Capacity Utilisation

This issue was not considered by Sraffa, but has been explored by the modern-day economist Janos Kornai. His conclusion was the diametrical opposite of the neoclassical position: competition in the context of growth and uncertainty would drive firms to have substantial excess capacity.

Kornai argued that there are at least two very good reasons why a firm in a market economy needs excess capacity to be competitive. Firstly, given that the future is uncertain, excess capacity gives the firm the flexibility it needs to respond to unanticipated events. These could range from a calamity befalling a competitor–a rival car manufacturer might suffer a serious product recall which damages their product marketing, for example–to an unexpected growth in sales, or the opening up of an export market. Secondly, markets are never static, but instead products develop as firms innovate to try to secure an advantage over competitors. A firm’s future sales therefore depend not just upon its current products, but also upon new products that it must develop to remain competitive.

Its new products could have substantially higher sales than anticipated, and it will also plan for sales to grow over time. Hence it cannot simply produce sufficient new capacity to meet its immediate plans and no more. Investment will thus build in a degree of excess capacity relative to expected sales at commencement. The firm will then try to maintain some excess capacity in order to be able to respond to market opportunities.

Since a successful firm will need excess capacity to be able to respond to an uncertain market, the aggregate rule will be excess capacity rather than production which is capacity-constrained. Firms will therefore be operating in a region where they experience constant or falling marginal costs, and falling average costs–since fixed costs are substantial compared to variable costs, and increased sales amortize these fixed costs over a larger output.

The statistical data certainly supports Kornai’s argument. Figure 1 shows the level of capacity utilization and employment in the United States, as well as times of severe economic downturn. Even during times of booming economic performance such as the late 60s and early 70s, the level of recorded capacity utilisation for the entire economy never exceeded 90%, while during economic downturns the level fell as low as 72%. Indeed, look carefully and you will notice that the level of capacity utilisation was generally falling during America’s ‘Internet boom’. This implies that much this boom was based on firms competitively expanding capacity even faster than demand was growing.

Figure 1: The relationship between capacity utilisation and employment in the USA, with capacity utilisation never exceeding 90%, and falling to 80% during the Internet boom

The otherwise strong correlation between employment and capacity utilisation also emphasises the conclusion that demand is the main constraint upon the economy’s output, rather than fixed capacity and diminishing marginal returns (and the undeniably strong relationship between downturns in employment and downturns in capacity utilisation implies that capacity utilisation may plummet to historically low levels when America’s Internet boom finally ends).