Capacity, volume flexibility, and costs

Abstract

This paper studies strategic firms' capacity choices in the presence of demand uncertainty and imperfect downside and upside volume flexibility. It provides conditions under which firms' capacity is greater or less than their expected output. It shows under certain conditions, a first-order stochastically dominant demand distribution induces higher capacity, while a mean-preserving spread of a demand distribution induces lower capacity. By endogenizing volume flexibility, it shows that firms' downside flexibility tends to be lower than their upside flexibility. This implies a firm's short-run average cost tends to be asymmetrically U-shaped, namely, the average cost increases more when output falls below capacity (the efficient scale) than when output rises above capacity by an equivalent amount.