hile conceding that songwriters and poets can make a strong case for "I
love you," economists know that the three little words that really make
the world go around are "supply and demand." This familiar marketplace
mantra - its symmetry at once both elegant and illusory - has, like
nearly everything else in business, grown more complex in the age of the
global economy. In fact, according to some observers, the implied
balance between its two component parts may be tilting increasingly
askew, even as the world's economy and its various participants enter
new, uncharted territory.
Overcapacity - too much product (and too much production capability) chasing too few buyers - is hardly a new phenomenon. As a factor in market capitalism, overcapacity has been recognized and analyzed as a business-cycle reality by economic thinkers ranging from Karl Marx to Adam Smith. At HBS, Joseph L. Bower, the Donald K. David Professor of Business Administration, in his 1986 book, When Markets Quake, documented the problem as it affects the petrochemical industry. He has also observed it in other sectors over the years. "In one industry after another," Bower notes, "the market has not worked the way it's supposed to."
Bower continues: "Theoretically, when an industry has excess capacity, prices fall and the least efficient producers can't survive." But, Bower adds, that doesn't always happen. "In many countries, for all sorts of economic and political reasons - governments fearful of job layoffs and lost revenues, for example - weak companies are artificially supported," he explains. "Other firms won't or can't restructure themselves or exit unprofitable businesses because they are too set in their ways, lack sound governance systems, or are hindered by a variety of other constraints and pressures. It can be a brutal situation." Indeed, as the Wall Street Journal's front page proclaimed last fall in the wake of the downturn in Asia, overcapacity has become "a dire and obvious problem for countries around the world."
Typically, the seeds of overcapacity are planted when markets are booming. Banks and companies, eager for a piece of the action, invest heavily in production capability. Not surprisingly, a market can soon become saturated with too much product; consequently, demand drops, revenues slow to a trickle, loans and debts go unpaid, and economies suffer. In recent years, sectors as diverse as automobiles, semiconductors, steel, textiles, consumer electronics, tires, and pharmaceuticals have been afflicted by overcapacity and some or all of its unpleasant side effects: loss of jobs, plant closings, the pain of restructuring or relocation of entire industries overseas, trade friction, and government intervention. Recession - and fears of even worse - often follow.
Forecasts and the Eye of the Beholder
Lately, such repercussions have been felt around the world, particularly in Asia. Along with real-estate and financial speculation, overcapacity in several manufacturing industries has been identified by some observers as a key factor in the current economic crisis in that region, a collapse that has been called the greatest threat to the world's economic stability in fifty years.
Overcapacity per se isn't necessarily bad. With excess supply, prices go down; that's good for the consumer's pocketbook as well as for those industries benefiting from low-priced materials or commodities. In addition, overcapacity often springs from innovation - an improved product muscles into the market alongside previous versions, now rendered passé. The result may be a temporary glut, but one that is a result of progress, which is good for the overall economy. Furthermore, when overcapacity produces a drop in demand, production usually slackens, excess supply is gradually drawn down, and, over time, supply and demand eventually come back into alignment.
But excess capacity can also mean serious difficulties for companies in afflicted markets and can bring with it - as the current global downturn reminds us - the risk of recession. It is sometimes difficult to understand, therefore, why this predicament persists. In a modern global economy, closely linked by commercial and trade activity and agreements, with mountains of up-to-the-minute data available to firms and governments for making sophisticated projections, why do industries and countries continue to overproduce and create such potentially harmful gluts?
HBS associate professor Willis Emmons, who teaches Business, Government, and the International Economy in the MBA Program, cites several periods in history when excess capacity has been blamed for economic upheaval. Emmons says that "accurate business forecasting is never really possible when dealing with variables such as political change, technological breakthroughs, market deregulation, consumer preference, or even weather and climate." Any of these factors, he argues, may affect particular markets, which in turn influence related markets and send ripples through the larger economy.
Furthermore, Emmons notes, excess capacity is often in the eyes of the beholder. Producers may jump into a saturated market, convinced they will produce better quality goods more cheaply than their competitors. Or, if producers are willing to undersell competitors, they will likely find demand no matter what, at least as long as the market keeps growing. And some cyclical industries may even intentionally overbuild. All in all, "it's hard to say that there's an exact amount of production that's appropriate at any point in time at any given price," Emmons cautions.
ARICLE CONTINUES