The Dynamics of Firms in the Presence of Adjustment Costs

In this paper we investigate how capacity adjustment costs affect a firm¡¯s response to demand uncertainty. We first characterize the pattern of optimal capacity adjustment for a monopolistic firm and find that capacity behaves as a stabilizer for the firm¡¯s output. For duopolistic firms the pattern is similar. However, a firm may deviate depending on the demand and capacity circumstance. We find that when there is only a small cost of adjustment, a firm has more incentive to deviate at a larger capacity. We also derive conditions under which deviation in the high-demand state (regardless of present capacity) is more profitable. The case of zero adjustment costs is also discussed.