Capacity adjustment decisions in the service industry under stochastic revenue: the case of the shipping industry

Abstract

The paper proposes a model of capacity adjustment in the competitive ocean shipping industry the case of which is almost unique as a flexible response to market signals under operational constraints. While the concept of capacity adjustment is related usually with long-term investment or disinvestment, in the past shipping firms have responded extensively to the cyclicality of the market; a common medium-term solution has been the laying-up of ships. Although not without cost, lay-up allows minimization of losses without conceding assets in an unfavorable market for capital goods which is the case with ships during periods of shipping crises. We validate the hypothesized dependence of changes in the lay-up rates for ships on the speed of mean-reversion and volatility of freight rates on the basis of tanker market data. The results confirm that, for tankers at least, the lay-up decision is a function of more than the relation of prevailing freight rates to operating expenses levels. The speed of mean reversion is significant as faster mean reversion increases the perceived probability of recovery when the market is at low levels. The results can be considered also as proof of a rational response of firms to the rise in the cost of entry and exit of vessels from a full inactivity state as the case has been in recent years