What is Excess Capacity?

Excess capacity indicates that demand for a product is less than the amount that the business potentially could supply to the market. When a firm is producing at a lower scale of output than it has been designed for, it creates excess capacity.

Excess capacity = Potential Output - Actual Output

Although the term excess capacity generally is used in manufacturing, it also can apply to the service industry. If you see idle human resources, it may imply that a company has excess capacity. In the restaurant industry, for example, there are those that chronically have empty tables, along with a staff that appears idle. This inefficiency indicates that the restaurant can accommodate more guests, but that the demand for that restaurant is not equal to its capacity.

What Causes Excess Capacity?

Excess capacity can be caused by overinvestment, repressed demand, technology improvement, and external shocks—such as a financial crisis—among other reasons. Excess capacity also may arise from mispredicting the market or allocating resources inefficiently. To remain healthy and financially balanced a company's management needs to stay attuned to the realities of supply and demand.

Key Takeaways

  • Excess capacity means that demand for a product is less than what the business potentially could supply.
  • Excess capacity equals potential output minus actual output.
  • Excess capacity can indicate healthy growth, and too much excess capacity can hurt an economy.

Why is Excess Capacity Important?

Although excess capacity can indicate healthy growth, too much excess capacity can hurt an economy. If a product cannot sell at or above its production cost, then money is being wasted. If you shut down a plant because of too much capacity, then jobs are lost and resources wasted. Moreover, if you continue to make the product, then it will either sit on the shelf or sell for less than you paid to make it. 

A company with sizable excess capacity can lose sizable amounts of money if the business cannot pay for the high fixed costs that are associated with production. On the other hand, excess capacity can benefit consumers, as a company can use excess capacity to offer customers special discounted prices. Companies also may choose to maintain excess capacity deliberately as part of a competitive strategy to deter or prevent new firms from entering their market.

Real-World Example: China

Since 2009, the Chinese economy has been experiencing its third round of excessive capacity. Earlier periods of excess capacity ran between 1998 and 2001 and again between 2003 and 2006. Even though China became the world’s second-largest economy in 2010, it is facing both internal and external economic challenges. Excess capacity in China's manufacturing industries—including steel, cement, aluminum, flat glass, and shipbuilding—is one of its biggest challenges.

Rampant Excess Capacity Persists In China

The Chinese government has taken numerous steps to address this problem, but it continues still. In industrial economies, excess capacity is generally a short-term phenomenon that is self-correcting. However, the severity and persistence of excess capacity in China’s manufacturing sectors suggest that there are deeper, more fundamental issues within the Chinese economy. These problems also have significant implications for international trade, given the growing influence of China in the global marketplace.

How Excess Capacity Affects China's Automobile Market

A Wall Street Journal (WSJ) article of Dec. 25, 2018, reported that China could build 43 million vehicles annually—thanks to companies like Ford, Peugeot SA, Hyundai Motor, and others who added capacity because the market was growing so fast. However, that extra capacity is problematic because in 2018 Chinese factories produced only 29 million vehicles, according to the WSJ. The capacity issue is further compounded by cooling demand for cars in the Chinese market.

Ramifications of Excess Capacity In Autos

Typically, auto assembly plants have a lot of fixed costs to cover. Also, most new factories in China depend on economic incentives from local governments. So, there is pressure to keep the factories open and people employed—whether they can sell the excess output or not. Moreover, all of those extra cars need to find a home, which could mean price wars and lower profits in China's domestic market, along with a flood of exports to the U.S. and elsewhere. For companies like General Motors, who now derive significant sales and earnings from China that cannot be good news.

How Long Could It Last?

Perhaps the real issue is that there is little incentive to remove excess capacity from the Chinese market. Nobody wants to close a relatively new factory in China and risk the acrimony of a local government. Also, after almost two decades, it seems improbable that the excess-capacity trend in China would abate any time soon.