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Understanding Excess Capacity in Different Arenas With Examples

Understanding Excess Capacity with Examples
In simple terms, excess capacity is the situation where there is more capacity to produce than the requirement, and there are idle resources. When does excess capacity occur? This post helps you understand the concept better.
Neha B Deshpande
Last Updated: Mar 26, 2018
Did You Know?
Currently, the Chinese economy is facing the problem of excessive capacity.
Capacity is the 'ability' to do something. In business and economics, capacity means the ability to produce. Thus, the definition of excess capacity is the ability to produce more than there is demand. Similar to manufacturing, it also applies to the service industry. If you see idle human resources, it implies that the firm has excess capacity; however, the demand is comparatively lesser.
Excess capacity = Potential Output - Actual Output

As mentioned above, we see news reports that China's industry is facing the problem of excess capacity. Many industries no longer require any capital for expansion plans, and have to bear the increasing labor costs too. Thus, having overcapacity can prove harmful to the economy.
In business, excess capacity means a firm has more capacity to supply than its demand. A very common phenomenon observed is at some restaurants, where you find empty chairs and the staff being idle. What does this indicate? It indicates that the restaurant has capacity to accommodate more guests. However, the demand is not equivalent to its capacity.
What is Excess Capacity in Microeconomics?
A situation of excess capacity arises usually in the scenario of a monopolistic competition.

Monopolistic competition: It is that market, wherein, all manufacturers are selling products that are unique and not perfect substitutes of one another. In this market, any new firm is freely able to enter the fray. They tend to have excess capacity in order to provide for future growth in demand. It implies that a firm is operating at a level that is below that level of output where cost is minimum.
There is excess capacity always in a monopolistic competition, in the long run. Efficient sale is achieved at a point where 'Marginal Cost' is equal to 'Actual Cost'. Profit maximization occurs when 'Marginal Revenue' is equal to 'Marginal Cost', implying that there is an excess capacity left at the disposal of the firm. Thus, the difference between both the quantity levels is the excess capacity. The AC curve is downward sloping, which gives the firm an opportunity to produce more output at the same level than the actual production.
Monopolistic competition: graph indicating excess capacity
Excess capacity
MC = Marginal Cost Curve
AC = Average Cost Curve
AR = Average Revenue or Demand Curve
MR = Marginal Revenue Curve
Profit maximization is the level at which Marginal Cost = Marginal Revenue. Thus, the firm produces OQ level of output. However, the cost-minimization level is at OQ1. Hence, there is excess capacity. Thus, the difference between OQ and OQ1 is the excess capacity of the firm.
What is Excess Capacity in Business?
This means that the capacity to supply is more than the demand. If there is too much excess capacity, it may lead to the industry or factory getting converted into a sick unit.

➥ You may have more raw materials and factors of production than what is required. In that case, you will have excess capacity to produce. As a solution to this problem, the Just-in-Time (JIT) was developed to ensure that only the requisite raw materials were ordered as per production requirements. This also saves on the costs of storage.

➥ Empty chairs in a restaurant indicate that the capacity to supply is more than the demand.

➥ Idle salesmen, workers at a factory, idle machinery, etc., all indicate that there is excess capacity.

➥ There is new showroom for home decor and furnishing that has been set up in your locality. However, it faces threat from an old-known face in the market, that has its goodwill established over a period of time. Till the new firm penetrates itself into the market, it will have excess capacity. Until and unless customers approach the new showroom, its human personnel will also remain idle.
Having too much excess capacity can be harmful for an economy. Thus, though excess capacity indicates a sign of healthy growth, it also indicates that there is less demand for that product. Causes of excess capacity can also vary from incorrect prediction of market demand to inefficient allocation of resources. The management has to stay vigilant and consider divesting or any other strategy in this case.