Decomposing Capacity Utilization in Data Envelopment Analysis

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European Journal of Operational Research 195 (2009) 575594

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O.R. Applications
Decomposing capacity utilization in data envelopment analysis:

An application to banks in India
Biresh K. Sahoo a,b,*, Kaoru Tone c
a
Amrita School of Business, Amrita Vishwa Vidyapeethem, Ettimadai Post, Coimbatore 641 105, India
b
Institute for Monetary and Fiscal Policy, Vienna University of Economics and Business Administration, Augasse 2-6, 1090 Vienna, Austria
c
National Graduate Institute for Policy Studies, 7-22-1 Roppongi, Minato-ku, Tokyo 106-8677, Japan
Received 30 January 2006; accepted 15 February 2008

Available online 21 February 2008
Abstract
This paper briey reviews the existing methods of capacity utilization in nonparametric framework from economic perspectives, and
then suggests an alternative in the light of limitations therein. In the spirit of work by Coelli et al. [Coelli, T.J., Grifell-Tatje, E., Perel-
man, S., 2002. Capacity utilisation and protability: A decomposition of short run prot eciency. International Journal of Production
Economics 79, 261278], we propose two methods, radial and non-radial, to decompose the input-based physical (technological) capacity
utilization into various meaningful components viz., technical ineciency, ray economic capacity utilization and optimal capacity idle-
ness. A case study of Indian banking industry is taken as an example to illustrate the potential application of these two methods of
decomposition. Our two broad empirical ndings are that rst, competition created after nancial sector reforms generates high e-
ciency growth, and reduces excess capacity; second, the cost gap of the short-run cost from the actual cost is higher for the nationalized
banks over the private banks indicating that the former banks, though old, do not reect their learning experience in their cost minimiz-
ing behavior.
2008 Elsevier B.V. All rights reserved.
Keywords: Capacity utilization; Technical eciency; Optimal idle capacity; DEA
1. Introduction
In the literature on production economics, the indivisibility argument gives rise to the concept of minimum ecient scale
(MES), which is, in turn, used as a benchmark for dening idle/excess capacity.1 Idle capacities, in general, arise due to
indivisibilities in inputs (i.e., xed factor), or a secular decline in demand for existing product, or due to demand uncer-
tainty for the existing product. In case of single-product rms, idle capacities lead to scale eects2 when production is
expanded. If the demand for product is downward slopping, then instead of scaling up existing product merely on the basis
of capacity utilization (CU), rm could also use the existing idle capacities to diversify into other products so as to enjoy
economies of scope. So, the requirement that the rm faces a downward slopping demand curve indicates that scale
*
Corresponding author.
E-mail addresses: s_biresh@ettimadai.amrita.edu, biresh.sahoo@wu-wien.ac.at (B.K. Sahoo), tone@grips.ac.jp (K. Tone).
1
The excess capacity so dened can give no indication of the extent of idleness or underutilization in plant and machinery. On its detailed discussion, see
Cassels (1937).
2
For a historical discussion on the evolution of the concept of scale and its computational procedure, see, among others, Gold (1981), Sahoo et al. (1999,
2007) and Tone and Sahoo (2003, 2004, 2005, 2006).
0377-2217/$ - see front matter 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.ejor.2008.02.017
576 B.K. Sahoo, K. Tone / European Journal of Operational Research 195 (2009) 575594
considerations play a role only under perfectly competitive condition whereas scope considerations are more relevant to
rm in planning the size of operation facilities under monopolistic competition.3
The CU measure enables a rm to know the extent of idle/excess capacities available, and the dierences in the degree of
CU among rms depend precisely upon the ability in adjusting their xed factors4 in the short run. Instances of cost inef-
ciency behavior frequently observed in most rms are precisely due to the inability of adjusting xed factors. It is there-
fore imperative to analyze rms behavior concerning capacity utilization, a key economic parameter of performance, in
any competitive set up.
CU measures are of two types: physical (technological) or economic, the details of which will be spelt out in next section.
Physical measure of CU is not very meaningful in the sense that the contribution of unused (idle) capacities does not always
necessarily lead to increased prot. Therefore, keeping in mind the principle of behavioral short-run prot maximization,
Coelli et al. (2002) argue that it is always better for rm to have some optimal idle capacity. They decompose, using dif-
ferent variants of data envelopment analysis (DEA) models, the physical measure of CU (in terms of output) into three
meaningful components: (output) technical eciency, economic CU (net of technical ineciency) and optimal capacity
idleness, which are of practical use to managers.
Inspired by this work, we measure physical CU in terms of inputs, and then decompose this into technical eciency,
economic CU (net of technical ineciency), and optimal capacity idleness. We illustrate the use of this decomposition
in the banking sector in India, which may be precisely due to the possibility that the physical measure of CU in terms
of output expansion may not be so meaningful for the banking industry because it is often argued that capacity output
based on technology is not well dened for nancial services as it often uses primarily non-specic capital, which allows
high uctuations with market demand. And, this alternative way of measuring physical CU is also important because
the management would like to know the opportunity cost of not properly forecasting the future demand by dening
CU through reduction in xed inputs when output expansion might not be feasible due to either sudden decline in demand
or demand uncertainty or both.
