Staged Capacity Investments under Uncertainty

The theory of real options mainly establishes models in which firms have just a single investment opportunity. This paper extends this theory by considering multiple lumpy investments in a firm’s production capacity within an uncertain business environment. The firm decides the timing and scale of each investment. We show that the optimal investment size maximizes the profit over the expected duration until the next investment. More investment opportunities make the firm invest earlier and in smaller amounts, using subsequent investments to expand production when demand rises sufficiently. This strategy is particularly profitable if the firm has a few very price-inelastic customers. This paper bridges the gap between incremental investments and investing in one lump, as both are special cases of our framework.