Capacity Utilization: Concept, Measurement, and Recent Estimates

Author(s): Lawrence R. Klein, Virginia Long, Alan Greenspan, Douglas Greenwald, Nathan
Edmonson and George Perry
Source: Brookings Papers on Economic Activity, Vol. 1973, No. 3 (1973), pp. 743-763
Published by: Brookings Institution Press
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 LAWRENCE R. KLEIN
Universityof Pennsylvania
assisted by
VIRGINIA LONG
WhartonEconometricForecasting Associates

Capacity Utilization:
Concept, Measuremnent,
Iand Recent Estimates

ON SEVERAL OCCASIONS in the past fifteen years, my colleagues and I have

tried to explain disparities among alternative measures of capacity utiliza-
tion and to justify our own approach to the measurementproblem.1 George
Perry, in his contribution to this issue of Brookings Papers, has indicated
many of the important issues, and I would like to amplify his points or
restate them from another viewpoint in the interests of clarification.
Briefly, the Federal Reserve index estimates that as of mid-October 1973,
a fair amount of spare capacity existed in the American economy. The esti-
mated operating rate was only 83.4 percent for 1973:3. By contrast, the
Wharton index for manufacturing was as high as 96.7 in the same period,
and was rising faster than the Federal Reserve index. The McGraw-Hill
index was at an intermediate level of 86.5 percent in September. Similar
divergences among the indexes had been apparent for several months.
These messages are so differentthat they suggest the need for a close look
into the whole subject. For some years the Wharton and Federal Reserve
indexes of utilization followed similar paths. They began to diverge in 1965,
when the Wharton index rose sharply, as if signaling the onset of the
1. LawrenceR. Klein and Robert Summers,The WhartonIndex of CapacityUtiliza-
tion(Universityof Pennsylvania,WhartonSchool of Financeand Commerce,Economics
ResearchUnit, 1966).
743

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 744 Brookings Papers on Economic Activity, 3:1973
stronginflationarypressuresthat accompaniedthe VietnamWar.2Perry's
Table3 bringsout sharplythis breakin the relationship.For the two sub-
periods1954-65and 1966-72the seriesall havelargepair-wisecorrelations,
but the Whartonindex correlatespoorly with the others for the whole
period 1954-72. After 1965, the short-runmovementsin the Wharton
seriesarelike those in the others,but its level is muchhigherin termsof a
utilizationrate. I feel that the Whartonindex gave the correctsignalson
inflationin 1965and againat the beginningof 1973.

The Concept

Full capacityhas been variouslydefinedas a minimumpoint on a cost

function,a full input point on an aggregateproductionfunction, and a
bottleneckpoint in a generalequilibriumsystem.Full capacityshouldbe
definedas an attainablelevel of outputthat can be reachedundernormal
inputconditions-withoutlengtheningacceptedworkingweeks,andallow-
ing for usual vacationsand for normalmaintenance.Preoccupationwith
measuresfor individualindustries,consideredseparatelyfromothersat the
same time, tends to overstatecapacityfor the system as a whole. The
standardWhartonmeasureof trendlinesthroughpeaksof individualpro-
ductionseriesprovidesa systemof attainablepointsbecausemanyor most
industriespeak approximatelytogether.The Whartonapproachsatisfies
the conditionof feasibilityundernormalconditions;it runsthe risk,how-
ever,of callinga local maximumpoint one of full capacitywhenit maybe
only a partialrecoverypoint. This is the problemof the so-called"weak
peak."
I believethat 1959was the last time that the economypeakedout at a
local maximumwith less than full recovery.Some adjustmentfor the
Whartonindexaround1959becamenecessary.PrestonandI estimatedin-
dustryproductionfunctionsand insertedthe full employmentlabor force
andcapitalstockforeachindustry.Thevalueof productioncomputedfrom
theseinputsat full use yieldedestimatesof capacityoutputthat couldthen
be usedto adjustweakpeaksupward.3
2. See WhartonQuarterly,Vol. 6 (Winter1971), p. 16.
3. L. R. Klein and R. S. Preston, "Some New Results in the Measurementof Ca-
pacityUtilization,"AmericanEconomicReview,Vol. 57 (March 1967),pp. 34-58.

