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Another issue that arises is the choice of optimal capacity and capacity utilization when demand is stochastic (Steen, 1994). When uncertainty about future demand is significant, neglecting stochastic demand may lead to biased empirical results.

When demand is deterministic and a price-taking firm faces a known demand curve, the firm chooses capacity and thus production level to minimize costs, given factor prices (Steen, 1994). However, when demand is stochastic, the firm encounters potential losses when determining its capacity. If future demand is higher than the chosen capacity can handle, the firm will lose potential revenue from sales. If future capacity is too high relative to demand, the firm must bear the cost of excess capacity. Hence, in an uncertain environment, the choice of capacity depends on both the distribution of future demand and the magnitude of these two potential losses arising from a mismatch of capacity and demand.


Steen (1994) notes several limiting issues to most existing studies of capacity utilization: the assumption that firms can continuously and incrementally add capital, and in addition, the lack of dynamics so that possible adjustment costs and delivery lags regarding capacity changes are ignored. Lee (1995), Nelson (1989), and Morrison (1985) distinguish between the level of capacity capital or capacity output as the reference variable, and depending on which reference variable is used for comparison with current output, capital, or cost, alternative CU measures can be derived. Lee (1995) observed that capacity output in the dynamic cost function represents the optimal level of output given current quasi-fixed factors, as contrasted to maximal output when all factor inputs are full utilized. Since the optimal level of output is determined within the context of a dynamic cost minimization framework, it may be lower even than the currently level of output as long as the marginal cost of producing output above the current level exceeds the marginal benefit of additional production.

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