Capacity Investment in a New Production Location

Firms proactively search for low-cost production locations to enjoy cost-based advantages. In this article, we develop a two-stage stochastic program to study a firm's capacity investment and production decisions about the exploration of new production locations. In the first stage, the firm determines how much capacity to build at the new location, and in the second stage, after the product demand and the production cost at the new location have been observed, the firm determines the optimal production quantities. We first characterize the firm's optimal decisions and then examine how the optimal capacity level and firm profit are affected by the key parameters. We find that the firm may be better off when either the production cost or the demand is more variable. Using numerical analyses, we also investigate the value of retaining the existing location, and our results demonstrate that retaining the existing location obtains the highest value when the market size is large, the consumers are insensitive to price, the market demand is highly uncertain, or the variability of the production cost at the new location is either sufficiently high or sufficiently low. Finally, we extend our baseline setting in two directions: one in which the firm makes the production decision prior to demand realization, and the other in which there is a finite capacity at the existing location. For both extensions, we demonstrate the robustness of the results obtained for the baseline setting.

Automated summary

This article develops a two-stage stochastic program to study a firm's capacity investment and production decisions when exploring new production locations. The study finds that the firm may perform better when the production cost or demand is more variable, and retaining the existing location's value depends on market size, consumer price sensitivity, and production cost variability.