Firm capacity underutilization and the measurement of productivity

Large and persistent productivity differences are observed across firms in rich and poor countries. Standard cross-country comparisons implicitly assume firms fully utilize their installed capital. We document that firms frequently operate below capacity, particularly in low-income environments where supply-side constraints like access to electricity limit firms’ ability to produce and deliver output. We develop a simple model showing that when capital is underused, conventional measures of total factor productivity (TFP) conflate true productivity and utilization. Using unique panel data from Ethiopia in which firms report both actual and full-capacity production, we show that true productivity is about 40 percent higher than standard TFP measures for firms in the lowest quartile of capacity utilization, with negligible bias near full capacity. Using World Bank Enterprise Survey data covering over 80 countries, we find that accounting for capacity utilization narrows measured TFP gaps between rich and poor countries by approximately 15 percent.