The novelty of this paper is twofold: First, the Indian banking industry, which is now operating in a largely dereg-
ulated and competitive environment, is considered an empirical study because with the aim of increasing the operational
eciency, the nancial sector reforms initiated in 1992 by Reserve Bank of India (RBI) through entry deregulation,
branch delicensing, deregulation of interest rates, and allowing public sector banks to raise up to 49% of their equity
in the capital market, really changed the nature of competition, and paved the way for acceleration of technological pro-
gress in the industry. We believe that these changes might have created excess capacity.5 To the best of our knowledge,
we have, however, not come across any paper in India attempting to verify the existence of excess capacity using DEA in
the Indian banking sector.6 Second, our method of decomposition of the physical measure of CU (in terms of inputs) is
new to the literature. This decomposition is very useful to managers taking decisions in their short-run cost minimizing
behaviors.
The reminder of the paper proceeds as follows. In Section 2 we briey review the concepts of physical and economic CU,
then discuss their measurements in DEA framework, and nally point out the limitations therein in their measurement. We
illustrate in Section 3 the decomposition of physical CU into three meaningful components in both radial and non-radial
DEA models. Section 4 deals with the empirical application of banking industry in India, and Section 5 concludes.
2. Concepts of capacity utilization and measurement
CU is usually dened as the ratio of actual output to some measure of potential output. Two dominant approaches exist
in the literature to measure potential output technological approach and economic approach. In the former, Johansen
3
There is ample evidence that no matter whatever the extent of diversication, some idle capacities may still remain. However, if the production of single
output is envisaged, it is in the interest of rm to have some unused capacities. See Klein (1960) for details.
4
The failure to completely adjust the xed factors by the rms generates structural ineciency. Instances of such behavior are more likely in real-life
cases because other factors such as adjustment costs, administrative regulations, external factors, etc. play a major role to determine such behavior.
5
In the banking literature excess capacity might be due to decreasing costs and excessive risk. In case of the former, there are either too many rms in the
industry, or the average level of output by existing rms is too low to experience economies of scale that are generated by the xed inputs. However, the
latter is due to product dierentiation in terms of banks loans and investment policies producing an increase of risk without a corresponding increase of
return. That is, excess capacity exists if the return on loans and investments is less than the minimum rate of return that insures long-run protability in
which case banks have an amount of funds higher than the amount that can lend without reducing protability and increasing risk. See Chaai and
Dietsch (1999) for the details.
6
There are however two Indian studies, viz., by Sogala and Ramasastry (1998) and Ramasastry and Jayaraman (2005) who have studied, following
Frydl (1993), the existence of excess capacity using one indicator, i.e., minimum rate of return on earning assets. A bank is said to operate with optimal/full
capacity if the rate of return on average earning assets is greater than the minimum threshold rate and with suboptimal/excess capacity if the rate of return
on average earning assets is less than the minimum threshold level. The latter study uses two indicators viz., percentage of number of banks operating at
suboptimal level to total number of banks, and percentage of average earning assets of banks functioning at suboptimal level to total average earning
assets of all banks.
B.K. Sahoo, K. Tone / European Journal of Operational Research 195 (2009) 575594 577
(1968) denes capacity output7 as the maximum potential output that could be produced per unit of time with existing
plant and equipment, provided that the availability of variable factors is not restricted.8 This denition of potential output,
with slight modication, was rst made operational in DEA setting by Fare et al. (1989).
However, in the economic approach9 there are three denitions of capacity output. The rst denition corresponds to
output (Yt) at which the long and short-run average cost curves are tangent, yielding CUt = Y/Yt. (Klein, 1960; Fried-
mann, 1963 and Segerson and Squires, 1990). The second one corresponds to the output at which the short-run average
cost curve attains minimum, and thus CUm = Y/Ym (Cassel, 1937; Hickman, 1964; Berndt and Morrison, 1981). The third
denition of CU compares the cost gap when actual output diers from capacity (short-run optimal) output, i.e.,
CUc = C*/C where C is the rms actual cost and C* is its shadow cost (Morrison, 1985a,b). Note that the rst two mea-
sures of CU,10 i.e., CUt and CUm are the same under the assumption of constant returns to scale (Berndt and Hesse, 1986)
whereas in case of technology exhibiting increasing returns to scale, CUm < CUt, and in case of decreasing returns to scale,
CUt < CUm.
