Excess Capacity as an Incentive Device

This paper studies the factors determining plant size and interplant output allocation within the boundaries of a multiplant firm under conditions of demand uncertainty. It shows that asymmetric information between headquarters and individual plants is one factor determining plant size and output allocation: since the existence of excess capacity creates ‘high powered’ incentives for individual plants, capacity levels in a second-best setting exceed the corresponding benchmark in a first-best world if capacity prices are low. The presence of ‘agency costs’ in the case of fully-utilized capacity reverses this result for high-capacity prices. Also, in a recession output is not necessarily assigned to the plant with the lowest production costs.