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Lawrence R. Klein and Virginia Long 745
By distributingthe available(full employment)labor force over indus-
tries as it would be, historically,at full employmentpoints, we implicitly
take accountof the feasibility,in a generalequilibriumsense,of attaining
the outputlevelthatwe designateas fullcapacity.Thisapproachis different
from one relyingon a purelymacroeconomicproductionfunctionor from
one that estimatesoutputat full capacityin eachsectorwithouttakingac-
count of relationshipsto other sectors.Subsequentto 1959,the economy
consistentlypeakedout at full capacitypoints.The overshootingof inter-
mediatepeaks like those in 1959 when the trend lines are established
throughpeaks has providedus fairlyreliabletrendson capacitythat we
now use in the Whartonindex.
As the economyapproachesa turn,however,beforethe maximumpoint
has beenfullyreached-as at the end of 1973-the capacityvaluesin a few
cases keep exceedingthose in the previousquarterso that the capacity
trendsmustbe movedslightlyupward.Thisis a faultof ourmethod,but I
thinkthatthe resultingupwardbiasin capacityutilizationis less than2 full
percentagepointsin presentcircumstances.
Accordingto presentforecasts,it is likely that the economywill slow
down in comingmonths; thereforesubsequentquartersshouldnot push
economicperformancein separateindustrieson to new, higher,capacity
pointsthat wouldlead us to reviseupwardour capacitytrendlines.
Thefiguresin Perry'sTable9 areinterestingto me in thattheyindicatea
muchsmallerupwardbiasfor the Whartonindexoverthe FederalReserve
or McGraw-Hillmeasuresthan wouldbe suggestedby the comparisonof
the usualaggregateindexes.The FederalReserveestimatesin Table9 for
major materialsindustriesare more firmlybased on direct information
fromengineeringand tradesources.Theytendto be no morethan about5
pointsbelow the correspondingWhartonindexes.
Generallyspeaking,I like productionfunctionestimatesof capacityout-
put, but for quicknessof estimationand simplicityof concept,I preferto
workon a largescalewithourpresentmethodof trendlinesthroughpeaks,
usingproductionfunctionestimatesonlyfor adjustmentandextrapolation.4

4. Interestingmeasuresof productionfunctions are containedin a researchpaperby

Robert M. Coen and Bert G. Hickman,"AggregateUtilization Measuresof Economic
Performance,"ResearchMemorandum140 (StanfordUniversity,Centerfor Researchin
EconomicGrowth, February1973; processed).

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 746 Brookings Papers on Economic Activity, 3:1973
Yet anotherapproachdraws on linear programmingcalculations.In
studiesof chemicalproductionand petroleumrefining,Malenbaumand
Griffinmeasurecapacityas the "bottleneck"point in expansionalong a
givenray correspondingto a fixedproductmix.5When one producthits
sucha bottleneck,all othersdependenton it for intermediateinputarere-
strictedat lessthanfull capacityutilization.Thisprovidesa maximumout-
put point whilepreservinga givenproductmix.
The Malenbaumand Griffinestimatesfor petroleumandchemicalswere
checkedagainstthe Whartonestimatesof utilizationfor the same indus-
tries.In general,little agreementwas found betweenthe resultsfrom the
engineering-type estimatesand the standardWhartonprocedures,espe-
ciallyfor short-runmovements.But in most cases,the Whartonestimates
of utilizationfor petroleumrefiningare higherby about 4-5 percentage
pointsthanthosebasedon thelinearprogramming model.For thechemical
industry,the resultsare closer,but in a few isolatedyearsthe discrepancy
exceeds5 percentagepoints.
Systematicanalysisand coverageof all major sectors by production
functionestimation,input-outputmethods,andlinearprogramming calcu-
lationspromisethe greatestreturnin precisionof measurement,but that
combinedapproachseemsto be a longwayoff,exceptforintensiveresearch
in separateindustries.
In this connection,I disagreewith Perry'sview that limitationson pro-
ductionresultingfromshortagesof intermediateproducts(like today'san-
ticipatedshortagesof fuel)shouldnot affectthe conceptof capacity.Capac-
ity is a generalequilibriumconcept,whichshouldbe alteredin the light of
bottleneckswhoseeffectscan be tracedthroughan input-outputanalysis.
Thatis the wholepoint in usingcapacityutilizationmeasuresas signalsof
inflationarypressure,and accounts for my view that other measures
stronglyoverstatethe amount of spare capacityavailableby not taking
accountof interrelationships amongindustries.6

