A MODEL FOR THE LONG-TERM OPTIMAL CAPACITY LEVEL OF AN INVESTMENT PROJECT

We consider an investment project that produces a single commodity. The project's operation yields payoff at a rate that depends on the project's installed capacity level and on an underlying economic indicator such as the output commodity's price or demand, which we model by an ergodic, one-dimensional Ito diffusion. The project's capacity level can be increased dynamically over time. The objective is to determine a capacity expansion strategy that maximizes the ergodic or long-term average payoff resulting from the project's management. We prove that it is optimal to increase the project's capacity level to a certain value and then take no further actions. The optimal capacity level depends on both the long-term average and the volatility of the underlying diffusion.