IDEAS home Printed from
   My bibliography  Save this article

A real-option rationale for investing in excess capacity


  • Sudipto Sarkar

    (McMaster University, Hamilton, Ont., Canada)


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

    Download full text from publisher

    File URL:
    File Function: Link to full text; subscription required
    Download Restriction: no

    References listed on IDEAS

    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. 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.
    3. 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.
    4. Guiseppe Bertola & Ricardo J. Caballero, 1994. "Irreversibility and Aggregate Investment," Review of Economic Studies, Oxford University Press, vol. 61(2), pages 223-246.
    5. 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.
    6. Lieberman, Marvin B., 1989. "Capacity utilization: Theoretical models and empirical tests," European Journal of Operational Research, Elsevier, vol. 40(2), pages 155-168, May.
    7. Carol Corrado & Joe Mattey, 1997. "Capacity Utilization," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 151-167, Winter.
    8. 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.
    9. Bar-Ilan, Avner & Strange, William C., 1999. "The Timing and Intensity of Investment," Journal of Macroeconomics, Elsevier, vol. 21(1), pages 57-77, January.
    10. 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.
    11. Felipe L. Aguerrevere, 2003. "Equilibrium Investment Strategies and Output Price Behavior: A Real-Options Approach," Review of Financial Studies, Society for Financial Studies, vol. 16(4), pages 1239-1272.
    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. 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.
    15. 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.
    16. 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 are extracted by the CitEc Project, subscribe to its RSS feed for this item.

    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. Kamoto, Shinsuke, 2015. "Strategic capacity expansion under a potential entry threat," International Review of Economics & Finance, Elsevier, vol. 38(C), pages 157-177.
    3. Sarkar, Sudipto, 2014. "Product–market flexibility and capital structure," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(1), pages 111-122.

    More about this item


    Access and download statistics


    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.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing) or (Christopher F. Baum). General contact details of provider: .

    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 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.

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

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.