5. Helen Malenbaum,"Capacity Balance in the Chemical Industry,"in Lawrence

R. Klein (ed.), Essays in IndustrialEconometrics,Vol. 2 (Universityof Pennsylvania,
Economics Research Unit, 1969); James Griffin, CapacityMeasurementin Petroleum
Refining:A Process AnalysisApproachto the Joint Product Case (Heath, 1971).
6. A techniquefor estimatingcapacity utilizationrates in an input-outputmodel is
given in L. R. Klein, "Some Theoretical Issues in the Measurementof Capacity,"
Econometrica,Vol. 28 (April 1960), especiallypp. 280-86.

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Lawrence R. Klein and Virginia Long 747

CapacityUtilizationas an ExplanatoryVariable

Indirectuse of capacitymeasuresis importantin the constructionof

econometricmodelsand servesas a validationtest for the seriesactually
beingconsidered.Theindirectusesarein equationsfor(a) priceformation;
(b) capitalformation;(c) trade.Capacityutilizationis one of the most stra-
tegicvariablesin theWhartonmodel,andshowsup in severalplaces.In the
basic equationfor price formation-the manufacturingdeflator-a non-
lineartransformationof capacityis one of the most significantvariables:

loglg1-
I CPMF'

where CPMFis capacityutilizationin manufacturingconstrainedto lie

between0.87 and 0.99. In this nonlineartransformation,strongerupward
pressureon pricesdevelopsas CPMF comes closer to its limitingvalue,
0.99.
In equationsfor capitalformation,a one-quarterlag effectis introduced
by the linear term (CPMM)-1, where CPMM is capacityutilizationin
manufacturingand mining. This is a strong near-termeffect. The other
variableshave effectsspreadout over more quarters.Perhapsa nonlinear
transformationwouldbe appropriateheretoo, but it has not been tried.
In some studiesof exportequations,capacitylimitationson exportper-
formancehave provensignificant.In the trademodel of the Organisation
for Economic Co-operationand Development,exports for the United
Statesaremadeto dependon "pressureof demand,"whichis quitecloseto
the Whartonindexmeasure.7In newestimatesof U.S. exportfunctionsfor
usein theWhartonmodel,I havefoundthatEuropeancapacityutilization,
measuredanalogouslywith the Whartonmethods,is a highlysignificant
variable.
These are the main avenuesby whichthe capacityutilizationvariables
enterthe entiremodel.Theyarestronglysignificant,froma statisticalview-
point, in all these cases. But a properassessmentof the marginalcoeffi-

An EconometricAnalysis
7. F. G. Adams, H. Eguchi, and F. Meyer-zu-Schlochtern,
of InternationalTrade(Paris: Organisationfor Economic Co-operationand Develop-
ment, 1969).

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 748 Brookings Papers on Economic Activity, 3:1973
cientsof capacityvariablesdependson good specificationof therestof each
equationand on use of nonlineartransformations whereappropriate.
Best econometricpracticeshould be followedin specifyinginvestment
functionswith lag distributionsof outputand capitalstock; capitalrental
variablesshouldbe appropriately introduced.Unlessthesestepsaretaken,
the marginaleffectsof capacityutilizationon investmentmay not be cor-
rectlyassessed.In the sameway, the priceequationswith capacityutiliza-
tion variablesshouldhave unit laborcosts, insteadof wagerateswithout
appropriateproductivitycorrectionsas in Perry'sestimates.His estimates
andassessmentsof the role of capacityin modelsleaveme doubtfulthathe
has capturedthe rightmarginaleffect,becausesome of his othervariables
are not optimallyspecifiedand becausehe does not use a nonlineartrans-
formationof capacitywhereneeded,in the priceequation.This is particu-
larlyimportantwheninflationratesarehigh.
Usingcapacitymeasuresas strategicregressorsdependson the statistical
compilationof historicalseries-measuredas trendsthroughpeaksof pro-
ductioncurvesin the Whartoncase. But forecastingapplicationrequiresa
procedurefor extrapolatingcapacityutilizationin the samewaythat other
endogenousvariablesare extrapolated.This is accomplishedthroughthe
use of productionfunctions.Theseequationsare firstestimatedfrom his-
toricalsampledatawithobservedinputsof actualemploymentin the form
of a short-rundynamicadaptationto a long-runproductionfunction.The
short-runmodelis
A log L = X(log L* - log L-1),
where
L* =- -logA - t- -log K+ - log X + e,

and
L = employment
K = capital stock
X = output
e = error.

