Capacity utilisation and profitability: a decomposition of short run profit efficiency

The principal aim of this paper is to measure the amount by which the profit of a multi-input, multi-output firm deviates from maximum short-run profit, and then to decompose this profit gap into components that are of practical use to managers. In particular, our interest is in the measurement of the contribution of unused capacity, along with measures of technical inefficiency, and allocative inefficiency, in this profit gap. We survey existing definitions of capacity and, after discussing their shortcomings, we propose a new ray economic capacity measure that involves short-run profit maximisation, with the output mix held constant. We go on to describe how the gap between observed profit and maximum profit can be calculated and decomposed using linear programming methods. The paper concludes with an empirical illustration, involving data on 28 international airline companies. The empirical results indicate that these airline companies achieve profit levels which are on average US$815m below potential levels, and that 70% of the gap may be attributed to unused capacity.