2.1. Measurements of capacity utilization
Before introducing various measures of capacity utilization in DEA framework, we need rst to introduce various rep-
resentations of technology set. Throughout we deal with n rms, each rm uses m inputs to produce s outputs. Let the input
index set be IM = {1 ,2 , . . . , m} and output index set be IS = {1, 2, . . . , s}. For each rm o (o 2 IN) where IN = {1, 2, . . . , n}
is the index set of rms, we denote, respectively, the input and output vectors by xo 2 Rm and yo 2 Rs. Here, xo xfo ; xvo )
where the total m-input vector (xo) of rm o is partitioned into two: the rst g-input vector (xfo : i 2 IF; IF = {1, 2, . . . , g}) as
xed, and the remaining (mg)-input vector (xvo : i 2 IV; IV = {g + 1, g + 2, . . . , m}) as variable. Let the input price vector be
wo wfo ; wvo 2 Rm .
The technology (T) is dened as the set of all feasible inputoutput vectors, i.e.,
T fx; y : x can produce yg: 1
Alternatively, the technology can be described by its input set, L(y), which is the set of all input vector x, which can yield at
least output vector y, i.e.,
Ly fx : x; y 2 T g 8y: 2
T can also be described by its output set, P(x), which is the set of all output vector y, which can be obtained from input
vector x, i.e.,
P x fy : x; y 2 T g 8x: 3
2.1.1. Physical measure of CU

Following Fare et al. (1989), to measure physical CU of rm o, we set up the following two output-oriented DEA mod-
els in variable returns to scale (VRS) environment: one with all inputs, and other with only xed inputs, as follows:
h max h
P P P 4
s:t: xij kj 6 xio 8i 2 I M ; rrj kj P hy ro 8r 2 I S ; kj 1; kj P 0 8j 2 I N ;
j2I N j2I N j2I N
^
h max ^
h
P P P 5
s:t: xij kj 6 xio 8i 2 I F ; rrj kj P ^hy ro 8r 2 I S ; kj 1; kj P 0 8j 2 I N :
j2I N j2I N j2I N
The maximum potential output vector for rm o is h*yo when all the inputs are given as observed, whereas the capacity
output vector is ^
h y o when xed inputs are given, and the remaining variable inputs are allowed to freely vary. As per
Johansens denition, the physical CU for rm o is dened as the ratio of potential output to capacity output, i.e.
7
Gold (1955) is, however, the rst who provided two forms of capacity output estimates: (1) an estimate of total amount, which can be produced of any
given product, assuming some specied allocation of plant facilities to such output; and (2) an estimate of the composite productive capacity covering
some specied range of products. Johansen (1968) then utilizes the concept of production function to dene the capacity of existing plant in a similar way
to Gold (1955).
8
Following this denition of capacity output, Fare (1984) describes both necessary and sucient conditions for the existence of plant capacity.
9
The economic approach was rst analyzed by Cassel (1937).
10
In empirical application, the choice of a particular measure is of paramount importance if all the measures are found not to be highly correlated, and
correlation is not constant over time and across rms, because, the choice made may inuence the conclusions to be drawn from the study. See Nelson
(1989) for the detailed discussion on this.
CUo x; y h =^
h : 6
o
CU (x, y) 6 1. There are two points to be noted here. First, Fare et al. (1989) measure of CU assumes away technical inef-
ciency, resulting in a downward bias to the utilization rates of individual rms, because they treat technical ineciency
and unused capacity as two mutually exclusive components. However, Coelli et al. (2002) 11 argue that this measure might
lead to some unusual results,12 and therefore consider technical ineciency as a component of unused capacity. So, CU of
rm o is the ratio of actual output to capacity output, i.e., CUo x; y 1=^h . Second, this measure is based on the unre-
alistic assumption of zero shadow input prices for variable inputs.
Note also that the capacity output vector ^ h y o in the radial model (5) does not reect the true capacity output when
slacks remain in some of the outputs after full radial eciency is achieved,14 which results in an upward bias in CU esti-
13
mates. In an attempt to get rid of this problem, we can set up, in the spirit of slack-based measure (SBM) (Grifell-Tatje
et al., 1998; Tone, 2001), the following non-radial DEA model15 below to measure physical CU.
1X
SBMo g max 1 s =y
s r2I S r ro
X X X
xij kj 6 xio 8i 2 I F ; y rj kj s 7
s:t: r y ro 8r 2 I S ; kj 1;
j2I N j2I N j2I N
kj P 0 8j 2 I N ; s
r P 0 8r 2 I S :
Here CU = (1/g*). This scalar measure of eciency (g*) satises several nice properties such as units invariance and
monotonicity.
The most important reason why a non-radial measure was introduced to the literature pertains to the problem that the
radial measure does not always satisfy the fundamental condition, i.e., indication of ecient vectors. That is, for some
types of technologies that are estimated nonparametrically, the radial projection can, in fact, still be an inecient point
in the commonly accepted sense of Koopmans (1951).16 And, given the fact that the way the real-life rms frequently
change their output mixes using dierent input mixes, we do believe that the non-radial measure of eciency reects
the empirical realities more.