The parameterratio A/a is estimatedfrom long-runstatisticson average

factorshares.Capacityoutputis estimatedfromthis pairof equationsun-
dertwo conditions:A log L = 0; andL = LF, the laborforce.
A separateestimateof a full capacityproductionfunctionis not made;

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Lawrence R. Klein and Virginia Long 749
full capacityoutputis definedas a point on the long-runproductionfunc-
tion, determinedby usingfull employmentinputs.

Contemporary
Findings

The precedingdiscussiondescribesthe analyticaleconometricapplica-

tion of capacitymeasures.What signalshave the actualdata been giving
recently?Sincethe last low point,in the fourthquarterof 1970,the Federal
Reserveindexhas gained9.2 points,risingfrom74.2 to 83.4.The Wharton
index for manufacturinghas gained 13 points in the same period,moving
from 83.7 to 96.7 (see Table 1). More significant,96.7 is verynearthe his-
toricalhigh value for the index. After the index surpassed95, in the first
quarterof 1973,the stronginflationarypressuresthat had been suspected
earlier, when the index exceeded90 in 1972:3, became unmistakable.
Aggregatecapacity utilizationrates for the United Kingdom and five
WesternEuropeancountriesare shownin Table2.
It has been evidentfor some time that one strategicindustryafter an-
otherwas passingcriticalvaluesfor utilizationrateseachquarter,and that
the slack areaswerespecializedsectorswheredefinitecutbackshad been
ordered-aerospaceis a typicalexample.Table3 showsestimatesfor indi-
vidualindustrycomponentsof the Whartonindex.Throughout1973, the
sectors of high capacityutilizationare primaryand fabricatedmetals;
nonelectricaland electricalmachinery;motor vehicles and parts;instru-
ments;clay, glass, and stone products;lumberand furniture;miscellane-
ous manufactures; textiles;apparel;paper;printingand publishing;chem-
icals; petroleum;rubberand plastics; food; crude oil and naturalgas
extraction;electricpower;and gas utilities.Witha line-upof high (Whar-
ton) rates for a group of industrieslike these, severecapacitylimitations
quiteevidentlywerebuildingup.
Sincebusinesscyclepeaks(both specificand reference)havebeenstrong
and well-definedsince 1959,we havefelt quiteconfidentthat ourmeasures
usingtrendlinesthroughpeaksprovideadequateestimatesof capacity,but
untila newturnoccurs,we mustalwaysbe in doubtat the end of a cyclical
phaseabout the exact positionof the trendlines. Thereis only one refer-
encepointandnot two, as is the caseformoredistantpeaks.Yet, in the last
half of 1973,we foundlittleoccasionto reviseour series.The overallindex
in the firstquarterfor manufacturing, mining,and utilitieswas estimated

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 752 Brookings Papers on Economic Activity, 3:1973
Table 3. U.S. Capacity Utilization Rates and Weights, by Industry,First
Quarter, 1973, Estimated in April and October 1973
Utilizationrate,
first quarter1973
(percent)
April October
1973 1973
Industry estimate estimate Weight
Primarymetals 100.0 97.8 0.0188
Fabricatedmetal products 93.6 96.3 0.0194
Nonelectricalmachinery 89.3 93.6 0.0316
Electricalmachinery 95.1 97.6 0.0281
Motor vehiclesand parts 100.0 99.9 0.0220
Aircraftand miscellaneoustransportation
equipment 65.4 65.6 0.0162
Instruments 91.0 93.6 0.0084
Clay, stone, and glass products 97.9 98.0 0.0087
Lumberand products 99.5 100.0 0.0067
Furnitureand fixtures 99.1 95.6 0.0050
Miscellaneousmanufactures 100.0 100.0 0.0045
Textile mill products 94.5 99.0 0.0086
Apparelproducts 92.2 95.2 0.0107
Leatherand products 77.9 76.9 0.0026
Paperand products 100.0 100.0 0.0102
Printingand publishing 90.9 90.7 0.0154
Chemicalsand products 100.0 98.4 0.0213
Petroleumproducts 100.0 98.0 0.0067
Rubberand plastic products 100.0 98.5 0.0081
Food 99.2 100.0 0.0214
Tobacco and products 84.6 87.3 0.0018
Coal 84.5 85.9 0.0010
Oil and naturalgas extraction 91.8 92.0 0.0031
Metal mining 94.2 88.3 0.0009
Stone and earth minerals 77.8 85.0 0.0015
Electricutilities 100.0 99.0 0.0144
Gas utilities 96.1 92.8 0.0043
Source: Same as Table 1.

