Production Flexibility and Investment under Uncertainty

This paper extends the theory of real options, which mainly considers the problem of timing of investment, by letting the firm choose also the quantity produced after the time of investment. Under the conditions of irreversible investment and uncertainty in future demand, the firm can adjust its output quantity at each point in time in the future. Our paper shows that changing the structure of the demand function from iso-elastic to linear, implicates the need of a suspension option. We see that flexibility in quantity choice makes the firm invest earlier and the gap between the different investment timings increases with uncertainty and is remarkably high. In the flexible case it can either happen that capacity is fully used or some capacity is left idle right at the moment of the investment. We identify how uncertainty in demand influences this decision.