AS Macro Key Term: Spare Capacity

Spare capacity measures the extent to which an industry, or economy is operating below the maximum sustainable level of production - there are spare factor resources of land, labour and capital. There are many measures of capacity utilisation including surveys of business activity, the estimated output gap and the rate of unemployment in the labour market.

United Kingdom, Current level of capacity utilization in manufact… from Timetric

There are several reasons why a business will operate with spare capacity:

Lower demand:
- General reduction in market demand (e.g. during the credit crunch)
- Loss of market share (perhaps unsuccessful marketing, competitors introduce better product)
- Seasonal variation in demand - i.e. temporary, but expected spare capacity

Increase in capacity not yet matched by increased demand
- Possibly because new technology has been introduced in anticipation of higher demand in the future
- Improvements in productivity mean capacity increases for a given level of demand
- Be careful that the business has not over-invested in fixed assets

Provide some “slack”
- Allow some spare capacity to be able to respond to short-term or unexpected increases in demand
- Provide time for maintenance, repairs and training

Inefficiency
- A problem = less competitive - implies higher unit costs than the competition

United Kingdom, Industry - quarterly data, Seasonally adjusted da… from Timetric

Does spare capacity matter?

There are some potential downsides to operating with spare capacity:

- Higher fixed costs per unit produced implies lower profitability than could be achieved
- De-motivated employees: boredom, fear of job losses (factory workers who have been made redundant often say that they could “see it coming” because production had been quiet
- The opportunity cost of the spare capacity - the returns foregone from the cash invested

However, it is often said that a business should maintain a capacity buffer - somewhere around 10% of capacity to allow for unexpected demand, staff training and development. Spare capacity can be useful in that it allows businesses to respond to short-term or an unexpected increase in demand, when there is some productive slack, supply is price elastic. It also provides time for maintenance, repairs and employee training.