Capacity Expansion and the Size of Plants

Abstract

Scale economies in industrial plants confer a tradeoff on firms between the capacity of production facilities and the average cost of production. This tradeoff is central to firms' capacity expansion decisions in growing industries. This article imbeds the cost versus capacity tradeoff in an investment-timing game and explores the properties of equilibrium capacity expansion in growing industries with free entry. Some of the results are analytical and others are based on numerical examples using a particular class of demand functions. Equilibrium capacity expansion is suboptimal from a social point of view, but it involves zero profits. Small plants with high unit costs can coexist in a rent-dissipating equilibrium with large plants with low unit costs. Small plants sometimes precede and at other times follow the installation of large plants as the industry evolves along the equilibrium path.