Would the market mechanism cause the formation of overcapacity?: Evidence from Chinese listed firms of manufacturing industry

Most studies on overcapacity in China focus on the effect of policy or institutional mechanisms. Whether or not market mechanisms have induced overcapacity in China is a controversial subject. Most existing theories on the effect of market mechanism in inducing overcapacity do not apply to developing countries, whose economic realities are inconsistent with the assumptions embedded within these theories. In this paper, we have put forth a theoretical explanation for overcapacity formation in China from market mechanisms, which may also be adaptable to other developing countries. we study the market allocation mechanism of investment and production capacity and explore the formation mechanism of overcapacity in China using a three-phase investment model. The theoretical analysis shows that the market mechanism conditionally causes overcapacity; the market's strong effect on investment and weak effect on capacity exit cause overcapacity. The investment of Chinese listed firms in the manufacturing industry is induced by expansionary market signals; the inductive effect of high expansion signals on enterprises' investment and capacity allocation is remarkably stronger. The market induction mechanism for capacity exit during a slump period also lacks efficiency—the market will likely induce overcapacity. A heterogeneity test confirms that the nonlinearity of the market induction effect and the rigidity of market capacity exit are widespread among enterprises in the manufacturing industry.