Excess capacity

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

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.

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 existent stock of capital. Thus, a standard definition of capacity utilization is the (weighted) average of the ratios between the actual output of firms to the maximum that could be produced per unit of time, with existing plant and equipment (see Johanson 1968). Obviously, "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.

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.

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.

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.

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