Country-specific rigidities and investment decisions: quantity competition and demand uncertainty

This paper develops a two-stage quantity competition game between two firms in two different countries. Under demand uncertainty, firms initially install physical capacity. Once final demand has realized, they adjust their production levels by producing above or below capacity. We assume that countries adopt different capital and labour regulations in order to assess how institutions impact firms' investment decisions. Rigidity in the labour market impacts adjustment costs either with higher overtime wages or with higher temporary lay-off costs. What emerges is a potential explanation for excess of capacity, as the optimal investment in capacity is increasing in labour rigidity and decreasing in capital costs. Also, this model suggests that firms prefer to invest more in physical capacity, as a way to gain higher expected profits. As an extension, we differentiate firms' adjustment costs assuming that it is more costly to produce below capacity rather than above. In terms of optimal capacity installation, results confirm the substitution effect of the baseline model. Still, firms' performances are affected by the cost structure.