at 94.2 in April 1973.In October,this same value, with hindsightand re-

vised data, was estimatedto be 95.0.8The changeswereusuallynot more
thanone or two points,and rarelyas largeas fiveor six. They are detailed
by industrygroupsin Table4. As in 1965,the overallindicatorof average
utilizationhas servedas a fairlygood earlywarningsignal.
8. This figureis more comprehensivethan the manufacturingseries,cited earlier.If
constructionand serviceindustriesare included,the averagerate is estimatedat 94.4 for
1973:1.

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 Commentsand
Discussion

AlanGreenspan:I will be brieferthan usual, since the Klein-Longpaper

has anticipatedmany of my comments.The total operatingrate sought
hereis not an arithmeticweightingof operatingratesin individualindus-
tries,but ratherthe rateobtainedfromsometype of input-outputor linear
programming system.Sinceinterrelationships exist amongmaterialsflows
fromindustryto industry,the weightingsystemneededto obtainan overall
operatingrate is one that rests on these flows. The measureof the econ-
omy'spositionin termsof an overalloperatingratedependson the degree
of shortagein partsof the system.Today shortagesexist and they are re-
strictingproduction.Particularindustries,suchas coal mining,mayexhibit
excesscapacity,but this "slack"has only a limitedimpacton the adjust-
ment of the overalleconomyto inflationarypressures.
Unfortunately,it is not easy to use an input-outputsystemto get the
kind of answerthat is required.The economyis faced with specificengi-
neeringconstraints-that,for example,so muchelectricpoweris neededin
the electrolyticprocessto produceso much aluminumingot; but thereis
also a considerablerange of substitutabilityamong materialswhich is
basicallya functionof price.Therefore,the analysisrequiresnot onlysome
judgmentsabout engineeringinterrelationships, but also the price vector
that determineswhichmaterialsor processeswill be used.Withoutsome-
thing of that sort, the conceptof capacityis meaningless.
The real test of the conceptis about to be thrustupon us, becausethe
economyfacesa classicalcase of deprivationof a basicmaterialinput-oil.
Whatwillthatdo to the level of industrialactivity?Somepreliminarywork
has had resultsthat I don't fullyknow how to interpret.The analysissug-
geststhat as soon as the priceof energybeganto rise in 1972,energyper
unitof outputdroppedrapidly,clearlyimplyingsomepriceelasticityin the
relationshipof energyinputto outputof goods. The infrastructure of pro-
ductionin this countryis obviouslybased upon the low levels of energy
757

