Capacity Investment and Process Efficiency at Flexible Firms

ABSTRACT

When firms are endowed with volume flexibility, capacity investment may influence the subsequent production process via affecting the structure of production cost. Yet, the strategic interaction between capacity and production decisions has not been adequately addressed. In this paper, we consider two firms serving one market under price sensitive and uncertain demand. Firms incur costs to build capacity and produce. The firm’s capacity affects production cost through its influence on process efficiency, while the specific effects on the two firms differ. We establish a two-stage game-theoretical framework to characterize the problem and obtain two firms’ equilibrium capacity and production decisions. The results show that the firm whose process efficiency is more prone to improving as capacity expands will invest in more capacity and achieve a more efficient process, provided that production is not overly labor and material intensive. However, its competitor will spin off capacity and suffer profit reduction. Moreover, the firms are encouraged to scale up capacity investment to achieve a more efficient process in an expanding and more volatile market.