Review of Industrial Organization 15: 321–339, 1999.
© 1999 Kluwer Academic Publishers. Printed in the Netherlands.
Economic Capacity Utilization and its
Determinants: Theory and Evidence
H. YOUN KIM
Department of Economics,Western Kentucky University, Bowling Green, KY 42101, U.S.A.
Abstract. This paper develops and estimates a model of economic capacity utilization and its de-
terminants by allowing for the ﬁrm’s full optimization behavior that considers endogenous output
choice. The model consists of deriving the short-run output supply function and the capital demand
function which generate optimal and capacity output. Optimal capacity utilization is determined
as the ratio of optimal to capacity output and its determinants are identiﬁed. Evidence from U.S.
manufacturing shows that capital expansion not accompanied by market growth and higher materials
and capital prices has contributed to lower capacity utilization. Energy price increases have exerted
a stimulating impact on capacity utilization. Conventional capacity utilization measures are found to
be biased and fail to capture the inﬂuences of changes in economic conditions facing ﬁrms.
Key words: Capacity output, capital demand, capacity utilization, short-run cost function, variable
JEL codes: D24, E22, L60.
Capacity utilization is an important issue in economic analysis.
It is frequently
employed in empirical studies to help explain investment behavior, productivity
measurement, inﬂation, and inventory behavior, and is often used as an indicator
of the strength of aggregate demand (Schultze, 1963). Two important questions ger-
This paper was initially written in 1987, and different versions have been circulated over the
years. The research leading to the paper was supported by an EPSCoR grant funded by the National
Science Foundation and the Commonwealth of Kentucky through the University of Kentucky. The
author would like to thank the research team engaged in the EPSCoR project, in particular Mark
Berger who was instrumental in this project. Thanks are also extended to Ernst Berndt who kindly
supplied the updated KLEM data on U.S. manufacturing, John Wassom, Dennis Hanseman, Thomas
Wisley, Dan Black, and Steve Holland, and to participants of the Applied Microeconomics Workshop
at the University of Kentucky, especially John Garen, Frank Scott, Eugenia Toma, and Paul Anglin,
for their helpful comments and discussions. Special thanks also go to anonymous referees and Dale
Squires for detailed comments and suggestions and to Cathy Barnes for drawing a graph.
Capacity utilization and capital utilization are terms used interchangeably in the literature with-
out much distinction. The two concepts are the same under the condition of constant returns to scale
if capital is the only input subject to slow adjustment; see the discussion in Section II.