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 758 Brookings Papers on Economic Activity, 3:1973
pricesthat have persistedfor many decades.What is uncertain,unfortu-
nately,is whatthe structureof productionwouldbe withenergypricestwo
to threetimes what they have been. The input-outputcoefficientssystem
wouldbe markedlydifferent.Whatis visibleto date is dramaticevidence
of the short-termelasticityof energyinputwithrespectto price.It wouldbe
nice to believethat all the nationhas to do is sit tight,allowpricesto rise,
andlet thewholeadjustmentprocesstakeplacewithzeroeffecton capacity.
But thereis no way to be sure,becauseof uncertaintyabout engineering
constraintsthat complicatethe economicconstraints.
In principle,"capacity"has meaning.In the currentperiodof lengthen-
ing lags in deliveries,and of all sorts of reportedshortagesand difficulties
in obtaininggoods(regardlessof price),the economymustbe producingat
capacityin any meaningfulsense. If the numbersdo not indicatethat the
economy is currentlyat capacity,then I suggest that the numbersare
wrong,and that the correctconceptof capacitymust reflectthe situation.
Next, I wouldlike to raisea coupleof issuesaboutthe Whartonmethod
of measuringcapacity.As I understandit, outputof two-digitSICmanu-
facturingindustriesis used in constructingthe estimates.One problemis
thatthe two-digitdataimplya lowerlevelof capacitythanwouldfour-digit
data since all four-digitindustrieswithina two-digitgroupingwould not
reachoperatingrates of 100 at the same time. Sincethis is such a simple
computationalproblem,I don't understandwhy the classificationsof the
industrialproductionindexare not used in theirfull detail.If they were,I
suspectthat the aggregateoperatingrate wouldautomaticallylose a point
or two.
Furthermore,seasonalityis a very tough problemfor periodsof peak
output.I gatherthe unadjusteddata were not used becauseoccasionally
theyproducesomepeculiarresults.Seasonallyadjusteddatamaybejust as
misleading.In July, for example,seasonallyadjustedoperatingrates in-
creasedsharply,merelyreflectingthe fact that unadjustedproductionfell
less than usual duringnormalvacation periodsbecausedemandwas so
strong.I thereforehave considerabledifficultyinterpretingseasonallyad-
justedoperatingrateswhenthe economyis close to peak output.
I have a furtherquestionabout how decliningindustriesare handled.
For example,whenmilitaryequipmentcapacityis beingdismantledor the
aerospaceindustryis declining,a gap developsbetweenthe McGraw-Hill
operatingrate and the Whartonoperatingrate. The McGraw-Hillrate

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George L. Perry; and Lawrence R. Klein and Virginia Long 759
tendsto be muchhigherin the decliningindustries.The Whartonratchet
techniqueworkspredictablyon the up side, but how does it work on the
down side?
Finally,just a note on the use of capitalstock figures.They are notori-
ouslypooron retirements,but therearealso problemson additions.A con-
siderableportion of gross fixed investmentrepresentsplants undercon-
struction,a categorythat is highlyvariable.In a periodlike the present,
when there are long lags betweenconstructionstartsand completions,I
think(thoughI haveno datato verifythis)that a disproportionate amount
of theincreasein grossfixedassets,both as currentlyreportedandas calcu-
latedusing survivalcurves,resultsfrom the increasein plantsundercon-
struction.The FederalReserve'suse of the capitalstock with a 50 percent
weightmay thus introducea significantupwardbias to theircapacityesti-
mates.I do hopethatPerry'spaperwillleadto a thoroughgoingrevisionin
this index.
I find Perry'sanalysisof the cyclicalbias in the McGraw-Hillindex of
operatingratesexceptionallyinteresting.It explainsa lot of whathas been
observedbut couldnot be accountedfor in those series.I thinkthat Doug
Greenwaldcould improvethe McGraw-Hillnumbersthroughan effortto
adjustfor these effects.

DouglasGreenwald:I wouldliketo clarifya fewpointsaboutthe McGraw-

Hill indexrelevantto GeorgePerry'spaper.Firstof all, McGraw-Hillgets
all its answerson capacityutilizationratesand investmentplansfrom one
surveyin the spring.It is a packagesurveywhichwe thinkdrawsrelatively
consistentresponsesfromcompanies.Butit does havesomeproblems.One
involvesdiversificationby firms,whichmay make industryclassifications
misleading.For example,the rubberindustrymay reportthat it is adding
10 percentto capacity,when in realityall of this additionis devotedto
chemicals.I don't know how to correctfor this, but it is an important
qualificationto capacitynumbersfor individualindustries.Anotherprob-
lem is determiningthe amountof investmentdevotedto expansion,mod-
ernization,pollutioncontrol, and employeehealth and safety. We have
beenconcernedaboutthe firstthreeof thesefor some time, and questions
designedto get at expendituresfor healthandsafetyequipmentwereadded
to our surveylast spring.
Withregardto data on operatingratesin specificindustries,we do have

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 760 Brookings Papers on Economic Activity, 3:1973
on our worksheets data on all two-digit manufacturing industries, and I
will make these data available. We also now have unpublished data on
thirty-eight three- and four-digit industries.
Finally, I think the differencesin operating rates among firms can be il-
luminating. In a survey last fall, we asked companies where they were op-
erating with respect to their preferredrate, and their reasons for operating
above or below this level. The responses included some very odd reasons
for operating above or below their preferred rate, but I do think their
distribution is significant. While 47 percent of the companies reported that
they were operating under their preferred rate, 30 percent said that they
were operating over the preferredrate and 23 percent said that they were
operating either at the preferred rate or very close to it.

