Excess Capacity

What is Excess Capacity?

Excess capacity (or unutilized capacity) occurs when a firm operates or is producing output at less than the optimum level. It can happen when there is a market recession or increased competition, where demand declines and firms are forced to reduce capacity to decrease costs.

To increase demand, companies typically decrease prices when there is excess capacity in the industry. Excess capacity is determined using the minimum long-run average cost; hence, it is not a short-run occurrence.

Economists normally study excess capacity in the context of market structures – perfect competition and monopolistic competition – which we will examine below.

Excess Capacity Under Perfect Competition

Where:

• LAC – Long-run average cost
• LMC – Long-run marginal cost
• AR – Average revenue
• MR – Marginal revenue
• OP – Price
• OQ – Quantity
• E – Equilibrium point

Conditions of full equilibrium in a perfectly competitive market structure are reached when the demand curve (AR) is tangential to the long-run average cost curve (LAC) at its minimum point. This is also the point where the LMC = AR = MR = LAC.

The equation signifies that in the long run, despite the entry of new firms in the market, existing firms make efficient use of available resources to operate at the lowest point of the LAC.

Therefore, in the long run, the optimum output is OQ, and at the equilibrium point (E), all firms earn normal profits; abnormal profits are unattainable.

At E, where price (OP) and optimum output at the efficient scale (OQ), MR = LMC – AR = LAC. Consequently, there is no excess capacity in the long run for perfectly competitive markets.

Excess Capacity Under Monopolistic Competition

Excess capacity is more defined under monopolistic competition due to the nature of the market structure.

Unlike perfectly competitive markets where the demand curve is horizontal, monopolistic competitive markets show a downward sloping demand curve. The demand curve cannot be tangential to the LAC at its minimum point.

Conditions of equilibrium are reached at E, where LMC = LAC at the minimum point of the latter. Firms in monopolistic competition are likely to see excess capacity, as there is no incentive to produce optimum output at a higher long-run marginal cost (LMC) that is greater than marginal revenue (MR).

Firms in monopolistic competition operate below optimum capacity; hence, they are smaller in size, large in terms of population, and work under conditions of excess capacity.

Firms under monopolistic competition operate at the equilibrium point E1, where output OQ1 is produced, and the demand curve is tangent to the LAC at point A. It is the point where the LMC curve intercepts with the MR curve.

Firms do not operate at equilibrium (E), where the LMC curve intercepts the LAC curve at its lowest point, and optimum output (OQ) is produced. Beyond OQ1, firms will start making losses as LMC is greater than MR. Thus, excess capacity is created as represented by Q1Q.

The graph also reveals that in the long run, output is lower, and price is higher under monopolistic competition, compared to perfectly competitive markets where output is higher and price is lower.

Chamberlin’s View on Excess Capacity

The concept was explained by Prof. Chamberlin. He indicated that under monopolistic competition, where there is freedom of entry and price competition, the tangency of the demand curve and the long-run average cost curve would lead to optimum output and no excess capacity.

Furthermore, consumers are willing to pay a higher price for differentiated products and the increase in a variety of goods. Excess capacity occurs due to non-price competition despite the freedom of entry in a monopolistic competition market structure.

Chamberlin indicated that firms use the cost of production rather than demand when pricing their products, and they will aim to earn normal profits. Firms are generally unwilling to reduce product prices.

In addition, firms focus on product differentiation to dissuade attention from price competition. Some will also be led by business ethics to avoid cut-throat price competition.

Chamberlin’s Assumptions

Prof. Chamberlin excess capacity concept assumes the following:

• A large number of firms in the market
• Firms produce similar products independently of each other and can charge lower prices to attract customers from other firms or charge higher prices and lose customers.
• Consumer preferences are evenly distributed across product varieties.
• No product monopoly by any firm
• Long-run cost curves are U-shaped for all firms
• Freedom of entry and exit

Firms earn abnormal profits at initial short-run equilibrium point S and price (OP), which is above the long-run average cost (LAC) curve. However, the entry of new firms in the market will eventually wipe away abnormal profits.

Imaginary demand curve dd is of no material importance if there is no price competition. The entry of new firms will push the demand curve DD to the left, where it becomes D1D1 and is also tangent to the LAC curve at point G.

