What does the term 'excess capacity' mean in economic terms?

The concept of 'excess capacity' refers to a situation where a firm is producing less than what could be achieved at the lowest average total cost, which corresponds to the optimal scale of production. In other words, when excess capacity exists, a firm is not fully utilizing its capabilities and resources, leading to higher average costs than necessary.

When production is at a level below where average total costs are minimized, the firm could increase output and lower per-unit costs by taking advantage of economies of scale. This is often seen in monopolistic competition, where firms have some market power but do not produce at the most efficient point because they are facing a downward-sloping demand curve that allows them to set prices above marginal cost.

In contrast, producing at maximum output does not imply any excess capacity, because it indicates full utilization of resources. Also, producing more than demand would not reflect the true nature of excess capacity; it would likely lead to unsold goods and inefficiencies. Lastly, using all available resources efficiently means there is no excess capacity, as resources are being fully employed to meet output demands. Thus, the identification of excess capacity is directly tied to the relationship between actual output and the output level that minimizes average total cost.