While 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.

The Rush to Implement

Historically, overcapacity has been viewed as a recurring and predictable (however imprecisely) constant of capitalism - a sometime skunk at the market economy's otherwise celebratory garden party. But several modern-day developments, including the primacy of rapidly evolving, widely available technology and the emergence of the global marketplace, suggest to some that the impact of excess capacity as a factor in the world economy could increase in the coming decades.

Michael C. Jensen, the Jesse Isidor Straus Professor of Business Administration, is a member of the Organizations and Markets Unit at HBS. He sees a new global dynamic at work as the result of a "third industrial revolution" whose origins in the United States, he says, can be traced to the leaner and meaner approach to corporate operations that was spurred by the tenfold increase in energy prices during the 1970s. From that period on, a succession of events - the movement toward corporate efficiency, reorganization, and innovation; deregulation; technological advances; and the globalization of markets - has consolidated this revolution, Jensen believes.

These forces, according to Jensen, have also contributed to chronic excess capacity in a number of industries. "The most familiar manifestation of excess capacity," he explains, "is when market demand falls below the level required to yield returns that will support current production capacity. This is the 'demand-reduction' scenario commonly associated with recessions."

To this traditional formulation, however, technology adds an increasingly dynamic dimension by dint of its exponential power to boost output while reducing costs through speed and efficiency. Another feature of technology, its ability to produce innovation, can also quickly render existing products obsolete or too expensive, leaving a market saturated with outdated, overpriced product. (Ironically, overcapacity can still be found in industries that use innovations such as just-in-time manufacturing techniques, which theoretically should help keep inventories low.)

"Excess capacity can be further aggravated," Jensen says, "when many competitors rush to implement new, highly productive technologies without considering that all this simultaneous investment will result in much more capacity than the final product market will demand at current prices." (The resulting price declines, he notes, serve to increase the quantity demanded and to reduce the quantity supplied.) "In the years ahead, competition from these sorts of new entrants joining already overburdened markets will only get more intense."

No Exit?

Both Bower and Jensen tend to focus on excess capacity in terms of what it means to developed-world industries, companies, and managers that are directly affected by the problem. In such cases, the overriding concern for firms becomes whether to restructure or otherwise change existing arrangements, or to exit the business in question altogether. These are realities that companies (and often national governments) find extremely difficult to deal with for a variety of reasons.

Bower, for his part, believes that enlightened management and intra-industry cooperation (with government playing a positive support role where needed) - an approach that he says the U.S. petrochemical industry has successfully used - can help solve overcapacity dilemmas elsewhere in the world. Jensen, arguing for the salutary effects of the financial markets, says that merger and takeover activity - "the market for corporate control" - can, if it is permitted to, perform this function, as he believes happened during the 1980s. As an example, he cites the U.S. tire industry, which saw every one of its major firms either restructured or taken over during that decade.

Long an expert on the automobile industry, Malcolm S. Salter, the James J. Hill Professor of Business Administration, currently focuses his research on corporate strategy and governance. He shares Jensen's view that something akin to a modern revolution has taken place in recent years and that one result is a growing problem with overcapacity, a situation he believes is best resolved through the workings of the capital markets and the restructuring process, be it voluntary or involuntary.

Salter explains that, on a global scale, overcapacity is linked to demographics. "From Asia alone, there will soon be over one billion laborers earning less than $4 a day dominating the world's workforce," he observes. "Compare that with the U.S./EEC worker who earns $100 a day, and it's obvious where companies are going to choose to build and invest. Many exposed Western firms will have to exit certain businesses, redeploy resources to more productive ventures, and shut down large chunks of capacity - which competitors will more than happily make up for overseas," he predicts.

That all has social fallout, of course. Salter notes that one result in the United States will be a widening income gap as a growing pool of less-educated, low-skilled American workers see jobs that match their abilities increasingly exported abroad. "There should be a strong platform placed under threatened employees," Salter argues. "That can be achieved by syndicating the risks of transnational layoffs through basic national health insurance, earned income tax credits, portable pensions, and targeted education and training."

The jobs of the future may be mostly created in Asia, but their low wages will effectively prevent Asian workers from being able to purchase many of the manufactured goods they are creating. Since their own internal demand and consumption will be insufficient to generate revenues to stimulate development, Asian and other emerging-market nations, in order to improve living standards for their huge and rapidly growing populations, will presumably look to production-for-export on a massive scale. Unfortunately, as Salter points out, this dynamic will create large amounts of excess capacity in many industries where Western manufacturers have traditionally been major players. "Given the many psychological and political barriers that impede exit and the removal of capacity from production in the developed economies of the West, the potential for political and social disruption is high," Salter declares.

Real Questions

Until the Asian downturn and its fallout, many emerging-market countries viewed technology-driven manufacturing as a way to leapfrog into the world economy by exporting highly value-added, highly remunerative industrial products to the developed world, as Japan and the Asian tigers had so successfully demonstrated. But that may be changing, says Pankaj Ghemawat, the Jaime and Josefina Chua Tiampo Professor of Business Administration and a member of the Competition and Strategy Unit. "Real questions are being raised about the idea that every country can simply export its way to prosperity," he says. "That should reduce concerns - which I believe are exaggerated - that there is a growing tendency toward chronic overcapacity in the world's markets."

Ghemawat notes, however, that in virtually every country, certain industries are deemed simply too fundamental, too prestigious, or too politically sensitive to be allowed to fail. Furthermore, he says, industries with large sunk costs - typically, basic manufacturing operations such as steel plants - are often the ones in which the consequences of excess capacity are the most severe and enduring. "The current worldwide glut in many industries has changed some thinking," Ghemawat says, "but hope springs eternal."

For proof of that - and of the vagaries attached to overcapacity - one need look no further than the United States, at a sector plagued for years by excess supply worldwide. The U.S. steel industry, overwhelmed by cheap imported product, last fall was loudly demanding protective tariffs. At the same time, however, some U.S. steelmakers reportedly were planning to boost production.

It remains to be seen, therefore, whether overcapacity will loom larger, smaller, or unchanged as an economic and business factor in an increasingly income-disparate, development-oriented, production-intensive, and competitive global economy of the future. In that context, what seems certain is that some companies and countries, when confronted with overcapacity, will nevertheless plow ahead with the kind of go-for-it attitude that recalls Oscar Wilde's observation that "nothing succeeds like excess."

In the years ahead, that's one economic theory that may get a real-world workout.

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