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Excess capacity

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Business Economics

Definition

Excess capacity refers to a situation where a firm produces below its maximum potential output level, leaving some resources underutilized. This phenomenon often occurs in industries characterized by oligopoly or monopolistic competition, where firms have the ability to set prices above marginal costs. Companies may operate with excess capacity due to various reasons, such as fluctuating demand or competitive pressures that prevent them from maximizing production.

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5 Must Know Facts For Your Next Test

  1. Firms in oligopolistic markets may maintain excess capacity as a strategic choice to deter entry by potential competitors.
  2. In monopolistically competitive markets, firms may experience excess capacity due to their inability to perfectly match production with consumer demand for their differentiated products.
  3. Excess capacity can lead to inefficiencies in production and higher average costs per unit, impacting a firm's profitability.
  4. Some industries may have excess capacity during economic downturns when overall demand decreases, leading to idle resources.
  5. Firms with excess capacity may engage in price competition or promotional strategies to increase demand and fully utilize their production capabilities.

Review Questions

  • How does excess capacity impact pricing strategies in an oligopoly?
    • In an oligopoly, firms may choose to maintain excess capacity as a way to influence market dynamics and deter new entrants. By producing less than their maximum capacity, these firms can avoid aggressive price competition, which can erode profits. Instead, they might engage in non-price competition or limit output to sustain higher prices, creating a stable but less efficient market environment.
  • What role does excess capacity play in the strategic decisions made by firms in monopolistic competition?
    • In monopolistic competition, firms face downward-sloping demand curves for their differentiated products. Excess capacity becomes a factor as firms struggle to align production with fluctuating consumer preferences. They might choose to operate below full capacity to remain flexible and responsive to changes in demand without risking overproduction, thus allowing them to adjust prices and maintain profitability in the face of competition.
  • Evaluate the economic implications of excess capacity on overall market efficiency and consumer welfare.
    • Excess capacity can lead to inefficiencies in markets characterized by oligopoly and monopolistic competition, as it results in underutilization of resources and higher average costs. This inefficiency can translate into higher prices for consumers, reducing consumer welfare. However, it can also create some stability in prices and output levels that may benefit consumers by providing variety and innovation in products, depending on how firms leverage their excess capacity strategically.
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