Capacity Sharing Contracts and Subsidy Policies Under R&D Uncertainty

Besides R&D uncertainty, firms in the semiconductor and pharmaceutical sectors face long lead times to set up production facilities. To reduce time to market in a competitive environment, some firms make upfront (non-recoverable) capacity investment before the development of the new product is complete (and approved). To reduce capacity investment risk, capacity sharing enables a firm to recover some of its capacity investment by producing for its competitor should the firm fail and yet its competing firm succeed in product development. This observation prompted us to investigate the following questions. Should competing firms share production capacity to reduce risk? Should firms establish a capacity-sharing contract before (ex-ante) or after (ex-post) R&D uncertainty is resolved? To entice firms to invest in sufficient capacity, should the government subsidize a firm's capacity investment cost or its production cost? Our equilibrium analysis yields four results. First, relative to no capacity sharing, capacity sharing can entice firms to increase (decrease) their planned capacity when the per-unit capacity investment cost is relatively high (low). Second, ex-post capacity sharing benefits the laggard firm that has a lower R&D success probability, but hurts the leading firm when it has a much higher success probability than the laggard firm. In contrast, ex-ante capacity sharing is mutually beneficial when the per-unit capacity investment cost is low. However, for relatively high capacity investment costs and a small gap in firms' success probabilities, ex-post capacity sharing will be adopted by both firms. Third, without capacity sharing, capacity-based subsidy is more efficient than production-based subsidy to entice firms to increase their capacity. A caveat is that offering a higher subsidy can result in higher unmet demand (in expectation) because it entices the laggard firm to increase and the leading firm to decrease its planned capacity without increasing the total capacity. Fourth, under capacity sharing, capacity- and production-based subsidies are equally efficient in boosting the planned capacity. However, when demand is uncertain, even with capacity sharing, capacity-based subsidy is more efficient than production-based subsidy.