What is Excess Capacity?

Excess capacity refers to a situation in which the demand for a company's goods and services is less than its productive capacity. The result is an excessive investment in machinery and staffing, which reduces its profitability and cash flows.

Causes of Excess Capacity

An excess capacity situation can arise during the low point in a seasonal industry, where capacity is maintained to match the peak part of the season. Excess capacity can also arise when customer demand has permanently declined, which could be an opportunity for a firm to cut back on the amount of its capacity to reduce costs.

Economic Effects of Excess Capacity

When there is excess capacity in an industry, prices tend to decline. This is because producers want to sell as many units as possible in order to pay for their fixed costs, and are willing to drop prices in order to attract more business. This situation can result in the bankruptcies of financially weaker firms. The effect is especially pernicious when the cost to exit an industry is high; in this case, too much production capacity remains within an industry, resulting in extreme price-cutting among the market participants.