Excess Capacity

Published Mar 5, 2023

Definition of Excess Capacity

Excess capacity is defined as the unused production capacity in a market. This means that production levels are lower than they could be, given the existing technology and available resources. Or in other words, it is an underutilization of the resources available in a market.

Example

To give an example, let’s look at the airline industry. Most airlines have planes, pilots, and other staff. However, not all of the planes are used at all times, leading to excess capacity. This is partly because airlines want to have extra planes available to meet increasing demand or to replace a grounded plane. Now, suppose there is a sudden decrease in demand for flights. In this case, the airlines may continue to operate flights at reduced capacity to ensure that they maintain market share, even if that means running flights with a significant number of empty seats. The result is less efficient operations, leading to even more excess capacity.

Another example of excess capacity can be found in the construction sector. Suppose the demand for housing drops. In that case, developers may continue to build new houses, even if the market temporarily doesn’t have enough demand for them. As a result, houses may remain unoccupied or have tenants below market rental rates, representing an under-utilization of resources.

Why Excess Capacity Matters

Excess capacity is a significant problem for businesses because it results in costs that cannot be offset by the sale of goods or services. This excess capacity represents lost opportunities for firms to generate more revenue while incurring the same fixed costs.

Furthermore, excess capacity can lead to inefficiencies, which, in turn, can cause prices to rise, reducing the competitiveness of firms in the market. For these reasons, businesses should take measures to reduce excess capacity, e.g., by adjusting production or reducing fixed costs, to improve efficiency and maintain a competitive edge in the marketplace.