Capacity Utilization and Production Function Estimation: Implications for Productivity Analysis

During business cycles and disruptions of global value chains, capacity utilization has important implications for explaining variations in productivity and for evaluating the effectiveness of a certain investments such as R&D and ICTs. Unfortunately, data on capacity utilization is not easily available, especially at the firm level. This article develops and evaluates a methodology for measuring capacity utilization at the micro level. Unlike the literature using ad-hoc proxies (for example, the ratio of energy use to capital stock) or ex-post return to capital which is endogenous to productivity shocks, the new measure is practical and easily implemented. Importantly, it is based on the theory of the firm in terms of profit-maximizing and price-taking and is exogenous to productivity shocks. Using Canadian micro data, this article shows that the developed new measure under the assumption of capital being not adjustable in the short term explain well the variations in firm productivity. It also finds that controlling for capacity utilization may be essential in evaluating the economic impact of certain investments such as in ICT.