AbstractThis paper investigates the effects of zombie firms on Chinese manufacturing capacity utilization rate (CUR hereafter) from the perspectives of both the intra‐industry and supply chain propagation. The results show that zombie firms not only significantly reduce the CUR of healthy firms in the same industry, but also inhibit the increase of CUR through the supply chain propagation. Specifically, if the supply chain propagation effect is not considered, the inhibitory effect of intra‐industry zombie firms on the healthy firms' CUR would be overestimated on one hand, and the overall inhibitory effect of zombie firms on CUR would be underestimated on the other hand. The heterogeneity analysis demonstrates that the inhibitory effect of zombie firms on CUR is more pronounced for private firms, the firms in the industries with higher external financing dependence and the firms in the areas with a poorer institutional environment. In addition, this paper further studies the relationship among zombie firms, resource misallocation and the manufacturing aggregate CUR at the industry level, and finds that both intra‐industry and upstream (downstream) zombie firms have significant inhibitory effects on the growth of manufacturing aggregate CUR. However, there are differences in the ways of influence that, specifically, the upstream (downstream) zombie firms inhibit manufacturing aggregate CUR growth mainly through the within‐firm effect, while the intra‐industry zombie firms are more likely to restrain manufacturing aggregate CUR growth through resource misallocation. Our study contributes to a profound understanding of the causes of overcapacity in a large transition economy and also expands the research perspective of assessing the economic effects of zombie firms.