.
    9. Winston, Gordon C, 1974. "The Theory of Capital Utilization and Idleness," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 12(4), pages 1301-20, December.
    10. Smiley, Robert, 1988. "Empirical evidence on strategic entry deterrence," International Journal of Industrial Organization, Elsevier, Elsevier, vol. 6(2), pages 167-180.
    11. He, Hua & Pindyck, Robert S., 1992. "Investments in flexible production capacity," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 16(3-4), pages 575-599.
    12. Felipe L. Aguerrevere, 2003. "Equilibrium Investment Strategies and Output Price Behavior: A Real-Options Approach," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 16(4), pages 1239-1272.
    13. Esposito, Frances Ferguson & Esposito, Louis, 1974. "Excess Capacity and Market Structure," The Review of Economics and Statistics, MIT Press, vol. 56(2), pages 188-94, May.
    14. Lieberman, Marvin B, 1987. "Excess Capacity as a Barrier to Entry: An Empirical Appraisal," Journal of Industrial Economics, Wiley Blackwell, Wiley Blackwell, vol. 35(4), pages 607-27, June.
    15. Carol Corrado & Joe Mattey, 1997. "Capacity Utilization," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 11(1), pages 151-167, Winter.
    16. H. Kim, 1999. "Economic Capacity Utilization and its Determinants: Theory and Evidence," Review of Industrial Organization, Springer, Springer, vol. 15(4), pages 321-339, December.
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    Cited by:
    1. Sarkar, Sudipto, 2014. "Product–market flexibility and capital structure," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 54(1), pages 111-122.
    2. Luca Di Corato & Michele Moretto & Sergio Vergalli, 2013. "Long-run Investment under Uncertain Demand," Working Papers, Fondazione Eni Enrico Mattei 2013.65, Fondazione Eni Enrico Mattei.

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