Demand Uncertainity, Capacity Decisions and the Irreversibility Effect: Empirical Evidence from the U.S. Cement Industry, 1994-2006

Demand uncertainty is thought to influence irreversible capacity decisions. This paper examines some implications of this theory for the US cement industry. Firms in this sector deliver cement for local markets either from domestic plants or from imports. Since cement is costly to transport, the difference in marginal cost between local production and imports varies across local markets. In the presence of uncertain demand, capacity choices depend on whether firms are located on the coast or inland. We construct a model consistent with irreversibility theory embedding these industry characteristics. The properties of the model are then tested using industry data from 1994 to 2006. Consistent with our predictions, there is a negative relationship between the average level of excess capacity and demand uncertainty only for coastal areas. An increase in demand uncertainty is associated with an increase in excess capacity only in landlocked areas. More generally, the paper shows that the cost of imports relative to the cost of domestic production affects the relationship between uncertainty and domestic capacity levels. We briefy discuss the relevance of our results for multinationals' investment decisions and for the effects on US cement capacity of the introduction of a unilateral climate policy.