Overcapacity

Picture a year when ship orders were backed up and prices were rising. With so much work, shipyards decide to dig more docks. But digging one big new dock takes years. Good prices don't mean you can build more ships starting next month.

By the time the new docks open a few years later, orders have already cooled. The bigger problem is that more than one company made the same call. Companies that saw prices rising each expanded on their own, and all that capacity came online around the same time. Decisions that each made sense alone piled up, and the whole industry's capacity ended up above demand.

People easily mix this up with a game of chicken. A game of chicken is a standoff where both sides hold out and lose together, waiting for the other to back down first. Overcapacity isn't built to fight. It's what's left over when equipment that each company built by its own math piles up. Still, the spare capacity can later be used as a weapon in that kind of fight.

When prices drop below cost, it seems like factories should just shut down. In practice, they usually don't. A factory has money going out whether it runs or sits idle. Interest on borrowed money, the wear and tear on equipment, and the workers you need to keep are examples. These are called fixed costs.

Costs that only come up when you run, such as raw materials and electricity, are called variable costs. As long as the selling price is above the variable cost, running loses less than shutting down. The money left over covers at least a little of the fixed costs. So lines keep running at a loss, products keep coming out, and prices struggle to climb back up from the bottom.

Removing capacity isn't easy either. Demolition and severance take a lot of cash all at once, and the company that cuts first ends up handing its place to the ones that stay. So cutting production is easy to put off, with everyone waiting for someone else. If a government also steps in to hold on to jobs, the spare capacity stays even longer.

This is easy to confuse with sunk cost. A sunk cost is money already spent that can't be recovered, and continuing a bad decision because you hate to waste that money is called the sunk cost fallacy. Keeping a loss-making line running isn't about not wanting to waste money. It's the result of short-term math.

This is on a different level from a big pile of inventory in a warehouse. Inventory can be sold or dumped cheaply and gone within months, but capacity takes years both to build and to remove. So excess inventory can clear in a single season, but overcapacity drags on for years.

It also points to something different from a recession. A recession is a period when demand has sunk. Overcapacity is about the equipment still standing after that period ends. Even when demand returns, if more capacity is still there, prices won't rise as high as before.

It must also be told apart from countercyclical investment. Countercyclical investment is one company's choice of timing, deciding to start building during a downturn while others are cutting back. Overcapacity is the state left across a whole industry when many companies' decisions pile up. One is a timing a single firm picks, and the other is the condition of the whole industry, so they sit on different levels from the start.

It isn't defined by the outcome, either. Capacity built during a downturn also becomes a burden if the next boom never comes, but that doesn't change the name of what the company did. In the same way, the docks from the earlier example were sold on the strength of a boom, so whatever happened afterward, they were never countercyclical investment. Still, whichever way the capacity was added, when many companies' capacity is left over all at once, it piles up in the industry as overcapacity.

A little spare capacity is not a problem in itself. Keeping some room for when orders surge is normal. It becomes a problem when that room is so large that it isn't filled even after several years.