Nathan Edmonson: I agree with most of what Alan Greenspan said, es-
pecially on the question of bottlenecks. A high rate of capacity utilization
in one industry may not tell much about the economy as a whole, given con-
siderable ability to substitute materials. Copper strikes, for example, have
brought out almost unlimited possibilities for substitution for copper as an
input. Our intent in forming the major materials utilization series was to
assemble information on an admittedly small, but nevertheless strategic,
group of materials industries. If the average utilization rate in these indus-
tries were high, and the variance of the rates for individual industries
around this average were small, then substitution would become a moot
point-firms would have to substitute one scarce good for another. The al-
ternative to this approach would presumably be to use industry capacities
and input-output coefficients to build a matrix of constraint relations. Ca-
pacity would then be defined as the maximum of value added, or some other
measure of production, subject to these constraints. The weakness of this
approach is that it ignores the possibilities of substitution. That is why we
prefer to use information on the major materials industries.
My second comment is in response to a specific point made in Perry's
paper: that the capacity index obtained by dividing the industrial produc-
tion index by the McGraw-Hill utilization rate shows positive correlation
with the output series (Table 1). Perry suggested that one possible expla-
nation of this cyclical movement is that industries find capacity when things
get tight and forget about it when things get slack. This is especially likely
in an industry with a very heterogeneous product mix and a fairly nebulous
notion of capacity. Another possible explanation may relate to the value-

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George L. Perry; and Lawrence R. Klein and Virginia Long 761
addedweightingof the industrialproductionindex.The benchmarkingof
the industrialproductionindexto the Censusof Manufacturers is done by
seven-digitproductclasses, which are then added togetherusing value-
addedweights.Whencapacitygets tight, I thinkit is safe to assume,pro-
ducerstend to favortheirmore profitableproductlines. Assuminga posi-
tive correlationbetweenvalue added and profitability,the value-added
weightingsystemwould tend to exaggeratethe level of the cyclicalpeaks
in the productionindex,as the productmixwouldbe shiftedtowardhigher-
value productswhen utilizationis high. The implied capacity measure
is constructedby dividingindependentestimatesof utilizationcollected
fromfirmsinto the relevantcomponentsof the industrialproductionindex.
If the product-mixeffectis in the productionindex(thenumerator)but not
in the reportedutilizationrate (the denominator),the resultingcapacity
measurewouldexhibitthe sameupwardmovementat cyclicalpeaksas the
productionindex.The workwe havedone withindustrypeopleleadsus to
believethat theseproduct-mixeffectsmay not be pickedup in the reports
on utilization.In materialsindustriesespecially,capacityis a fairlysimple
and well-establishedconcept,oftenbasedon engineeringestimatesthat do
not takeaccountof the productmix.In the paperindustry,capacityutiliza-
tion is expressedas the ratio of actualtons of paperto potentialtons of
paper,and the tonnagemeasureis not sensitiveto productmix. Much the
samecan be said for estimatesof utilizationratesin the steel industryand
in petroleumrefining.To the extentthat productmix may not affectthe
reportedutilizationratesas it does the industrialproductionindex,a cycli-
cal bias would emergein this estimateof capacityas it alone among the
capacity indexes studied is directlybenchmarkedto industrialproduc-
tion.

GeorgePerry:I wouldlike to commenton the suggestion,madeby Klein

and Long and by Greenspan,that an input-outputapproachbe taken to
measuring aggregate capacity. Certainly, a lot of important information is
lost in simplyaveraginga lot of disparateoperatingrates for individual
industries.And a moresophisticatedconceptof aggregatecapacity,which
took accountof bottlenecksandshortages,wouldbe niceto have.But,even
if the manydifficultiesin constructingsuch a measurecould be overcome,
it mightnot be the best one for most uses.A materialshortageor a bottle-
neck in an industrysupplyingintermediateproductscan restrainoutput
andraisepricesin a userindustry,just as a shortageof physicalcapacityin

