Capacity Investment Under Tariff Risk: Rigid Export, Localization, and Flexibility

Abstract

This study examines firms’ capacity-investment choices among export-oriented rigid capacity, localized capacity, and flexible capacity under tariff risk. We develop a single-firm, two-region, two-stage stochastic optimization model with recourse in which capacity is committed before the tariff state is realized, while production and flexible-capacity allocation are determined afterward. We derive analytical optimal decisions for each mode and establish explicit pairwise dominance conditions. The results identify three distinct responses to tariff risk. Export-oriented rigid capacity preserves the cost advantage of production in the lower-cost region but can generate tariff-induced underutilization when the high-tariff state occurs. Localization eliminates cross-border tariff exposure at the cost of higher local production and investment costs. Flexible capacity instead mitigates capacity mismatch through state-contingent cross-market reallocation. Its value is conditional: when the reallocation benefit is insufficient to offset the flexibility premium, rigid export strictly dominates; otherwise, partial or complete reallocation can make flexibility attractive. Model-based numerical analyses quantify capacity utilization and reallocation and characterize the regions in which each mode is optimal. Robustness analyses further show that inexpensive post-realization capacity expansion can partially substitute for ex ante flexibility, while a common rigid-export–flexibility–localization switching pattern remains highly stable under moderate joint parameter perturbations but can change under wider perturbations. Overall, optimal capacity investment reflects the interaction among production-cost efficiency, tariff avoidance, tariff-induced underutilization, and state-contingent capacity reallocation.