What is meant by excess capacity in a firm?

Excess capacity refers to a situation in which a firm can produce more goods than it is currently producing, but it is not doing so. This concept is closely tied to the efficient scale of production, which is the level of output where the firm minimizes average costs and fully utilizes its resources. When a firm operates below this efficient scale, it is said to have excess capacity.

Therefore, the correct interpretation of excess capacity is that it indicates a difference between actual output and the efficient scale of production. The firm has the potential to increase production without needing to invest in additional resources or capacity, yet it chooses not to do so for various reasons—such as not having sufficient demand or strategic decisions to maintain a certain level of output. Understanding excess capacity helps to analyze market conditions and the operational efficiency of firms, particularly in industries characterized by fixed costs and varying demand.