Economic measures of capacity utilization: A nonparametric cost function analysis

Abstract

Cost based measures of capacity utilization and capacity output are important metrics for evaluating firm performance. Understanding where firms are producing on their average cost curve provides information about whether capacity utilization is greater then, less than or equal to one. This in turn tells managers whether output should be increased, decreased or kept constant. Most firms are multi-output, multi-input in nature which makes estimation of capacity utilization and capacity output challenging if a cost based metric is desired. For a multi-output firm, the relevant concept is ray average cost (RAC) which can be estimated through non-linear DEA models. This paper demonstrates a method to linearize the non-linear DEA program to estimate average, or ray average cost, and to use the results to determine capacity utilization and optimal output. The methods are empirically tested on data from a panel of U.S. electricity producers for the single output case, and a sample of dental practices for the multi-output case. Results show that for both industries, most firms were operating at less than full capacity, and needed to expand output to minimize their costs. For the dental practices, examination of results from six randomly chosen firms showed the importance of operatories in determining optimal levels of output.