Quantifying the allocative efficiency of capital: The role of capital utilization

Higher dispersion of log average revenue product of capital (ARPK) is commonly associated with lower capital allocative efficiency. We show this is a result of the assumption that capital utilization is fixed. However, when capital utilization is endogenous, higher capital allocative efficiency is associated with lower dispersion of log average revenue product of capital services (log difference between revenue and utilized capital), not ARPK. Furthermore, contrary to the standard relationship, increases to capital allocative efficiency is associated with higher ARPK dispersion when such improvements arise from greater utilization flexibility. We provide evidence supporting the mechanism and demonstrate counterfactuals where allocative efficiency gains are accompanied by higher ARPK dispersion. Lastly, we apply our framework to study the impact of a capital market liberalization reform in India. We estimate the reform improved allocative efficiency by 0.04%, but counterfactual analysis neglecting the response of utilization would have concluded efficiency gains of 5.25%. • Capital allocative efficiency depends on the distribution of capital services, not capital stock. • The distribution of capital services and capital stock differ due to heterogeneity in utilization. • Improvements in utilization flexibility increases allocative efficiency and ARPK dispersion. • This is contrary to common insight that ARPK dispersion is associated with capital misallocation. • We provide evidence that this bias is present and quantitatively important.