What is Excess Capacity?
Excess capacity is a condition that occurs when demand for a product is less than the amount of product that a business could potentially supply to the market. When a firm is producing at a lower scale of output than it has been designed for, this state results in excess capacity.
The term excess capacity is generally associated with manufacturing. If you find idle workers at a production plant, it might imply that the facility has excess capacity. However, this concept also extends to the service industry. For example, in the restaurant sector, some establishments might continually have empty tables and seemingly unproductive staff—indicative of excess capacity. This scenario suggests that the venue has the capability to serve more guests, yet the demand doesn’t match the establishment’s capacity.
Key Takeaways
- Excess capacity exists when market demand for a product is less than the volume a company could potentially supply.
- Primarily linked with manufacturing, but also applicable in the service sector.
- It can indicate growth potential, but extensive excess capacity can have negative economic ramifications.
What Causes Excess Capacity?
Several factors can lead to excess capacity, including overinvestment, technological improvements, repressed demand, and external shocks such as financial crises. Additionally, misplaced market predictions or inefficient resource allocation can contribute to this condition. For sustainable financial health, company management must remain vigilant to the realities of supply and demand.
Why Does Excess Capacity Matter?
While excess capacity might suggest healthy growth potential, excessive levels can damage an economy. If a company can’t sell its product for an amount at or above production cost, it could incur losses or end up with unsold products that consume storage and money. Furthermore, excess capacity can result in plant closures, job losses, and inefficient resource utilization.
On the flip side, companies can leverage excess capacity to offer consumers discounted prices. Some organizations maintain deliberate excess capacity to discourage new firms from entering the market.
Case Example: Excess Capacity in China
Rampant Excess Capacity Persists in China
Since 2009, China has been embroiled in its third wave of excessive capacity, following earlier periods from 1998 to 2001 and 2003 to 2006. Even though China became the world’s second-largest economy in 2010, internal and external challenges persist. China’s manufacturing industries, including steel, cement, aluminum, flat glass, and automobiles, struggle with significant excess capacity.
Efforts to rectify the issue have made little difference. In industrial economies, excess capacity is usually a short-term and self-correcting condition. However, China’s entrenched manufacturing issues point to deeper economic complexities.
Excess Capacity in China’s Automobile Market
Auto assembly plants typically have high fixed costs. Because many new factories in China are incentivized by local governments, pressures to remain operational despite excess output prevail. This could lead to price wars, reduced profit margins, and increased automotive exports.
How Long Could It Last?
There is scant motivation to eliminate excess capacity in China’s automotive market. Shutting down a relatively new factory could evoke friction with local governments, making it unlikely for the excess-capacity trend to diminish soon.
The Impact of COVID-19
Coronavirus significantly disrupted the auto industry, with February 2020 witnessing an over 80% decline in auto sales in China. Given China’s centrality to the global auto supply chain, this disruption affected automakers globally. Many companies estimate the pandemic will have far-reaching impacts on their 2020 revenues.
While China might recover from the pandemic sooner than other regions, the long-term economic implications remain uncertain, especially concerning China’s chronic excess-capacity issues.
Related Terms: fixed costs, production cost, supply and demand, competitive strategy.
References
- Congressional Research Service. “China’s Steel Industry and Its Impact on the United States: Issues for Congress”.