At this point, all firms will now be earning normal profits at price (OP) and output (OQ). To note, however, is that OQ is output achieved in the absence of price competition.

The optimum output is OQ1, where excess capacity does not exist as each firm’s demand curve d2d2 is tangent to the LAC at point H, the lowest possible point on the curve under price competition.

However, each firm produces OQ in the absence of price competition. Therefore, output OQ1 signifies excess capacity due to non-price competition. In the long run, prices and costs are governed by excess productive capacity.

Chamberlin indicated that although optimum output is greater than actual output under monopolistic competition, it should not be termed as inefficient, but it is the price paid for product differentiation by the consumer.

He further outlined that the difference between OQ and OQ1 is a measure of the cost of product differentiation rather than excess capacity. Hence, the conditions for optimum output under monopolistic competition are freedom of entry and non-price competition.

Excess capacity is often caused by fixed prices, but when prices are flexible, the entry of new firms causes an increase in price elasticity of demand, which lowers prices and, subsequently, profits. Prices will be more than costs, and profits are likely to stay at the same level if consumer apathy exists.

The degree of excess capacity is primarily dependent on:

• Elasticity of demand
• Intensity of economies of scale
• The rate of fall of long-run average cost (LAC)
• Degree of the desired product differentiation
• Presence of price competition

The absence of price competition between firms has various reasons, as given by Chamberlain and include the following:

• Policy of live and let live
• Formal and tacit agreements
• Fear of low price being perceived as synonymous to low-quality products
• Professional ethics
• Masked price cuts in the form of rebates or free maintenance

These factors often lead to excess capacity in imperfect markets.

Causes of Excess Capacity

There are two main causes of excess capacity under monopolistic competition:

1. Downward-sloping demand curve or average revenue (AR) curve

The demand curve can only be tangential to the LAC when the LAC is falling. Hence, only the horizontal demand curve under perfect competition can be tangential to the LAC at its lowest point.

The downward-sloping shape of the demand curve is caused by product differentiation. Hence, the greater the elasticity of demand for a firm under monopolistic competition, the less the excess capacity. Under perfect competition, where demand is perfectly elastic, there is no excess capacity.

2. Entry of new firms in the industry

It also causes excess capacity in the long run, as illustrated by Chamberlin. New entrants are attracted by abnormal profits earned by firms in the short run.

As firms continue to enter the market, the industry is reduced to earning normal profits. Each firm produces less than its optimum capacity due to the sharing of market demand.

Benefits of Excess Capacity

Excess capacity under monopolistic competition is caused by product differentiation that leads to product variety and quality, which is beneficial to consumers. Consumers generally do not prefer homogenous products. Technically, excess capacity increases consumer satisfaction.

Real-World Issues on Excess Capacity

Excess capacity in manufacturing sectors of industrialized economies is caused by demand or supply factors. It is mostly attributable to demand factors due to reduced demand globally or from home because of business cycles and other demand-induced factors.

However, excess capacity can also be attributable to supply-side factors such as continued rapid growth in fixed-asset investment, which increases manufacturing capacity and crowds out consumption.

The relationship between supply and demand weakens, and this results in overinvestment and excess capacity. Common remedies for eliminating excess capacity in the real world are as follows:

• Boosting domestic demand to absorb excess capacity
• Boosting external demand through a global strategy
• Encouraging mergers and acquisitions to decrease excess capacity through consolidations
• Enforcing environmental and energy-efficient standards to reduce capacity

How to Monetize Excess Capacity

Monetizing excess capacity is a prudent way of unlocking revenue for the firm, and it is also good for society. The main strategy is focusing on non-cash transactions, as well as the use of technology. Here is a list of ways to monetize excess capacity:

• Renting out, selling, or trading excess capacity – Amazon’s computing power and storage are used to full capacity during the festive season rush. The rest of the months, Amazon rents out its computing capability to other firms and government agencies.
• Excess office space and industrial machinery can be sold, rented out, or traded to firms. Excess industrial equipment can be traded for much-needed equipment.
• Excess restaurant food is usually wasted – With the help of applications such as Too Good To Go, Karma, and YWaste, which facilitate the sale of excess restaurant food at reduced prices.
• Selling unused data is now conveniently done through various applications such as Dove Network.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Monopolistic Competition
• Economic Equilibrium
• Demand Curve
• Law of Supply
• See all economics resources