A real-option rationale for investing in excess capacity
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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.
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