Understanding Overcapacity – Supply vs Demand

Author: Samant Nagraj

All ESRs already have a plan about their future, after the PhD. One might want to become a professor or a researcher or another might want to become a consultant or perhaps an entrepreneur. But, whatever field they might choose, they will become an influencing person of a huge system called market. So, it is important for them to know various aspects of the market and their behavior. The main motive behind this article is to give the reader an insight on the behavior of the market in the perspective of supply and demand. In this article, I focus on the one of the biggest problems in many industries and how to tackle it.

We all have learnt that excess of anything is bad in an easier or painful way. Is there any exception to this rule? I believe not, especially in the world of economics. Supply and demand are one of the most elemental concepts in economics and the anchor of market economy. It is a fundamental economic model to determine the price of a product in the market. A balance in supply and demand is essential for the market to run efficiently. The curve below explains the balance between supply and demand of goods and services. The economy of the market will be in equilibrium only if the supply and demand are in equilibrium or close to equilibrium. But, if the equilibrium is lost, the effects on the economy can be minor to devastating.

Supply vs Demand

When the supply is less than demand, there will be shortage of goods and services. Therefore, the demand for it increases. In a similar way, when the supply is greater than demand, there will be a surplus resulting in the decrease of the demand for the product.

Overcapacity is a state where a company produces more goods than the market can take. Everything in excess is called excess capacity and it is not good for the industry and the market. It is a huge problem and exists in many industries such as iron and steel, fishing, container shipping, airlines etc.

Overcapacity: Production is higher than demand

What are the problems associated with Overcapacity?

  • Unsold goods
  • Unfair trading
  • Wage cuts to unemployment
  • Economic losses
  • Reduced profits to collapse of the company
  • Long term and irreversible damage to the industry

Which industries are most effected?

  • Steel industry

Steel is a very important and the most used metal in the modern human history because of wide range of applications and low cost. But, the steel industry is collapsing rapidly in an unrecoverable manner because of the overcapacity and the main culprit is China. In the 1622Mt of global steel produced in 2015, 804Mt came from China. It is estimated that over 50% of the steel produced in China is surplus. To get rid of this excess capacity, China is dumping it across the world at extremely low price. Unable to compete with Chinese market, many companies are incurring huge losses and shutting down. Only a few companies remain in the market who are earning enough profits to ensure long term sustainability.

The degree of overcapacity changes with regions. The graph below gives the magnitude of overcapacity in various regions in 2013 [2].

Effective overcapacity in different regions/countries and the world

Lack of profitability brings less investments for innovation. Most companies would benefit from a reduction in overcapacity by balancing the supply and demand to increase profits in the future, but they are reluctant to take on the costs involved and see other companies benefit.

  • Container shipping industry

Container shipping is one of the three methods of intermodal cargo transportation around the world in a standardized container. About 90% of cargo worldwide is transported using this method and the remaining 10% uses trains and trucks.

Return on net assets / utilization of assets of shipping companies every year [3]

Before 2008 global economic crises, container shipping industry was booming with more than 10% increase in demand every year. To keep up with the demand and the increasing fuel prices, shipping companies invested to buy 3.1 million new containers and new fuel efficient vessels as much as 50% of the existing ones. In the year following the economic crises, the demand went down by 50%. The new vessels and containers, which were ordered before the economic disaster, overflown the market creating an overcapacity in the container shipping industry [3]. However, by implementing cost reduction, the industry’s overall profitability started increasing slowly since 2011.

What can we do to overcome this problem?

Over the years, many companies have developed several strategies to overcome overcapacity. Hereunder, I have discussed some of the most commonly employed strategies.

  1. Lowering the production

Depending on the market situation, a company can adjust the demand by producing less than its capacity. It can adapt via different strategies depending on the market situation. For example, if the difference between demand and production is less, strict control and effective management on the production on temporary basis will do good to both the market and the company. It will allow the market to recuperate. But, if the difference is bigger, many factors come into play to bring the market into control such as the size of the market, number of producers, price history of the goods etc.

Problems/challenges involved in this strategy:

  • Low profitability
  • Wage cut down
  • Unemployment
  1. Selling the product at reduced price

The products are sold at lower prices to increase the demand until the market stabilizes. This kind of strategy is well suited in transportation business.

Problems/challenges involved in this strategy:

  • Low profitability
  • Wage cut down
  • Reduced value of the product
  1. Exporting

The excess capacity is exported to different areas (states, countries etc.) where the demand for the product exists. But, when exporting a product into a different area, several laws laid by the local governments and World Trade Organization (WTO) come into play. Which means, the company must follow trading laws of that area to allow fair trading. Some important fair trading laws are as follows:

  1. If a company exports a product at a price lower than the price it normally charges on its domestic market, it is said to be “dumping” the product. To overcome this unfair trade, WTO came up with a set of rules on how local governments can and cannot to dumping and it is called Anti-dumping agreement [1].
  2. To protect the domestic companies, safeguard tariffs are imposed on the goods which are being imported. Which means, the buyers cannot import more than the allowed number of products in an area in a certain period of time.
  3. The company must pay import and export taxes.

 Problems/challenges involved in this strategy:

  • Fair trade laws
  • More competitors
  • Increased price of the product

Above listed strategies are very few of several. However, there are no standard solutions to this problem and it cannot be solved in one stroke either. It is a long-term process with multiple measures taken collectively by industries and the government. Many economists and experts in their respective fields around the world are working to overcome this problem.

References

[1] “Anti-dumping,” 15 03 2017. [Online]. Available: https://www.wto.org/.
[2] Felix Schuler, “Coping with Overcapacity: Navigating Steel’s Capacity Conundrum,” Boston Consulting Group, Dusseldorf, 2014.
[3] Ulrik Sanders, “Battling Overcapacity in Container Shipping,” Boston Consulting Group, 2015.
[4] I. Perera, “Weak demand and overcapacity to be looming dangers for container shipping industry,” The Chartered Institute od Logistics and Transport, 2014.
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