Strategic use of forward contracts and capacity constraints

This paper analyzes the implications of forward markets under demand uncertainty when oligopolistic firms endogenously choose capacity levels. The paper shows that a forward market that occurs after the investment decision is committed does not increase social welfare if demand uncertainty is relatively small. This result is contradictory to Allaz and Vila (1993) findings that forward markets mitigate market power and enhance efficiency. However, a forward market improves social welfare if demand uncertainty is relatively large. The findings have important policy implications for capital-intensive industries where capacity expansion requires long lead time.