What it is: The capacity excess or excess capacity (e Xcess capacity) is a situation where the production capacity is not fully utilized to achieve the minimum efficient scale. In other words, the firm is producing at a lower scale of output than it was designed for. Not only companies, 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 average costs. Actual output is the realization of the quantity of goods and services produced during a certain period, for example one year.
Mathematically, the excess capacity formula is as follows:
Excess capacity = Potential output – Actual output
For example, a motorcycle factory has a production capacity of 1,500 motorcycles per day. If in reality, the factory only produces 1,000 units per day, then there is an unused capacity of 500 units per day. Thus, the factory has excess capacity because it is not producing at its potential output, 1,500 motorcycles per day.
The plant may still be able to increase output to reach the minimum efficient scale point. If it manages to increase, it contributes to lower average costs.
Furthermore, you can also measure excess capacity by looking at the level of capacity utilization. It measures the extent to which installed production capacity is used. In this case, you divide 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 more capacity is idle.
Why is overcapacity bad
Several reasons explain why excess capacity is bad.
First , if you relate it to the state of the economy, it usually lasts during a recession. Economists typically use capacity utilization rates to observe trends in excess capacity. If the utilization rate decreases, it indicates an increase in excess capacity.
Because utilization rates vary across industries, economists develop indexes to represent average levels of utilization so that they are easier to read. For example, the capacity utilization rate in the United States in October 2020 was approximately 72.75%. That includes average capacity utilization across 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 rates fall). 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 the company has not yet reached the minimum efficient scale point. It is still possible to lower average cost by producing more output.
Third , selling price pressure increases. When companies invest too aggressively, it results in much higher capacity than the market demands. As the law of supply and demand, this condition will push the market price to fall.
Companies are competing to lower selling prices to stimulate demand. They hope that, by increasing sales, they can improve capacity utilization. That way, they can pay a flat fee.
A fall in market prices can result in the bankruptcy of companies that are financially weaker.
Factors that cause excess capacity
Excess capacity can arise when demand is seasonal. During peak season the firm operates close to its potential output. However, during the regular season, they face more idle capacity.
Overcapacity can also arise when customer demand has permanently declined. The evolution of technology makes some industries like typewriters die. We replaced it with computers, eliminating the need 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 rely more on short-term demand trends.
When demand increases, companies in the market aggressively invest and expand capacity, more than is needed to meet the increasing demand. This is common during demand booms .
Because the company has already built production facilities and incurs high fixed costs, the company cannot stop investing. Therefore, although demand shows signs of weakening, they still continue to build production facilities. The reason is that stopping construction will cost more than continuing it.
As a result of this decision, the market faced a drastic increase in production capacity. As most companies do, the market is oversupplied and causes prices to fall. This condition occurred during the commodity boom in 2010-2014. In the global oil market, for example, the price of oil fell from around US$120 per barrel to US$40 per barrel.
Strategies to prevent new players from entering
Incumbent companies 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, incumbents take advantage of excess capacity to increase market supply. That will cause market prices to fall and lower profitability.
This situation makes it difficult for potential entrants to earn profits and return adequate investment capital. They may not enter the market. Or, they take another strategy, for example by acquiring an existing company, instead of entering as a new player.
Excess capacity in a monopolistic market
Overcapacity often occurs in monopolistic competition and natural monopoly markets. In monopolistic competition, there are many players and each has market power by differentiating its offerings.
Due to the large number of players, it makes it difficult for coordination (collusion) between companies to influence supply in the market. Thus, when demand increases, each company will expand production capacity. Due to lack of coordination, it ends up in overcapacity, especially when market demand weakens.
However, another argument suggests, the opportunity for excess capacity in a monopolistically competitive marketmay be less significant. Players face a flat demand curve whereas the long-run average cost curve tends to be steeper.
In addition, when prices and profitability fall due to overcapacity, some players exit the market (low exit barriers). That ends up reducing supply in the market and pushing prices up.
Meanwhile, in natural monopoly markets, incumbents maintain excess capacity to deter new players from entering, as I mentioned earlier. This strategy is a signal to potential newcomers that the incumbent has a strong capacity for strong retaliation.