Here are some measures of capacity utilization in the industrial sector as discussed in the sources:
- Capacity or Capacity Output: Capacity is a concept that can change based on time and economic conditions. Capacity output is defined as the level of output at which the short-run and long-run average total cost curves intersect. Under constant returns to scale in the long run, capacity output is the output at the minimum point of the short-run average total cost curve.
- Capacity Utilization Rate: The capacity utilization rate (for an industry or economy) is the ratio of actual output to the sustainable maximum output (capacity output). While the capacity utilization rate can exceed 100 percent for a specific firm or industry, it will not reach 100 percent for the economy as a whole.
- Significance of Capacity Utilization: The change in the level of capacity utilization demonstrates the evolution of the supply-side of a firm, industry, or economy, relative to the demand-side. Improving capacity utilization is especially important for developing countries, like India, where capital is scarce. Improved capacity utilization, which can lead to economic growth without additional investment, is a critical determinant of productivity growth. Increasing capacity utilization reduces production costs and leads to higher profitability.
- Capacity Utilization and Business Cycles: Capacity utilization is an important variable in business cycle theories, particularly those based on the acceleration principle. During an economic expansion, businesses utilize more of their existing capacity, leading to higher employment and incomes. This leads to increased demand, causing a further increase in capacity utilization. This is called the multiplier effect. If producers expect this demand to continue, they will invest in new plants and machinery. This is called the accelerator effect. The opposite of the multiplier and accelerator effects occur when demand falls, leading to recessionary pressures. Capacity utilization is also an indicator of inflationary pressure.
- Measures of Capacity Utilization:
- Peak-to-Peak Measure: Capacity utilization can be measured by plotting actual output over time. The relative peaks of the output represent points of full capacity utilization. These peaks are connected by a straight line, and this line can be extrapolated to show the path of capacity output. Capacity utilization is calculated as the ratio of actual output to capacity output. The advantage of this method is that it only requires output data.
- Survey-Based Measures: The most direct way to measure capacity utilization is to ask firms for their own assessment of their capacity utilization. In India, companies are required to disclose installed capacity and actual production of various products in their annual reports.
- Production Function Approach: The production function approach attempts to estimate a mathematical relationship between inputs, technology, and output. Once the function has been estimated, capacity output can be determined by finding the level of output when all resources are fully utilized. This approach is useful because it can show how changes in capacity output are affected by changes in capital stock, technological progress, and potential labor supply.
The sources discuss several challenges related to capacity utilization in the Indian industrial sector. Low capacity utilization rates have been a persistent problem in India’s industrial development. One factor contributing to capacity under-utilization in the industrial sector is the economic policies followed by India before 1985. These policies contributed to the build-up of excess capacity and low returns on investment.
The sources also note that structural reforms introduced in the 1990s, led to a decline in manufacturing sector output in the first two years. During this period, the capacity utilization rate in the industrial sector also decreased. However, by 1995, the capacity utilization rate began to increase and the manufacturing sector experienced above-trend growth until 1998. By 1999, the capacity utilization rate had fallen again. There was some improvement in 2000 and 2001.
Political instability and inconsistent government policies are some of the reasons that the economic reforms have not led to higher investment and better capacity utilization rates. Additionally, the Reserve Bank of India’s monetary policy and the Ministry of Finance’s industrial policy have not always been well-coordinated. Tight financial regulation has also limited the credit available to the commercial sector.