What’s it: Excess capacity is where production capacity is not fully utilized to achieve the minimum efficient scale. In other words, the firm produces at a lower output scale than it was designed for. Not only companies but this term can also be associated with industry and the economy.
Calculating excess capacity
You can calculate excess capacity from the positive difference between the potential output and the actual output. Potential output is the highest output that can be achieved without increasing the average cost. Actual output is the number of goods and services produced during a specific period, for example, one year.
Mathematically, the excess capacity formula is as follows:
Excess capacity = Output potential – Actual output
For example, a motorcycle factory has a production capacity of 1,500 motorbikes per day. If, in realization, the factory only produces 1,000 units per day, then there is an unused capacity of 500 units per day. So, the factory has excess capacity because it is not producing at its potential output, 1,500 motorbikes per day.
The plant may still be able to increase output to achieve a minimum efficient scale point. If successfully increased, it contributes to a lower average cost.
Furthermore, you can also measure excess capacity by looking at the capacity utilization rate. It measures the extent to which the installed production capacity is being used. In this case, you are dividing the actual output by the potential output.
Capacity utilization rate = (Actual output/Potential output) x 100%
A decrease in the utilization rate indicates an increase in excess capacity. The actual output is lower than the potential output, so there is more idle capacity.
Why is excess capacity bad
Several reasons explain why excess capacity is terrible.
First, if you relate it to economic conditions, it usually takes place during a recession. Economists usually use the capacity utilization rate to observe trends in excess capacity. If the utilization rate decreases, it indicates an increase in excess capacity.
Because utilization rates vary between industries, economists develop an index to represent the average utilization rate to be easier to read. For example, the capacity utilization rate in the United States in February 2022 was around 77.62%. That covers the average capacity utilization in 71 industries in manufacturing, 16 in mining, and 2 in utilities in the country.
Often in a recession or economic slowdown, excess capacity increases (utilization rate falls). Weak demand prevents businesses from maximizing their capacity. As a result, production costs tend to increase, and more workers do not operate machines. And to rationalize costs, they will reduce workers.
Second, average costs tend to be high. Excess capacity indicates that the company has not reached the minimum efficient scale point. It is still possible to lower average costs by producing more output.
Third, it pushes down the selling price. When companies invest too aggressively, it generates much higher capacity than the market demands. As the law of supply-demand, this condition will push the market price down.
Companies are competing to reduce selling prices to stimulate demand. They expect that, by increasing sales, they can improve capacity utilization. That way, they can pay their fixed costs.
A fall in market prices can result in the bankruptcy of financially weaker companies.
Factors affecting excess capacity
Excess capacity can arise when demand is seasonal. During the peak season, the company operates close to its potential output. However, during the regular season, they face more idle capacity.
Excess capacity can also arise when customer demand has decreased permanently. The evolution of technology makes some industries such as typewriters die. We replace it with computers, eliminating the demand for typewriters.
Other reasons for excess capacity are:
- Excessive response to a temporary increase in demand
- As a strategy to create barriers to entry
Increasing production capacity is a long-term investment. However, companies are often biased in making decisions and base more on short-term demand trends.
When demand increases, companies in the market are aggressively investing and expanding capacity, more than is needed to meet increasing demand. This is common during booms in demand.
Because they have already built production facilities and bear high fixed costs, they cannot stop investing. Therefore, even though demand shows signs of weakening, they are still continuing to build production facilities. The reason is that stopping development will cost more than continuing.
As a result of this decision, the market faces a drastic increase in production capacity. Because most companies do this, the market is oversupplied and causes prices to fall. This condition occurred during the commodity boom in 2010-2014. For example, in the global oil market, the oil price fell from around $ 120 per barrel to $40 per barrel.
Strategies to discourage new players from entering
Incumbents may choose to retain excess capacity as part of a deliberate strategy to prevent potential entrants from entering the market. If potential entrants force their way in, the incumbent takes advantage of the excess capacity to increase market supply. That causes market prices to fall and reduce profitability.
This situation makes it difficult for potential newcomers to earn sufficient profits and return investment capital. They may not enter the market. They take other strategies, for example, by acquiring an existing company instead of entering as a new player.
Excess capacity in monopolistic markets
Excess capacity often occurs in monopolistic competition and natural monopoly markets. There are many players under monopolistic competition, and each has some market power by differentiating their offering.
Due to many players, it is difficult for coordination (collusion) between companies to influence supply. Thus, when demand increases, each company will expand its production capacity. Because there is no coordination, it ends up in excess capacity, significantly when market demand weakens.
However, other arguments suggest, the opportunities for excess capacity in monopolistic competitive markets may be less significant. Players face a flat demand curve, whereas the long-run average cost curve tends to be steeper.
When prices and profitability fall due to excess capacity, some players exit the market (low exit barriers). That ultimately reduces the supply in the market and drives up the price.
Meanwhile, in a natural monopoly market, the incumbent maintains the excess capacity to deter new entrants from entering, as I mentioned earlier. This strategy is a signal to potential newcomers that the incumbent has a strong capacity for strong retaliation.