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A real-option rationale for investing in excess capacity

  • Sudipto Sarkar

    (McMaster University, Hamilton, Ont., Canada)

Registered author(s):

    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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    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
    Contact details of provider: Web page: http://www3.interscience.wiley.com/cgi-bin/jhome/7976

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    1. Fagnart, J.-Fr. & Licandro, O. & Sneessens, H. R., 1995. "Capacity Utilization and Market Power," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 1996006, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
    2. Ciaran Driver, 2000. "Capacity Utilisation and Excess Capacity: Theory, Evidence, and Policy," Review of Industrial Organization, Springer, vol. 16(1), pages 69-87, February.
    3. 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.
    4. H. Kim, 1999. "Economic Capacity Utilization and its Determinants: Theory and Evidence," Review of Industrial Organization, Springer, vol. 15(4), pages 321-339, December.
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    6. 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.
    7. Bertola, Guiseppe & Caballero, Ricardo J, 1994. "Irreversibility and Aggregate Investment," Review of Economic Studies, Wiley Blackwell, vol. 61(2), pages 223-46, April.
    8. Bar-Ilan, Avner & Strange, William C., 1999. "The Timing and Intensity of Investment," Journal of Macroeconomics, Elsevier, vol. 21(1), pages 57-77, January.
    9. Subhash C. Ray & Kankana Mukherjee & Yanna Wu, 2005. "Direct and Indirect Measures of Capacity Utilization: A Nonparametric Analysis of U.S. Manufacturing," Working papers 2005-36, University of Connecticut, Department of Economics.
    10. Winston, Gordon C, 1974. "The Theory of Capital Utilization and Idleness," Journal of Economic Literature, American Economic Association, vol. 12(4), pages 1301-20, December.
    11. Carol Corrado & Joe Mattey, 1997. "Capacity Utilization," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 151-167, Winter.
    12. 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.
    13. Smiley, Robert, 1988. "Empirical evidence on strategic entry deterrence," International Journal of Industrial Organization, Elsevier, vol. 6(2), pages 167-180.
    14. He, Hua. & Pindyck, Robert S., 1989. "Investments in flexible production capacity," Working papers 2102-89., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    15. 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.
    16. Lieberman, Marvin B, 1987. "Excess Capacity as a Barrier to Entry: An Empirical Appraisal," Journal of Industrial Economics, Wiley Blackwell, vol. 35(4), pages 607-27, June.
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