Full capacity refers to the potential output that could be produced with installed equipment within a specified period of time. Actual capacity output can vary within two limits: (1) an upper limit that refers to the engineering capacity—that is, the level of output that could be produced when the installed equipment is used to its maximum time of operation and maximum technical efficiency; and (2) a lower limit identified with the scrapping of plant and equipment—that is, the level of output that is no longer profitable to produce. By full (or normal) capacity at the microeconomic level, economists refer to the level of output that corresponds to minimum cost production, usually identified with the minimum point of a usual U-shaped average cost curve. Before this point, we have economies of scale that firms would be willing to take advantage of by expanding their output. Past this point, firms encounter diseconomies of scale that they would like to avoid by cutting down their level of production. The problem with this definition is that such a minimum point is hard to identify empirically. Furthermore, the average cost curves in manufacturing are usually characterized by constant returns to scale for fairly large variations in the output produced, and so full (normal) capacity is identified with the level of output past which the firm considers the installment of a new plant. Consequently, normal output is conceived differently in the various schools of economic thought.
Starting with the classical economists, full or normal capacity is identified with the level of output where the forces of demand and supply are equal and the production technique along with the distributive variables (i.e., the real wage and the rate of profit) are taken as givens. Hence, normal capacity is different from engineering capacity in the sense that it takes into account economic considerations. Consequently, normal or full capacity will equal a certain percentage of maximum engineering capacity simply because it does not pay to use the plant and equipment past this percentage point, even though engineering-wise such a use would be possible. It is important to point out that full capacity in classical economics is restricted to capital. The idea is that the purpose of production is the extraction of profits as an end in itself, so the primary concern of entrepreneurs is the full employment of their capital, while labor simply adjusts to the requirements of capital regardless of the level of unemployment. In short, full capacity may be accompanied by considerable unemployment of labor.
For neoclassical economists, full capacity is identified with both the full employment of capital and the full employment of labor. Full capacity is expected to prevail in the economy in the long run, and any deviations from full capacity are attributed to external economic shocks that may displace the actual output away from the full capacity output. However, neoclassical economics claims that if the price mechanism works freely it is expected that sooner rather than later the actual level of output will be restored back to its optimal level.
A characteristically different view was propounded by John Maynard Keynes (1883–1946), who argued that the unemployment of capital may coexist with the unemployment of labor, precisely because of the failure of the market system to generate effective demand sufficient to fully employ all the factors of production. Keynes further argued that once the economy finds itself in such a situation it stays there, since aggregate demand and aggregate supply are equal to each other. Output and therefore employment of both capital and labor can change through variations in aggregate demand induced by government intervention, and in this way the economy may reach a point that is consistent with the full capacity of both capital and labor. In the Keynesian perspective, prices do not play a role because of the assumption of constant returns to scale.
Modern macroeconomic approaches envisioned a novel concept of full capacity identified with the level of output at which there are no pressures for the acceleration or the deceleration of the inflation rate. Furthermore, the rate of capacity utilization defined as the ratio of actual output to the full capacity output has established, at least for the U.S. and Canadian economies, a benchmark capacity utilization rate that is consistent with a stable inflation rate. This concept came to be known with the acronym NAICU, that is, the nonaccelerating inflation capacity utilization rate, which is supposed to be more general than the currently more popular nonaccelerating inflation rate of unemployment known as the NAIRU, which is restricted to the employment of labor alone. Full capacity output is identified on the basis of survey measures for the U.S. and Canadian economies and is associated with a rate of capacity utilization approximately equal to 82 percent of potential output. The empirical evidence for the years before the mid-1990s has been supportive of this hypothesis for both the U.S. and the Canadian economies, but this hypothesis lost part of its explanatory force in the post-1990 years. These rather negative results raised doubts about the official measurement of potential output based on surveys, and encouraged research in the development of alternative measures of the full capacity output.
There are various methods for the estimation of potential output that can be distinguished between those based on economic theory and those that are not. Economic measures include those derived from the use of production or cost functions. More recently, there have been measures developed based on the use of econometric techniques such as the cointegration and the structural vector autoregressive models. Noneconomic measures include various statistical methods starting from peak-to-peak measures of capacity output to simple moving averages and sophisticated filtering techniques. Finally, among the atheoretic measures of capacity output, the approach based on surveys is the most popular and is conducted in many countries. The survey measures of capacity output of the U.S. Federal Reserve Board is the oldest one and is based on a nationwide survey where the managers of manufacturing firms are asked to identify “the maximum level of production that their establishment could reasonably expect to attain under normal and realistic operating conditions, fully utilizing the machinery and equipment in place.” Despite the subjective content of the responses, surveys are used extensively in economic research and also for economic policy purposes.
Today there are many estimating methods of measurement of capacity output; nevertheless, full capacity output continues to be a slippery concept and, therefore, remains controversial within economic theory, attracting the attention of economists, who in spite of the recognition of its unquestionable theoretical significance and practical importance nevertheless are still far from reaching any agreement as to the adoption of a single estimating method.
SEE ALSO Capital; Economics, Keynesian; Economics, Neoclassical; Full Employment; Keynes, John Maynard; Machinery
Artus, Jacques. 1977. Measures of Potential Output in Manufacturing for Eight Industrial Countries, 1955–1978. International Monetary Fund Staff Papers 24: 1–35.
Berndt, Ernst, and Dieter Hesse. 1986. Measuring and Assessing Capacity Utilization in the Manufacturing Sectors of Nine OECD Countries. European Economic Review 30: 961–989.
Tsoulfidis, Lefteris, and Theologos Dergiades. 2006. The Inflation-Capacity Utilization Conundrum: Evidence from the Canadian Economy. Applied Econometrics and International Development 6 (2).