Dynamic Capacity Investment Under Competition

Abstract

Problem definition: We study a dynamic capacity investment problem in a competitive market under demand uncertainty. Two firms make sequential capacity decisions. Each firm's decision interacts with the opponent's current and future capacity. A firm can either plan investments proactively, assuming that the opponent will react using a given strategy, or respond reactively. Academic/Practical relevance: Our research problem originates from practice: a staggering investment race in the container shipping market since the 2008 global recession, which has led to huge losses for many carriers and even bankruptcy for some. This phenomenon and the dynamics of competitive investment can be explained by our model. Methodology: In each period, a firm's optimal decision is determined according to an ISD (Invest, Stayput, Disinvest) policy. We derive the optimal reactive ISD policy as a function of the opponent's latest observed action, and develop an efficient algorithm to derive a firm's optimal long-term proactive ISD policy, which is a function of the opponent's response policy. Results: The optimal policy is a so-called Multi-ISD decision rule, with disjoint ISD intervals. This may lead to non-obvious decisions. For instance, holding more assets may trigger even higher investments for a firm, while having fewer assets may trigger disinvestment. We validate our model using detailed data from the container shipping market (2000 - 2015). Our results show that capacity decisions of the main players were close to optimal, assuming proactive competitive strategies. Managerial implications: A proactive policy considers various competitive goals. By giving a firm strategic responsiveness to the opponent's strategy, a proactive competitive strategy appears to be better than a reactive strategy in the long run, in terms of profit and market share. We also provide a practical guideline with four steps for achieving an effective competitive investment strategy.

Keywords: capacity, dynamic investment, proactive strategy, Stackelberg competition, feedback policies