Excess capacity results in weak pricing power as excess supply chases demand.
In evaluating the future competitive environment in an industry, we should examine current capacity levels as well as how capacity levels are expected to change in the future.
It is important to keep in mind that:
- If new capacity is physical (e.g., manufacturing facilities) it will take longer for the new capacity to come online so tight supply conditions may linger on for an extended period. Usually however, once physical capacity is added, supply may overshoot, outstrip demand, and result in weak pricing power for an extended period.
- If new capacity requires financial and human capital, companies can respond to tight supply conditions fairly quickly.