The Effect of Cost Asymmetry and Output Flexibility on Capacity Choices
35 Pages Posted: 4 Apr 2013 Last revised: 17 Apr 2019
Date Written: April 15, 2019
Strategic interactions are part of business life. We model a situation where several firms may enter the market at a future time and compete with invested rivals in quantity. In the second-stage dynamic Cournot model, firms have operational flexibility to set output in the face of competition given stochastic demand and capacity constraints. Owing to capacity constraints, the firm cannot fully tap on increased demand, with the value of a firm growing at a lower rate once the upper capacity constraint becomes binding. Earlier entry decisions may give rise to a coordination problem among would-be entrants. We characterize the Markov Perfect Equilibria (MPE) and obtain the value of the investment option in the most likely MPE. The value of the investment option is not necessarily monotone increasing and convex under competition but rather it exhibits "competitive waves."
Keywords: Operational flexibility, real options, market entry, industrial organization
Suggested Citation: Suggested Citation