Overcapacity Hobbles U.S. Economy
Subject Productive Capacity
Topic Productivity and Growth
Key Words Capital Goods, Investment Demand, Expected Profits, and Overcapacity
News Story

One of the biggest remaining obstacles to U.S. economic recovery is beginning to fade as firms are reducing the huge overcapacity that has been built in to the economy in recent years. Capital spending by businesses has fallen 11% in the last three years, but existing projects, such as office buildings, take a long time to construct and they come on line at a time when they are not needed. Manufacturing capacity expanded by more than a third in the five years through mid-2000, the largest such expansion in 50 years. In the last 12 months, however, capacity growth has hung at only 0.7%.

Certain industries face contractual agreements that prevent them from reducing capacity. The big three automakers, for example, have clauses in their contracts with the United Auto Workers that prevent the companies from closing plants while contracts remain in effect, regardless of economic conditions. This clause prevents management from adjusting capacity to meet current demand, resulting in overcapacity.

The overcapacity problem leads businesses to slow capital spending on new buildings and equipment, except for replacing factories and machinery that wear out. As demand picks up with the growing economy, businesses will be able to fill the demand without building new facilities. They will simply use existing overcapacity to produce the needed goods and services. This upward trend in demand will eventually boost profits and help firms resist the pressure to cut prices just to make sales.

The telecommunications industry suffers from extreme overcapacity due to the construction of too many fiber-optic cables by several different companies. A slump in leasing prices, especially on trans-Atlantic firer-optic lines, means "no new cables are being built or even discussed," says Alan Mauldin, an analyst at TeleGeography, a telecommunications consulting firm. "No one has any money to do it anyway if they wanted to." With Internet traffic rising briskly, the overcapacity will slowly be reduced, but Mr. Maulding said it will take more consolidation among carriers to stabilize prices.

Firms with excess capacity have little incentive to invest in new capital spending projects. If the capacity glut continues to lessen, it will be good news for the economy. Recent reports show increased spending in all areas of the economy, and a business sector that expects profits to rise once again; thus firms will start building new plants and purchasing new equipment. In this scenario, new hiring will not be far behind.

(Updated October, 2003)


Define overcapacity.

2. Explain the relationship between expected profit and investment demand.
3. Explain overcapacity in terms of its affect on business investment?
Source Greg Ip, "Long a drag on the Economy, Capacity Glut Begins to Ebb," The Wall Street Journal, September 8, 2003.

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