Lateral capacity exchange and its impact on capacity investment decisions

We study the problem of capacity exchange between two firms in anticipation of the mismatch between demand and capacity, and its impact on firm’s capacity investment decisions. For given capacity investment levels of the two firms, we demonstrate how capacity price may be determined and how much capacity should be exchanged when either manufacturer acts as a Stackelberg leader in the capacity exchange game. By benchmarking against the centralized system, we show that a side payment may be used to coordinate the capacity exchange decisions. We then study the firms’ capacity investment decisions using a biform game framework in which capacity investment decisions are made individually and exchange decisions are made as in a centralized system. We demonstrate the existence and uniqueness of the Nash equilibrium capacity investment levels and study the impact of firms’ share of the capacity exchange surplus on their capacity investment levels.