New insights in capacity investment under uncertainty

An important development in the real options theory is the notion that an investment decision is not only about timing but also about size. This plays for instance a crucial role when the firm has market power, implying that quantity affects the output price. Analyzing the resulting problem requires the inclusion of a demand function in the real options model. The present paper analyzes the general problem, and gives an overview of possible demand functions and its implications for the optimal investment decision. We carry out an extensive comparative statics analysis of the uncertainty parameter, the market trend, and the discount rate, thereby distinguishing between net present value (NPV), option, and quantity effects.