11
Coelli et al. (2002) came across this limitation while studying the decomposition of prot gap between actual and short-run maximum prot into
various components that are of practical use to managers, with special emphasis on that component due to unused capacity, along with measures of
technical ineciency and allocative ineciency. However, earlier literature in this direction includes Gold (1955, 1973, 1985), Eilon and Teague (1973),
Eilon (1975, 1984, 1985) and Eilon et al. (1975).
12
For example, a decrease in CU sometimes produces an increase in the level of short-run prots, and the optimal behavior of rms is, therefore, to have
some idle capacity in their plant possibilities. Winston (1974), therefore, treated the idleness of CU as an economic variable.
13
Slacks are obvious in all reference technologies that are constructed nonparametrically, i.e., when the reference technology is obtained as the convex
monotonic hull of the observed input and output vectors. Since Afriat (1972) this nonparametric representation is of particular importance if one follows a
revealed preference approach to producer behavior, which has been advocated by Varian (1984) for its use in testing regularity conditions and for
nonparametric eciency measurement itself by Banker et al. (1984). However,
14
In the radial measure, the assumption of equiproportionate increases in all outputs/inputs has been taken as a rule though there is no a priori reason to
measure eciency radially, even for homothetic technologies. This means that there is no trade o between outputs/inputs, which is counter intuitive. Price
information would generally indicate that the opportunity costs of production/consumption of one output/input over another are not the same.
Consequently it might be optimal to expand outputs/inputs in non-equal proportions reecting their diering opportunity costs. To argue why the non-
equiproportionate changes in outputs for multi-output rms is a reality, Chambers and Mitchell (2001) said: . . .many modern rms rather routinely
change their output mix by moving in and out of dierent product lines in response to perceived market opportunities. Further, it is not unusual to
encounter rms that were once highly specialized in a single-product line that subsequently move into entirely new product lines in an attempt to capture
new markets, prevent entry by potential competitors, or simply to diversify their productive portfolio. For example, Schmalensee (1978) documented
that the six leading producers of breakfast cereals introduced roughly eighty new brands between 1950 and 1972! (p. 35). Similarly, we can argue that
when the techniques and inputs used at higher scale of production is very dierent from those used at a smaller scale, an equiproportionate changes in all
inputs has no economic meaning, implying dierential increases in inputs is a reality for rm expansion.
15
Note that this proposed model is completely new to the literature to measure physical CU.
16
However, in spite of indication problem, the radial eciency measures have been not only very popular but also widely used. See Cherchye and Van
Puyenbroeck (1999) who have cited four reasons for this. (1) The reference technologies on the empirical level normally approximate in nature and
therefore the indication problem may be considered as an accidental and somewhat articial consequence. (2) The axiomatic approach on the theoretical
level, as further developed by various authors such as e.g., Bol (1986), Russell (1988, 1990) and Christensen et al. (1999), has forwarded the insight that no
universally best measure exists, which has also been shown empirically by Sengupta and Sahoo (2005). (3) These axioms refer to desirable mathematical
characteristics of an eciency function, which are noted originally by Shephard (1970), and in an eciency measurement context by Fare and Lovell
(1978), Bol (1986, 1988) and Russell (1985, 1988, 1990). However, even though convexity postulate is under severe attack because it assumes away many
important technological features such as indivisibilities, economies of scale and scope, some authors e.g., Kopp (1981) or Russell (1985) clearly took a
favorable stance towards the radial measure, given its economic interpretation for the class of convex monotonic technologies. (4) Ferrier and Lovell
(1990) have claimed that slacks may be viewed essentially as resulting from allocative rather than technical eciency. Slacks appear because of the
piecewise linear structure imposed on the technology set. To Frsund (1998), this way of determining technology is really an expression of our ignorance,
and represents a pessimistic limit. As a remedy, he points out that following Varian (1984) it should be easy to modify the vertical and horizontal
segments of technology in such a way that there is no room for slacks.
More importantly, in the long-run radial measure of eciency, the output is related to the inputs only by dening the
input-mix in a special way, e.g., as a replication measure. This replication measure is purely statistical often used in sta-
tistical theory of design of experiments. But this lacks any economic meaning because the techniques and inputs used at
higher scale are in general very dierent from those used at lower scale of production.17
2.1.2. Economic measure of CU

Using optimal kj in model (5), the optimal rate of CU of variable inputs can be obtained as:
X
CUio xij kj =xio 8i 2 I V : 8
j2I N
Note that model (5) is based on the premise that the shadow price of all the variable inputs are all zero, which yields capac-
ity output vector ^ h y o coinciding with short-run shadow prot maximizing output vector, y*, where output price equals
marginal cost. However, in real-life cases, it is most unlikely that the point of optimal scale and short-run prot-maximiz-
ing point will ever coincide,18 which has led to turn the attention of many19 to look at the short-run cost function as a
necessary tool for measuring capacity utilization.
