Capacity Utilization - Economic Significance

Economic Significance

If market demand grows, capacity utilization will rise. If demand weakens, capacity utilization will slacken. Economists and bankers often watch capacity utilization indicators for signs of inflation pressures.

It is believed that when utilization rises above somewhere between 82% and 85%, price inflation will increase. Excess capacity means that insufficient demand exists to warrant expansion of output.

All else constant, the lower capacity utilization falls (relative to the trend capacity utilization rate), the better the bond market likes it. Bondholders view strong capacity utilization (above the trend rate) as a leading indicator of higher inflation. Higher inflation—or the expectation of higher inflation—decreases bond prices, producing a higher yield to compensate for the higher expected rate of inflation.

Implicitly, the capacity utilization rate is also an indicator of how efficiently the factors of production are being used. Much statistical and anecdotal evidence shows that many industries in the developed capitalist economies suffer from chronic excess capacity. Critics of market capitalism, therefore, argue the system is not as efficient as it may seem, since at least 1/5 more output could be produced and sold, if buying power was better distributed. However, a level of utilization somewhat below the maximum prevails, regardless of economic conditions.