Although overbuilding is a critical problem in capacity expansion in a commodity business, there is a strong tendency toward capacity expansion. The risk is most severe for two reasons, i.e., demand is cyclical, and products are not differentiated.
Cyclical demand leads to optimistic expectations in upturns while the second reason makes costs crucial to competition, sales are tied to the amount of capacity, and ensure “adequate capacity to achieve their target market share.”
Pros And Cons Of Tail Risk Funds
Editor’s note: This article is part of a series ValueWalk is doing on tail risk hedge funds. The series is based on over a month of research and discussions with over a dozen experts in the field. All the content will be first available to our premium subscribers and some will be released at a Read More
Michael Porter in Competitive Strategy Techniques for Analyzing Industries and Competitors divided the commodity business and other businesses into the following categories with brief details.
- Adding capacity in Large Lumps: “The necessity to add capacity in large units increases the potential for overcapacity.”
- Economies of Scale or a Significant Learning Curve: The cost advantage obtained by firm's that add capacity early will motivate other companies to move quickly and aggressively.
- Long Lead Times in Adding Capacity: Porter extensively wrote in the book of Competitive Strategy; “Long lead times penalize the firms that are left behind and motivates them to add more capacity.”
- Increased Minimum Efficient Scale (MES): He believed that “as larger size plants are built, the minimum efficient size plant increases to motivate firms to keep building larger capacity.” For example; the capacity of supertankers ordered in the early 1970s far exceeded the market demand.
- Changes in Production Technology: “New production technology attracts investment in new plant capacity, but the older facilities tend to remain in service because of exit barriers.”For example; this situation is occurring in the production of chemicals.
- Significant exit barriers: Inefficient excess capacity remains in the market where exit barriers are necessary.
- Forcing by Suppliers: Behavior by suppliers can force overcapacity by subsidies, or price cuts.
- Building Credibility: Overcapacity is sometimes needed in industries to motivate buyers to switch to a new product otherwise they will be vulnerable to the suppliers.
- Integrated Competitors: “If competitors are integrated either downstream or upstream, there will be pressure on them to overbuild capacity to protect these operations so that they do not lose market share.”
- Capacity Share affects demand: As buyers are prone to approach airline firms, greater capacity may get the disproportionate share of the market.
- Age and Type of Capacity Affect Demand: “Having the most modern, well-decorated fast-food outlet may yield competitive benefits because capacity is marketed directly to the buyers.”
A large number of firms gain market position, the lack of a robust and credible market leader, new entry with low entry barriers, and motivation from first mover advantages contribute to the overcapacity problems.
Highly optimistic and overinflated demand expectations promote overexpansion. Divergent misestimates or assumptions and perceptions of competitor’s strength, resource, and staying power may lead to overexpansion. Signals that are stable support orderly expansion, while distrust of market signals causes instability. As structural change needs the firms to invest in new plant, overbuilding of capacity occurs. By asking excessive questions to the management, financial communities and analyst create pressures to increase expansion.
“Capacity overbuilding seems to be particularly liable to occur when production has been the traditional concern of management.” Asymmetric aversion to risk is the cost to the firm that is left behind because of a lack of capacity is higher than the value of overbuilding capacity.
Tax incentives that tax un-invested profits or that allows tax-free retention of earnings by U.S. subsidiaries can encourage overinvestment. If the minimum efficient scale is large relative to the world market, the desire by many countries to establish a position to lead to overcapacity. Governments may pressure firms to invest in capacity expansion to maintain employment and reduce unemployment.
Limits to Capacity Expansion:
There are some checks against the tendency for overbuilding including financing constraints, company diversification, an additional cost of new capacity, uncertainty about the future, and previous periods of overcapacity. Some firms may discourage expansion in various ways. For example “they may announce a large addition, or release discouraging messages about future demand, or predict technological obsolescence of the current capacity in the industry.”
Porter stated that “Under capacity in an industry is rarely a problem since it will usually attract new investment. Overbuilding is indeed a chronic problem that has repeatedly and severely plagued many industries—paper, shipping, iron ore, aluminum, and many chemical businesses, just to name a few.”
Moroe from the book here