In the short run, with the given xed input vector (xfo ), the minimum short-run variable cost C vo y; w of rm o to pro-
duce yo can be obtained from the following LP (Prior and Filimon, 2002):
X
C vo y; w min wio xi
xi ;k
i2I V
X X
s:t: y rj kj P y ro 8r 2 I S ; xij kj xi 6 0 8i 2 I V ; 9
j2I N j2I N
X X
xij kj 6 xio 8i 2 I F ; kj 1; kj P 0 8j 2 I N :
j2I N j2I N
The short-run cost eciency (CESRo ) can be dened as the ratio of minimum short-run total cost to actual total cost, i.e.,
!, !
X X X
SR v
CEo C o y; w wio xio wio xio wio xio : 10
i2I F i2I V i2I F
However, in the long run where xed inputs can be adjusted to their respective optimal levels, the required minimum long-
run total cost Co(y, w) for rm o to produce output vector (yo) can be obtained from the following LP (Fare et al., 1985):
X X
C o y; w min wio xi wio xi
xi ;k
i2I V i2I F
X X
s:t: y rj kj P y ro 8r 2 I S ; xij kj xi 6 0 8i 2 I V ; 11
j2I N j2I N
X X
xij kj xi 6 0 8i 2 I F ; kj 1; kj P 0 8j 2 I N :
j2I N j2I N
The long-run cost eciency (CELR) of rm o is then dened as the ratio of minimum long-run total cost over actual total
cost, i.e.,
!
X X
LR
CEo C o y; w= wio xio wio xio : 12
i2I V i2I F
17
For replication any rm can be replicated by a new rm. But this has no practical and economic meaning because it is not a controlled experiment. It is
usually very hard to judge the economic relevance (i.e., eect) of a replicated rm of a given size (i.e., treatment) in real-life unless it is well compared with
an actual rm of that size. The issue involved here is how representative a replicated rm is of an actual rm to which the investigator would like to project.
It can be argued that a replicated rm may not properly represent a real-life rm because of indivisibilities not only in technology, but also in unique
attributes associated with geographic locations and innovative mangers. If there is no such indivisibilities, there is no economic justication for the
existence of large rms, i.e., there is nothing to be gained by organizing economic activity in large, durable and complex units such as assembly lines,
bridges, transportation and communication networks, giant presses, and complex manufacturing plants, which are available in specic discrete sizes, and
whose economic usefulness manifests itself only when the scale of operation is large.
18
The dierence between prot-maximizing output (Y*, say) and cost minimizing output (Y**, say) can aect the short-run equilibrium in the sense that
potential output may or may not occur at the level of output where the short-run average cost (SRATC) curve reaches its minimum: Y* > Y** or (Y* < Y**)
when the output price is greater than (lower than) the minimum level of the SRATC. See Berndt and Morrison (1981) for a detailed discussion on how
variations in input prices might aect the minimum point of the SRATC and hence Y**.
19
See, for example, among others, Klein (1960), Berndt and Morrison (1981) and Prior and Filimon (2002) for the details.
The CU for xed inputs in the short run is dened as the ratio of optimal value of xed input in the long run (xio ) over
actual value of it in the short run, i.e.,
CUio xio =xio i 2 I F :20 13
CUio = 1 represents that actual and long-run xed input levels are the same, implying both short and long-run average
costs to be tangent with each other. However, any value of CUio being less than one represents under utilization of xed
input by rm o operating under increasing returns whereas CUio being more than unity represents over utilization of xed
input factor by rm o under decreasing returns. However, the CU for rm o is dened as the ratio of minimum short-run
total cost over minimum long-run total cost,21 i.e.,
!,
X
v
CUo C o y; w wio xio C o y; w: 14
i2I F
One can now argue that in many instances the true performance of rms may not be well captured from the cost DEA
models such as (9) and (11). First, consider a case of technology involving one input and one (multiple) output(s) where
input technical eciency and cost eciency are the one and same, which implies that input prices have no role to play in
determining cost eciency (CE). Second, consider a case where, if any two rms, say A and B, use same amount of input
(x) to produce the same amount of output (y), i.e., xA = xB and yA = yB, but unit prices of input (x) of rm A are twice
those of rm B, i.e., wA = 2wB, then CEA = CEB. See Tone (2002), Tone and Sahoo (2005, 2006) for the details. Third is the
implied one when scale elasticity in production environment (qp) is not dierent from its dual counterpart, i.e., scale elas-
ticity in cost environment (qc), thus giving the illusion that returns to scale and economies of scale are the one and the
same22 (Tone and Sahoo, 2004, 2005; Sengupta and Sahoo, 2006; Sahoo et al., 2007).
