Capacity utilization

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Capacity utilization or capacity utilisation is the extent to which an enterprise or a nation uses its installed productive capacity. It is the relationship between output that is produced with the installed equipment, and the potential output which could be produced with it, if capacity was fully used.

Productive capacity is the maximum possible output of an economy. According to the United Nations Conference on Trade and Development (UNCTAD), no agreed-upon definition of maximum output exists. UNCTAD itself proposes: "the productive resources, entrepreneurial capabilities and production linkages which together determine the capacity of a country to produce goods and services." The term may also be applied to individual resources or assets; for instance the productive capacity of an area of farmland.

Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country", whether consumed or used for further production. The concept of national output is essential in the field of macroeconomics. It is national output that makes a country rich, not large amounts of money.

Contents

Engineering and economic measures

One of the most used definitions of the "capacity utilization rate" is the ratio of actual output to the potential output. But potential output can be defined in at least two different ways.

In economics, potential output refers to the highest level of real gross domestic product that can be sustained over the long term.

Engineering definition

One is the "engineering" or "technical" definition, according to which potential output represents the maximum amount of output that can be produced in the short run with the existing stock of capital. Thus, a standard definition of capacity utilization is the (weighted) average of the ratios between the actual output of firms and the maximum that could be produced per unit of time, with existing plant and equipment (see Johanson 1968). Output could be measured in physical units or in market values, but normally it is measured in market values.

However, as output increases and well before the absolute physical limit of production is reached, most firms might well experience an increase in the average cost of production—even if there is no change in the level of plant & equipment used. For example, higher average costs can arise because of the need to operate extra shifts, to undertake additional plant maintenance, and so on.

Economic definition

An alternative approach, sometimes called the "economic" utilization rate, is, therefore, to measure the ratio of actual output to the level of output beyond which the average cost of production begins to rise. In this case, surveyed firms are asked by how much it would be practicable for them to raise production from existing plant and equipment, without raising unit costs (see Berndt & Morrison 1981). Typically, this measure will yield a rate around 10 percentage points higher than the "engineering" measure, but time series show the same movement over time.

Measurement

Capacity utilization (black line) in manufacture in the United States, unemployment rate (red line, upside down, scale on the right), employment rate (dotted line) Harddatafredgraph.png
Capacity utilization (black line) in manufacture in the United States, unemployment rate (red line, upside down, scale on the right), employment rate (dotted line)
Capacity utilization in manufacturing in the FRG and in the USA KapaAuslUSABRDEngl.png
Capacity utilization in manufacturing in the FRG and in the USA

In economic statistics, capacity utilization is normally surveyed for goods-producing industries at plant level. The results are presented as an average percentage rate by industry and economy-wide, where 100% denotes full capacity. This rate is also sometimes called the "operating rate". If the operating rate is high, this is called "full capacity", while if the operating rate is low, a situation of "excess capacity" or "surplus capacity" exists. The observed rates are often turned into indices. Capacity utilization is much more difficult to measure for service industries.

Economic statistics is a topic in applied statistics that concerns the collection, processing, compilation, dissemination, and analysis of economic data. It is also common to call the data themselves 'economic statistics', but for this usage see economic data. The data of concern to economic statistics may include those of an economy of region, country, or group of countries. Economic statistics may also refer to a subtopic of official statistics for data produced by official organizations. Analyses within economic statistics both make use of and provide the empirical data needed in economic research, whether descriptive or econometric. They are a key input for decision making as to economic policy. The subject includes statistical analysis of topics and problems in microeconomics, macroeconomics, business, finance, forecasting, data quality, and policy evaluation. It also includes such considerations as what data to collect in order to quantify some particular aspect of an economy and of how best to collect in any given instance.

There has been some debate among economists about the validity of statistical measures of capacity utilization, because much depends on the survey questions asked, and on the valuation principles used to measure output. Also, the efficiency of production may change over time, due to new technologies.

