A situation in which a firm is producing less than the maximum it is capable of producing. A firm may hold excess capacity to meet random flucniations in demand. Alternatively, the firm may have undertaken the past fixed investment to meet a higher level of demand than it is currently facing. Excess capacity may also be a strategic choice: investment in capacity signals a credible commitment to raise output if a potential competitor chooses to enter the market. This is an example of strategic entry deterrence.
Reference: Oxford Press Dictonary of Economics, 5th edt.