Therefore, in an attempt to get rid of the aforementioned problems, we suggest the following two LP models to measure
economic CU as follows:
P
SRVCo min xi
i2I V
P P
s:t: xij kj xio 8i 2 I F ; xij kj xi 6 0 8i 2 I V ; 15
j2I N j2I N
P P
y rj kj P y ro 8r 2 I S ; kj 1; kj P 0 8j 2 I N ;
j2I N j2I N
P P
LRTCo min xi xi
i2I F i2I V
P P
s:t: xij kj xi 6 0 8i 2 I F ; xij kj xi 6 0 8i 2 I V ; 16
j2I N j2I N
P P
y rj kj P y ro 8r 2 I S ; kj 1; kj P 0 8j 2 I N ;
j2I N j2I N
where xij wij xij 8i; j is the ith observed input cost of jth rm. Denoting the optimal solutions to model (15) and model
(16) with * and ** respectively, CU of rm o is then dened as the ratio of the long-run total cost over the short-run
total cost, i.e.,
20
Dating back to the Classics when McFadden (1978) developed an econometric model describing the utility behavior in the design of new electricity
generating plants where he introduced a load factor (l) by dening it as the ratio of observed output over potential output in the rst year of operation. The
potential output is given by the plant capacity in the rst year of operation. The following relations were then established: L = k(l)L* and M = k(l)M*,
where L and M are the observed labor and fuel inputs in the rst year of operation. L* and M* are the ex ante designed optimal quantities of labor and
materials. Here the load factor explains the dierence between the observed and ex ante optimal quantities. The expression of CU in (13) in fact extends the
aforementioned idea of McFadden to the case of capital, which is a xed input where we can rewrite (13) as K = k(l)K*, where K can be dened as the
optimal quantity of capital associated with the observed level of load factor (l). We owe to one anonymous referee who suggested us to relate our
expression of CU with McFaddens idea of load factor.
21
The reciprocal of CU dened in (14) is called structural eciency that arises from the ability of the rm to adjust its xed factors along with variable
factors. This reciprocal of CU is also called capacity eciency in the paper by Prior (2003), which constitutes one of the very few applications of the
concept of CU to the banking industry. Note that the CU measure, as dened in (14), is rst advocated by Fare et al. (2000, p. 106) in constant returns to
scale environment. But the cost measure employed here is very dierent from the other cost measures employed in the literature (e.g., Morrison, 1985a,b,
among others) where following Klein (1960), they evaluate the reference cost at the optimal (minimal long-run or short-run average cost) output levels.
22
In this cost DEA model where input factor prices are held constant, the cost structure, C(y;w) is based on an underlying production technology L(y)
where increasing returns to scale implies economies of scale because qc dy=y dy=y dy=y dy=y dy=dx MP
dc=c dw:x=w:x w:dx=w:x dx=x y=x AP qp . However, since the input
market is typically imperfect, these two concepts can no longer be the same. That is, when the demand for input is inversely related to its price, i.e.,
jew j
x = f(w) with f0 < 0, then, qc 1jewdy=y dy=y
jdw=w 11=jew jdx=x 1jew j qp where ew is input price elasticity of demand. A discussion of the conceptual
dierences between these two concepts lies beyond the scope of the current study. However, interested readers can refer to our earlier studies, e.g., Sahoo
et al. (1999) and Tone and Sahoo (2003), where both concepts are critically analyzed within classical and neoclassical perspectives.
! !
X X X X
CUo x
i x
i xi xi : 17
i2I F i2I V i2I F i2I V
Note that the value of CUo being less than one implies excess cost arising from non-optimal nature of xed input. However,
in the special case of unique constant xed input and unique constant xed input price for all production possibilities, both
optimal utilization rate for xed inputs and CU for rm take unity value, assuming away the distinction between long-run
and short-run cost eciency.
In our discussion concerning rms physical CU, our focus has been in describing it in terms of output expansion along
the capacity frontier, given the available xed input factor. This way of measuring CU is important for organizations, espe-
cially in the public (or non-for-prot) sectors where the workforce and the budget are xed and the management of these
organizations is asked to produce the maximal output (mainly services) with the resources given to it. However, given the
very nature of the construct of the capacity frontier, it could also be of interest to alternatively describe this concept in
terms of contraction of xed input factor to produce a given level of output23 because the management would like to know
the opportunity cost of not properly forecasting the future demand by dening CU through reduction in xed inputs when
output expansion might not be feasible due to either sudden decline in demand or demand uncertainty or both. And more
importantly, as has been argued in the introduction, the physical CU in terms of output expansion may not be so mean-
ingful for banking industry because it is often argued that capacity output based on technology is not well dened for nan-
cial services as it often uses primarily non-specic capital, which allows high uctuations with market demand. Therefore,
cost-based measure of CU will be more meaningful. In the immediately following section we will be demonstrating the
decomposition of physical CU into technical eciency, ray economic CU and optimal capacity idleness.
3. Decomposition of physical CU
We now rst present in radial scheme the decomposition of physical CU.
3.1. Radial scheme
We set up the following DEA model [Model I] to estimate physical CU of rm o.
