Capacity utilization in emerging economy firms: Some new insights related to the role of infrastructure and institutions

Highlights

• This paper studies influences of institutions on capacity utilization.

• Informal competition signals weakness of internal institutions, and corruption weakness of external institutions.

• Results, using data for more than 100 nations, show both corruption and informal competition undermine capacity maximization.

• Water supply and electric supply restrictions limited capacity utilization, but transportation limitations were not binding.

• Firms' size, age, ownership structure, and managerial experience have important bearings on capacity utilization.

Abstract

This paper adds to the literature on capacity utilization at the firm level by considering the influences of institutions. Specifically, we consider the threat of informal competition as a sign of weakness of internal institutions, and corruption as a signal of the weakness of external institutions. The extant literature has generally considered the role of market and technical factors in dictating capacity utilization. Results, using data across more than 100 nations, show that both corruption and informal competition undermine firms' incentives to use capacity maximally. We also consider the role of infrastructure bottlenecks. Our findings showed that water supply constraints and severe electric supply restrictions limited firms’ ability to utilize capacity, but transportation limitations were not similarly binding. Further, firms' attributes, including size, age, ownership structure, and managerial experience have important bearings. An important implication is that firms’ inability to utilize capacity might be rooted in factors beyond technical constraints.

Introduction

Optimal utilization of production capacity is essential for firms’ competitiveness and profitability, although in some cases, such as credible entry deterrence, excess capacity might be kept (Dixit, 1979). Besides its effects on firms’ economic performance, capacity utilization has wider implications for economic growth and economy wide resource allocations.

Researchers have undertaken both theoretical and empirical studies of firms’ capacity utilization, with one constraint empirical studies face deals with the measurement of capacity utilization. The extant literature has mainly focused on two aspects in trying to explain capacity utilization – technical aspects on the one hand (dealing with malleability issues or inputs in achieving optimal capacity utilization) and non-technical aspects on the other hand (internal inefficiencies (X-inefficiency) or competitive pressures).

A key argument in this paper is that there is another important and previously overlooked influence on firms’ capacity utilization by highlighting the role of institutions (or low institutional quality). In doing so, we consider two aspects – weak institutions that are internal to the industry that the firms operate in and weak institutions that are external to the industry or are overreaching across different industries (e.g., governmental institutions). As a complement to X-inefficiency plaguing firms (see Leibenstein, 1966), we term our considerations Z-inefficiencies.

While institutions are multidimensional (Knack and Keefer, 1995), we denote internal institutional weakness by the threat firms face from informal sector competitors, and external institutional quality weakness by the presence of corruption. Presence of informal competitors, who do not pay taxes/licensing fees and do not adhere to regulations, are signs of weaknesses that industry associations are unable to control (e.g., taxi associations unable to control the plying of unauthorized taxis), and corruption undermines the judiciary and enforcement bodies while also enabling the handing out of government favors out of turn. In the context of the potential impact on capacity utilization, institutional weakness undermines potential payoffs and thus would reduce incentives to operate at optimal capacity. In other words, the presence of informal competitors and corruption amounts to adding uncertainty about potential payoffs that reduce capacity utilization.¹ This consideration of non-technical bearings on capacity utilization has largely been overlooked and we use firm-level data across thousands of firms in scores of nations to test these predictions. In addition to this, we are also able to consider some technical aspects by the way of infrastructure limitations dealing with water, electric supply and transportation. This is an additional contribution of this work.

Key questions addressed are the following:

• Do weak institutions diminish firms’ incentives to utilize production capacity optimally?

• Are the effects of internal institutional weakness on capacity utilization similar to those of external institutional weakness?

• How do different infrastructure limitations inhibit firms’ abilities to utilize capacity?

• What new insights does Z-inefficiency bring over X-inefficiency?

Our results, using firm-level data across more than 100 nations, show that both the presence of corruption and informal competition undermine firms' incentives to use capacity maximally, while some, but not all, infrastructure constraints have a similar debilitating effect. Further, firms' attributes, including size, age, ownership structure, and managerial experience have important bearings. Implications for policy formulation are discussed.

The layout of the rest of the paper includes the literature and the model in the next section, followed by data and estimation, results, robustness analysis, and conclusions.