Irreversible Investment, Capacity Choice, and the Value of the Firm

A model of capacity choice and utilization is developed
consistent with value maximization when investment is irreversible
and future demand is uncertain. Investment requires the full
value of a marginal unit of capacity to be at least as large as
its full cost. The former includes the value of the firms option
not to utilize the unit, and the latter includes the opportunity
cost of exercising the investment option. We show that for
moderate amounts of uncertainty, the firm's optimal capacity is
much smaller than it would be if investment were reversible, and a
large fraction of the firm's value is due to the possibility of
future growth. We also characterize the behavior of capacity and
capacity utilization, and discuss implications far the measurement
of marginal cost and Tobin's q.