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, some firms make upfront capacity investment before the development of the new product is complete. To reduce capacity investment risk, capacity sharing enables a firm to recover some of its capacity investment by producing for its competitor should it fail and yet its competing firm succeed in product development. This raises several questions. Should competing firms share production capacity? 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 capacity, should the government subsidize a firm’s capacity investment cost or its production cost? First, we find relative to no capacity sharing, capacity sharing can entice firms to increase (decrease) their capacity when the capacity investment cost is relatively high (low). Second, ex-post capacity sharing benefits the laggard firm with a lower R&D success probability, but hurts the leading firm when it has a sufficiently high success probability. In contrast, ex-ante capacity sharing is mutually beneficial when the capacity investment cost is low. Third, without capacity sharing, capacity-based subsidy is more efficient than production-based subsidy. 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 capacity without increasing the total capacity. Fourth, under capacity sharing, capacity- and production-based subsidies are equally efficient.
