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Optimal monopoly investment and capacity utilization under random demand

Listed author(s):
  • David B. Nickerson
  • Stanley S. Reynolds

Unique value-maximizing programs of irreversible capacity investment and capacity utilization are described and shown to exist under general conditions for monopolist exhibiting capital adjustment costs and serving random consumer demand for a nondurable good over an infinite horizon. Stationary properties of these programs are then fully characterized under the assumption of serially independent demand disturbances. Optimal monopoly behavior in this case includes acquisition of a constant and positive level of capacity, the maintenance of a positive expected value of excess capacity in each period, and an asymmetrical response of price to unanticipated fluctuations in consumer demand. Under a general form of Markovian demand, the effect of uncertainty on irreversible capacity investment is also described in terms of the discounted flow of expected revenue accruing to the marginal unit of existing capacity and the option value of deferring the acquisition of additional capital. The option value of deferring such acquisition, created by the irreversibility of capacity investment, is characterized directly in terms of the value function of the firm, and is then shown to be zero in a stationary equilibrium with serially independent demand disturbances. The response of investment to increase demand uncertainty depends, as a result, directly on the properties of the marginal revenue product of capital. A non-negative response of optimal capacity to increased uncertainty in market demand is demonstrated for a general class of aggregate consumer preferences.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1990-003.

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Date of creation: 1990
Handle: RePEc:fip:fedlwp:1990-003
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  1. Brock, William A & Burmeister, Edwin, 1976. "Regular Economies and Conditions for Uniqueness of Steady States in Optimal Multi-Sector Economic Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 17(1), pages 105-120, February.
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