Making Right Capacity Investment Decision Under Demand Uncertainty

Capacity choice is a long-term decision and usually made before firms have a good idea of demand. Production and pricing decisions can be made before or after the actual demand curve is known. Whether or not a firm can exploit demand information to better adjust output depends on the capability of its infrastructure. For example, any production system entails a lead time. Subcontracting production (say, overseas) requires a long lead time, whereas in-house production can be done much more quickly. Consequently, with subcontracted production, it is likely that a firm makes production decisions before observing the actual demand. Alternately, for a given production technology, a firm can choose to invest in an infrastructure to obtain information earlier in time. Regardless of the approach, a firm develops a capability to postpone production decisions.