Capacity investment choices under cost heterogeneity and output flexibility in oligopoly

Abstract

We study capacity investment decisions among oligopoly firms under conditions of cost heterogeneity and output flexibility within capacity constraints. Output flexibility causes the value of the firm to be convex in the state of demand, which implies that the firm invests in larger capacity when the economic environment is more uncertain. Under cost heterogeneity among oligopoly firms, a lower-cost firm invests in larger capacity, while a less efficient rival chooses lower capacity as capacities are strategic substitutes. Consequently, higher uncertainty leads to more dispersion of equilibrium capacities and greater industry concentration. More competition thus induces a welfare loss when uncertainty and cost heterogeneity are high.