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 762 Brookings Papers on Economic Activity, 3:1973
that industry would. But the two sources of restraint differ in many re-
spects. It would be helpful to know that, even in the presence of under-
utilized facilities, auto output could not expand because steel was unavail-
able; but, for an investment equation, this concept might give the mislead-
ing idea that the auto industry was operating at "capacity" in this situation.
Quite apart from this, none of the present indexes clearly meets the criterion
of a more sophisticated aggregationbetter than the others. If output in 1973
was constrained by bottlenecks and material shortages to a greater extent
than usual, that in itself does not recommend the index that registers the
highest operating rates for the year. Rather, with the present state of the art
of measuring capacity, it seems better to note separatelythe level of operat-
ing rates and conditions in the labor and materials markets and analyze
from there.

GeneralDiscussion

William Branson questioned the procedure of choosing among utiliza-

tion measures on the basis of their performance in explaining prices, invest-
ment, trade flows, and the like. He directed this criticism at both Perry's
paper and Klein's defense of the Wharton measure. Lawrence Krause, on
the other hand, approved a methodology by which one picks a utilization
measure on the basis of the questions one wishes it to answer. Krause
agreed that a linear programming approach might produce a useful mea-
sure of potential production for the entire economy, but noted that such an
approach would have to make specific allowance for the possibilities of sub-
stituting foreign for domestic materials. William Nordhaus suggested that
labor constraints as well as capital constraints be considered in formulating
a capacity concept.
There was some discussion of the merits of the Wharton measure in par-
ticular. Klein answered Greenspan's question about declining industries: in
such cases, judgments are made as to how much of the retired capacity
could be reactivated at short notice, and the downward trend in capacity is
"leveled off" accordingly. Branson pointed out that the effectiveness of
other utilization variablesin explaining trade flows in other models weakens
Klein's case for the Wharton measure. Murray Foss reported the success of
the Wharton measure, as compared to the FRB measure, in his own regres-
sions explaining investment between 1964 and 1973. Gardner Ackley was
disturbed by the inherent inability of the Wharton measure to determine

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George L. Perry; and Lawrence R. Klein and Virginia Long 763
differences in capacity pressures at different cyclical peaks, except to the
extent that the aggregatemeasure would vary due to a differenttime disper-
sion of individual industry peaks. In particular, he noted that its failure to
distinguish between inflationary and noninflationary peaks would hinder
the Wharton measure's performance in price equations.
Charles Holt and Franco Modigliani thought it would be useful to sort
out the effects of preferredand actual utilization rates by including both as
independent variables in Perry's regressions. Stephen Goldfeld added that
this procedure would be particularly important if the response of the de-
pendent variable to utilization was nonlinear as the preferredrate was ap-
proached. Perry agreed that in principle one expected these nonlinearities
to be important; but the limited attempts to find nonlinear effects reported
in the text did not turn up many significant cases. Modigliani and Nord-
haus objected to the use of utilization levels to explain rates of price in-
crease. They noted that since an increase in utilization will raise prices by
raising the desired markup, the proper explanatory variable for the rate of
change of prices is the rate of change of the utilization rate. Otherwise, a
utilization rate that simply remained high could create an ever-widening
gap between prices and wages. Perry replied that he had reported on results
from both specifications because he agreed with these doubts conceptually,
but found that the empirical results did not confirm the doubts. Arthur
Okun suggested that the price equation might be viewed as a reduced form
of a larger model in which utilization worked through investment to accel-
erate the growth of capacity. In this case, an unusually high rate of utiliza-
tion could be sustained only by the continued frustration of plans to expand
capacity to meet demand. Thus prices could reasonably be expected to rise,
even though utilization remained stable at a high level.
Foss cited independent evidence on the tightness of capacity in 1973.
Two series related to capacity utilization published in Business Conditions
Digest-percent of firms reporting slower deliveries, and percent of firms
reporting long-term commitments to buy production materials-exceeded
previous postwar peaks during 1973. Also, as of June 1973, 48 percent of
the firms (weighted by gross fixed assets) responding to a BEA survey re-
ported that they were short of capacity, as compared with 48 percent at the
peak in 1969 and 51 percent at the 1966 peak. Foss also reported that the
chief reason given by firms responding to the McGraw-Hill survey for
operating below their preferred rates was a supply constraint; only 24
percent of those operating below preferredrates cited insufficient demand.

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