For example, Michael Perelman has argued in his 1989 book Keynes, Investment Theory and the Economic Slowdown: The Role of Replacement Investment and q-Ratios that the US Federal Reserve Board measure is just not very revealing. Prior to the early 1980s, he argues, American business carried a great deal of extra capacity. At that time, running close to 80% would indicate that a plant was approaching capacity restraints. Since that time, however, firms scrapped much of their most inefficient capacity. As a result, a modern 77% capacity utilization now would be equivalent to a historical level of 70%.

Michael Perelman is an American economist and economic historian, currently professor of economics at California State University, Chico. Perelman has written 19 books, including Railroading Economics, Manufacturing Discontent, The Perverse Economy, and The Invention of Capitalism.

John Maynard Keynes English economist

John Maynard Keynes, 1st Baron Keynes, was a British economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. He built on and greatly refined earlier work on the causes of business cycles, and was one of the most influential economists of the 20th century. Widely considered the founder of modern macroeconomics, his ideas are the basis for the school of thought known as Keynesian economics, and its various offshoots.

Economic significance

If market demand grows, capacity utilization will rise. If demand weakens, capacity utilization will slacken. Economists and bankers often watch capacity utilization indicators for signs of inflation pressures.

It is often believed that when the utilization rate rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.

All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation. Higher inflation—or the expectation of higher inflation—decreases bond prices, often prompting a higher yield to compensate for the higher expected rate of inflation.

Bond market financial market where participants can issue new debt or buy and sell debt securities

The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation.

Implicitly, the capacity utilization rate is also an indicator of how efficiently the factors of production are being used. Much statistical and anecdotal evidence shows that many industries in the developed capitalist economies suffer from chronic excess capacity. Critics of market capitalism, therefore, argue the system is not as efficient as it may seem, since at least 1/5 more output could be produced and sold, if buying power was better distributed. However, a level of utilization somewhat below the maximum typically prevails, regardless of economic conditions.

In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, finished goods and services. The utilized amounts of the various inputs determine the quantity of output according to the relationship called the production function. There are three basic resources or factors of production: land, labor, and capital. The factors are also frequently labeled "producer goods or services" to distinguish them from the goods or services purchased by consumers, which are frequently labeled "consumer goods".

Capitalism is an economic system based on the private ownership of the means of production and their operation for profit. Characteristics central to capitalism include private property, capital accumulation, wage labor, voluntary exchange, a price system, and competitive markets. In a capitalist market economy, decision-making and investment are determined by every owner of wealth, property or production ability in financial and capital markets, whereas prices and the distribution of goods and services are mainly determined by competition in goods and services markets.

Modern business cycle theory

The notion of capacity utilization was introduced into modern business cycle theory by Greenwood, Hercowitz, and Huffman (1988). They illustrated how capacity utilization is important for getting business cycle correlations in economic models to match the data when there are shocks to investment spending.

Output gap percentage formula

As a derivative indicator, the "output gap percentage" (%OG) can be measured as the gap between actual output (AO) and potential output (PO) divided by potential output and multiplied by 100%:

%OG = [(AO – PO)/PO] × 100%.

FRB and ISM utilization indexes

In the survey of plant capacity used by the US Federal Reserve Board for the FRB capacity utilization index, firms are asked about "the maximum level of production that this establishment could reasonably expect to attain under normal and realistic operating conditions, fully utilizing the machinery and equipment in place."

By contrast, the Institute of Supply Management (ISM) index asks respondents to measure their current output relative to "normal capacity", and this yields a utilization rate, which is between 4 and 10 percentage points higher than the FRB measure. Again, the time series show more or less the same historical movement.

See Board of Governors of the Federal Reserve System: Industrial Production and Capacity Utilization. [1]

Data

The average economy-wide capacity utilization rate in the US since 1967 was about 81.6%, according to the Federal Reserve measure. The figure for Europe is not much different, for Japan being only slightly higher.

The average utilization rate of installed productive capacity in industry, in some major areas of the world, was estimated in 2003/2004 to be as follows (rounded figures):

Average utilization rate

Notes

  1. "The Fed - Industrial Production and Capacity Utilization - G.17". federalreserve.gov. Retrieved 14 April 2018.
  2. "Turkish Statistical Institute". Turkstat.gov.tr. 2009-04-09. Retrieved 2013-09-27.

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