Excess Capacity – Complete Lesson with FAQ

What is excess capacity?

First of all, let’s consider the term of excess capacity. 

Excess capacity occurs when firms operating or producing under (less than) the optimum capacity. In other words, when firms operating on a lower scale than they have been designed, there will be excess capacity in these firms. The business firms have to produce at excess capacity because of the decreasing demand for products.

Has excess production capacity in the long run?

We can identify the term of excess capacity by studying the minimum point of the long-run average cost function.  So, it does not occur in the short run. Only, in the long run, excess capacity occurs.

What is the formula for excess capacity?

Excess Capacity = Optimum Capacity Output– Actual Output

What are examples of capacity?

1. In a manufacturing firm, employees are in the without of work. In other words, there are idle workers. So, there is an excess capacity of the employees.

2. In a restaurant, there are empty tables. So, the staff is working at under productivity in other words, less efficiency. In this restaurant, guests (customers) have not come to fill the entire number of tables. Demand is less than the capacity of this restaurant.

What is excess capacity under monopolistic competition?

We can identify four major types of market structures. They are perfect competition, monopolistic competition, oligopoly, and monopoly. To see them, kindly click here.

Monopolistic Competition, Oligopoly, and Monopoly firms operate at excess capacity while perfectly competitive firms operate at the efficient scale level in the long run.

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Monopolistic competition graph , characteristics & examples

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Because the production of monopolistically competitive firms does not align with the output at the minimum of the LAC curve, excess capacity continues to exist even when there are no economic profits generated by the firms.

We will graphically illustrate the long-run market situation of a firm in monopolistic competition.

Graph – capacity under monopolistic competition

In the above graph, the average revenue (AR) curve equals to demand (D) curve. The marginal revenue (MR) curve has been graphed as it is lower than the average revenue curve. The marginal cost curve has been labeled MC curve which is initially decreasing and after its minimum point, increasing. The long-run average cost curve has been labeled as the AC_LR which shows the unit per cost of each output level.

According to the above graph, in point E, MR=MC. The point where MR =MC can be considered as the profit maximization point or loss minimization point.  Profit maximization can occur at the over-capacity, efficient scale level, or under-capacity.

In this example, this monopolistic competitive firm operates at the point Q1. (Where MR= MC). So the price level equals P1 where the relevant price to Q1 production is. So, this monopolistic firm produces under the excess capacity in other words produces a lower amount of output than the optimum amount of output.

In the above monopolistic competitive firm, in point “D”, average cost comes to the minimum point. So, it is the efficient scale level.  Q2 is the optimum output level. But the firm produces in the point Q1 which is a lower amount of output than the optimum amount of output. So, Excess capacity is the difference between the Q2 output level and the Q1 output level. (Q2 –Q1).

Also, this firm earns a supernormal profit. Supernormal or abnormal profit means, the amount of the profit that exceeds the normal profit. Normal profit means a minimum level of profit is needed to keep the firm ongoing. It occurs when the average revenue equals to average income (AR = ATC). This monopolistic firm can earn normal profit at the Q2 output level. But currently firm produces a Q1 output level. So, supernormal profit equals BCAP1 rectangular.

What does no excess capacity mean?

Excess capacity occurs when firms operating or producing under (less than) the optimum capacity in other words less than the minimum efficient capacity. There is no excess capacity in the long run for perfectly competitive markets

In the long run, a perfect competitive firm comes to the minimum efficient scale where the long-run average cost curve comes to its minimum point. On this point, the firm allocates its resources efficiently in other words, the firm produces the maximum amount of output using an input or minimizing the wastage.

Before the efficient scale level, when a firm increases the output level, it can reduce the average cost (Economies of scales). After the efficient scale level, when the firm increases the output level, the average cost is increased. (Diseconomies of scale).

Let’s understand the market structure of a perfectly competitive firm which operates under an efficient scale in the long run.

According to the above graph, in point A, AR=D=MR=MC where profit is maximized. Because the point where MR =MC can be considered as the profit maximization point or loss minimization point. 

In this example, this perfectly competitive firm operates at the point Q1. (where MR= MC). So, the price level equals P1 where the relevant price to Q1 production is.

So, this perfectly competitive firm produces at efficient scale in other words it produces optimum amount of output in the long run. Because at point A, the firm’s long-run average cost curve comes to its minimum point. There is no excess capacity. Also, the firm earns the normal profit where average revenue equals average cost. (AR =AC).

Causes of excess capacity.

As the explanation by Professor Chamberlin, there are two major reasons for the excess capacity. They are,

1. Non-price competition

2. Despite entering the market

Let’s discuss them as follows.

1. Non-price competition

When sellers provide differentiated products or unique products to the customers, they can increase the prices hence their products are varied when compare with the other sellers’ products. Here, the demand curve is downward sloping. Because firms can influence to the price and firms compete using the non-price competition methods. This is a reason for the firms are operating less than the optimum capacity.

2. Despite entering the market

In Monopolistic Competition, Oligopoly, and Monopoly, when new firms enter the market, they have to face barriers. Also, there are barriers for exiting from the market. But, in the perfect competition market structure, firms do not have such kinds of barriers to enter the industry or exit from it.

Is excess capacity bad?

Although the word “excess capacity” is also used in the services industry, it mostly applies to manufacturing. It might signal healthy expansion. But having too much of it can harm an economy.