Real Options Analysis For The Strategy Of Excess Capacity Setting

Strategy behavior is one of the most important competitive strategies, and excess capacity management is a typical strategy behavior. Strategic capacity management concerned with determining the sizes, type, and timing of capacity investment and adjustments under uncertainty. Capacity is a measure of processing abilities and limitations. Generally, a firm who has a larger capacity can produce more and have much market force, while maintaining larger capacity will induce higher costs. Then determining capacity is a trade-off. Especially, excess capacity strategy principally aiming at resisting rivals must be seriously considered on both efficiency and benefit.This paper builds a mathematical model, in virtue of quantitative methods, to decide the capacity in the duopoly competition. First, when the market demand is certain, we discuss the feasibility of the incumbent's strategy of entry deterrence with excess capacity. Decision principle of capacity of the incumbent is studied in two periods. Second, when the demand is uncertain, we use real option approach to analyze how the incumbent's capacity strategy affects the entrant's value of the project and timing to invest. Then efficiency of entry deterrence with excess capacity is examined. At last, based on the studies above, the target and method of deciding capacity of the incumbent and entrant as well as affection of excess capacity strategy on the entrant's timing to invest are analyzed with real option approach.