Decentralized Capacity Management and Internal Pricing

Decentralized Capacity Management and Internal Pricing This paper studies the acquisition and subsequent utilization of production capacity in a multi-divisional firm. In a setting where an upstream division provides capacity for itself and a downstream division, our analysis explores whether the divisions should be structured as investmentor profit centers The choice of responsibility centers is naturally linked to the internal pricing rules for capacity services. We establish the efficiency of an arrangement in which the upstream division is organized as an investment center and capacity services to the downstream division are priced at full historical cost. This conclusion applies, however, only if there is no flexibility in the divisional capacity assignments in the short-run. In contrast, if capacity is fungible in the short-run, it becomes essential to let divisional managers negotiate adjustments to their initial capacity rights. Yet the anticipation of negotiated capacity reallocations exposes the upstream division, as the owner of capacity assets, to a dynamic holdup problem by the downstream division which merely rents capacity on a period by period basis. Such holdup problems can be alleviated with more symmetric responsibility center arrangements. The firm can either centralize ownership of capacity assets with the provision that both divisions rent capacity on a periodic basis from a central unit. An alternative decentralized solution can be obtained by a system of bilateral capacity ownership in which both divisions become investment centers and therefore acquire long-term capacity rights in exchange for long-term cost charges.