Model I min ^
h
X X X
s:t: xij kj 6 ^
hxio 8i 2 I F ; y rj kj P y o 8r 2 I S ; kj 1; kj P 0 8j 2 I N : 18
j2I N j2I N j2I N
The minimum technological capacity (also called ray capacity) input vector corresponding to output vector yo is at point
xc ^
h xo (see Fig. 1). The physical CU (or, ray CU) is oxc/oxo, i.e., ^h itself. By construct, ^h 6 1 . Using optimal kj in
[Model I], the optimal variable inputs could be determined. By running this model n number of times, one for each rm,
one can generate the radial physical capacity frontier for all the rms. As discussed earlier, one of the factors explaining this
CU is the concept of technical ineciency. To measure the extent to which technical eciency of rm o explains physical
CU, one can set up the following DEA model [Model II]24:
Model II min h
X X
s:t: xij kj 6 hxio 8i 2 I F ; xij kj 6 hxio 8i 2 I V ;
j2I N j2I N 19
X X
y rj kj P y o 8r 2 I S ; kj 1; kj P 0 8j 2 I N :
j2I N j2I N
23
The analysis of productive performance on the input side can be argued to hold for a variety of reasons. First, Real world managers are never given a
bundle of inputs and told to produce the maximum output from it. Instead they are given output targets and told to produce them most eciently. Second,
protability in any business hinges on the eciency of operations. But if the business involves a commodity, then what depends on ecient operations is
survival. When prices are beyond companies control, what remains are the costs. This reects the companies emphasis on the input dimension policies.
On a tentative basis, it has been suggested in the literature that costs (or inputs) are generally more predictable than outputs, giving cost targets a greater
credibility than those for outputs. Sengupta (1987) has argued that . . .data variations may arise in practical situations . . . when the output measures have
large and uncertain measurement errors which are more signicant than in the input measures (p. 2290). For example, in school eciency studies, the input
costs, such as teachers salaries, administrative expenses, etc., may have low measurement errors whereas the performance test scores of students may
contain large errors of measurement of true student quality. This argument is most compelling where measurement errors are large relative to true
random uctuations in the production process.
24
[Model II] is same as the input-oriented BCC model.
Input (x2)
xo
x*
L (y: x)
C' xe
L (y: xv)
xrec L (y: xv,rec)

xc L (y: xv,c)
O
Input (x1)
Fig. 1. Decomposition of technological CU.
The input technical ecient point for rm o, is xe(=h*xo) (see Fig. 1) whose technical eciency score is oxe/ oxo, i.e., h*
itself. One can thus generate technical eciency frontier for all the rms by running this model n number of times, one for
each rm. Note that this frontier is a subset of capacity frontier. Note that both capacity point and technically ecient
point lie on the ray from the origin through observed input vector of rm o because input proportions are maintained
constant.
Since it is most likely that cost at point xc is not minimized, point xc may not therefore deem t to be a meaningful
measure of economic capacity. Now, invoking the behavioral assumption of cost minimizing behavior, we need to set
up the following short-run cost DEA model [Model III]25 to nd out the cost minimizing input vector of rm o:
X
Model III min wio xi
xi ;k
i2I V
X X
s:t: y rj kj P y ro 8r 2 S; xij kj xi 6 0 8i 2 I V ; 20
j2I N j2I N
X X
j2I N j2I N
Let the cost minimizing input vector be at point x* to produce output vector yo (see Fig. 1). The trouble in describing x* as
economic capacity point is that it may or may not lie on the ray from the origin through the observed input vector xo. To
make the cost minimizing input vector lie on this ray, we set up the following DEA model [Model IV] for rm o:
X
Model IV min wio bxio
b;k
i2I V
X X
s:t: y rj kj P y ro 8r 2 S; xij kj 6 bxio 8i 2 I V ; 21
j2I N j2I N
X X
j2I N j2I N
The cost minimizing input vector is at point xrec (=b*xo), which now falls on the ray from the origin through point xo. This
cost minimizing point is also called as ray economic capacity (REC) point. Note that input vectors xrec and x* are not on
the same iso-cost line CC0 , and their corresponding cost values exhibit the following relationship: C(xrec) P C(x*). Now,
the physical CU of rm o can be decomposed as:
oxc oxc oxrec oxe
CU xo ; y o ; 22
oxo oxrec oxe oxo
where (oxe/oxo) is the measure of input technical eciency (TE), (oxrec/oxe) is the measure of ray economic capacity uti-
lization net of technical ineciency, and (oxc/oxrec) is the measure of optimal amount of capacity idleness. The product of
(oxrec/oxe) and (oxe/oxo) is termed as ray economic capacity utilization. So, physical CU is the product of ray economic CU
and optimal amount of capacity idleness.
25
[Model III] is the same as that in (9).
Now, one can demonstrate the decomposition of the dierence between actual and minimum cost of rm o producing
output vector yointo some meaningful components as:
Cxo Cx Cxo Cxe Cxe Cxrec Cxrec Cx : 23
The rst component represents loss due to technical ineciency, the second component is loss due to not operating at ray
economic capacity, and last one is loss due to input-mix eect. The rst two components combined together represents loss
due to unused capacity.
