Optimal Investment Strategies for Product-Flexible and Dedicated Manufacturing Systems under Demand Uncertainty

This paper studies the optimal investment strategy of a firm having the managerial freedom to acquire both flexible or dedicated production capacity. Flexible Capacity is more expensive but allows the firm to switch costlessly between products and handle changes in relative volumes among products in a given product mix. Dedicated capacities restrict to manufacture one specific product but for lower acquisition cost. Specifically, I model the investment decision of a monopolistic firm selling two products in a market characterized by price-dependent and uncertain demand, in a continuous time setting. The paper takes a real option approach to consider optimal capacity investment decisions under uncertainty. Besides the timing of the investment, the firm can choose the optimal capacity level and is free to undergo investment in flexible or dedicated capacity. The sensitivity of the firm’s optimal capacity investment considering flexible and dedicated capacity to key problem components is analyzed. The main focus is on the effect of demand variability a key driver of flexibility as well as substitutability and product profitability effects. I find that if uncertainty goes up the firm invests later in higher capacity. Flexibility especially pays off when uncertainty is high, substitutability low, and profit levels between the two products are substantially different. In the flexible case, under high demand the firm just produces the most profitable product, if demand is low the firm produces both products to make total market demand bigger. In the dedicated case the firm invests in both capacities only if the substitutability rate is low and profitability I would like to thank my supervisors Prof. Peter M. Kort and Dr. Kuno J.M. Huisman for many interesting and fruitful discussions about this topic. Furthermore I would like to thank participants of the Economics Workshops Seminar at Tilburg University for helpful discussions and comments.