A real-option rationale for investing in excess capacity

Excess capacity is expensive, yet persistent excess capacity is widely observed in the corporate sector. Using a real-option approach to capacity planning, this paper shows that under certain conditions it is optimal to invest in long-term (even permanent) excess capacity. This results from the asymmetric nature of operating flexibility resulting from excess capacity-the ability to increase output under favorable demand shocks. The model is used to identify conditions under which excess capacity is more likely to be optimal. The implications are generally consistent with existing empirical evidence from studies on excess capacity and capacity utilization. Copyright © 2008 John Wiley & Sons, Ltd.