The Causes and Symptoms of Overcapacity

Overcapacity, where an industry can produce more than customers currently demand, is the result either of a fall-off in demand or the expansion of competition. During the 80s and 90s, three quarters of the industries that went into overcapacity did so as a result of expansion of competition. Industries such as semiconductors, airlines, mini-computers and even orange juice went into hostility as competitors expanded faster than demand grew.

More recently, though, most of the industries going into overcapacity have suffered from a major fall-off in demand as the world-wide economy slips into recession. Any industry associated with residential building is now in overcapacity, as new housing starts to plummet. Mall owners are suffering as retailers go out of business.

Even very low cost competitors in an industry suffer when the industry goes into overcapacity due to a fall-off in demand. During the 80s, much of the U.S. domestic textile industry shifted off shore to low-cost producers such as India. But in this latest economic crisis, even the Indian textile industry is suffering from overcapacity. Textile employees in India in the least-skilled jobs may earn only $2.00 a day. But many of them are losing their jobs as European and American clothing retailers slash orders.

No matter how an industry enters overcapacity, it will follow a common evolutionary pattern. (See the Perspective, “Success Under Fire: Policies to Prosper in Hostile Times” on StrategyStreet.com.) There are six phases to this evolution:

Phase 1: Margin pressure. Competitors begin discounting to maintain their utilization rates. As a result, prices and margins fall throughout the industry.

Phase 2: Share shifts. Some competitors, often the leaders in the industry, refuse to go along with the price declines spreading throughout the industry. We call this phenomenon the Leader’s Trap. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.) This occurs early in overcapacity and causes significant early share shifts from high-priced to low-priced competitors. Following this early shift in shares, the industry will see additional shifts in shares due to the flight quality from less reliable to more reliable competitors and due to acquisitions.

Phase 3: Product proliferation. The industry floods the market with new products in order to reignite customer demand. These new products include bundling of benefits in an attempt to upgrade the product by adding additional features or functions, and product unbundling, where the innovator seeks to remove product features to reach a new, lower price point.

Phase 4: Self-defeating cost reduction. Inevitably, companies face the need to reduce their costs. The less successful companies reduce costs at the customer’s expense. They do so by conscious decisions leading to feature failure, where the company delays matching popular new product features, quality slippage, where the company does not keep pace with the industry’s quality and delivery standards and distribution conflicts, where manufacturers seek to shift their margin pressure away from themselves on to their channels of distribution.

Phase 5: Consolidation and shake-out. Over time, the industry goes through several waves of consolidation and shake-out where new, stronger companies emerge and weaker firms are absorbed.

Phase 6: Rescue. Once an industry enters overcapacity, it can stay hostile for a number of years. The American automobile industry and the airline industries have been hostile for well over twenty years. An industry is rescued from hostile conditions by demand growth in most cases. The industry demand gradually catches up to industry capacity and prices rise to encourage new investment once again. A few industries see a rescue from the consolidation and rationalizations in the industry that reduce industry competition to three or four players who control more than 80% of the total market. Often, these industries will develop “gentlemanly” competition where true price competition is rare. Industry prices then rise to attractive levels. The industry is no longer in overcapacity because competitors will not discount against one another to use marginal capacity.