The diagrammatical representation of decomposition of physical CU for a technically inecient rm o, which is oper-
ating at point xo, is illustrated in Fig. 1. This rm can improve its eciency by moving onto the point xe in the technical
ecient frontier, and its TE score is (oxe/oxo). The technological capacity point corresponding to yo is point xc, and the
physical CU is (oxc/ oxo). The point x* is the short-run cost minimizing input vector, given the variable input price vector
(CC0 is the iso-cost line) whereas xrec is the cost minimizing point when input-mix of the original input vector xo is pre-
served. So the ray economic CU of rm o is (oxrec/oxo).
3.2. Non-radial scheme
The decomposition of physical CU in radial scheme suers from two fundamental shortcomings. First, the capacity
input vector, xc ^h xo obtained from Model I does not reect true potential capacity when there remains slacks in some
inputs after full radial eciency is attained. Similarly, technically ecient point xe (= h*xo) obtained from Model II might
suer from the problem of slacks. Second, as already discussed earlier, cost models (III and IV) suer from serious prob-
lems. Therefore, we suggest the following non-radial input-oriented models to decompose the physical CU. To determine
non-radial measure of physical CU, analogous to radial input-oriented [Model I], we set up the following input-oriented
non-radial model [Model I0 ].
!
0 ^ 0 1 X s i
Model I h min 1 24
g i2I F xio
X X
s:t: xij kj si xio 8i 2 I F ; y rj kj P y ro 8r 2 I S ;
j2I N j2I N
X
kj 1; kj P 08j 2 I N ; s
i P 0 8i 2 I F :
j2I N
c c
Let the optimal solutions of this
P P model be kj and si . The optimal input and output vectors of rm o is ^xo ; ^y o

j2I N xij kj 8i; j2I N y rj kj 8r , which represents a point on the capacity frontier with no slacks in either input or output.
^ 0
Here h measures the physical measure of CU (inclusive of technical ineciency) of rm o.
To determine input technical eciency as a component of physical CU, the corresponding analogous input-oriented
non-radial model to [Model II] can be set up as
!
1 X s
Model II0 h0 min 1 i
25
m i2I M xio
X X
s:t: xij kj s
i xio 8i 2 I F ; xij kj s
i xio 8i 2 I V ;
j2I N j2I N
X X
y rj kj P y o 8r 2 I S ; kj 1; kj P 0 8j 2 I N ; s
i P 0 8i 2 I M :
j2I N j2I N
Let the optimal P solutions of this model be k

jand s
i . The optimal input and output vector for rm o is
e e P
^xo ; ^y o j2I N xij kj 8i; j2I N y rj kj 8r , which represents a point on the technically ecient frontier with no slacks
in either inputs or outputs. The term h0 here measures the technical eciency of rm o indicating average reduction in
all inputs.
To determine the minimum variable cost to produce output vector yo for rm o, analogous to [Model III], we set up the
following short-run cost DEA.
X
Model III0 C Vo y o min xi 26
i2I V
X X
s:t: xij kj 6 xio 8i 2 I F ; xij kj xi 0 8i 2 I V ;
j2I N j2I N
X X
y rj kj P y o 8r 2 I S ; kj 1; kj P 0 8j 2 I N ;
j2I N j2I N

where xij wij xij 8i;j is the ith observed input cost of jth rm. Let the optimal solutions to this model be xi and kj . The
P P P
vector xv xfo ; y o
o ; xij kj 8i 2 I V ; j2I N xij 8i 2 I F ; j2I N y rj kj 8r 2 I S representsthe ecient variable-xed cost-
j2I N
P
output vector of rm o. Note P that this short-run P minimum
cost C sr C vo y o i2I F xi is very dierent from the cor-

responding minimum cost i2I V wio xi i2I F wio xi in Model II.
Finally, to determine the long-run capacity cost where xed and variable costs are optimally adjusted to their corre-
sponding long-run levels, we set up the following capacity cost DEA model for rm o to produce output vector yo.
X
Model IV0 C Co y o min xi 27
i2I M
X X X
s:t: xij kj xi 6 08i 2 I M ; y rj kj P y o 8r 2 I S ; kj 1; kj P 0 8j 2 I N :
j2I N j2I N j2I N
P
Note that it always holds that C Co y o 6 C Vo y o i2I F xi . Unlike in input-oriented radial models, the ratio decomposition
in non-radial models is not possible. However, one can decompose for rm o the total cost dierential between actual cost
and capacity cost into various meaningful components, for the given output vector (yo), as follows:
C o y o C co y o C o y o C eo y o C eo y o C sr sr c
o y o C o y o C o y o : 28
The rst component represents the loss due to rm being not technically ecient, the second component is the loss due to
the rm not operating at cost minimizing point in the short run and the last one represents the loss due to inability of the
rm not being able to adjust its xed cost in the short run.
4. The empirical application
The Indian banking sector is taken to illustrate the decomposition of ray capacity utilization. We will be analyzing the
trend behavior of ray CU and its components with respect to ownership and size. The next section describes the choice of
selection of inputs and outputs.
4.1. The data
In the literature, there are two approaches production approach and intermediation approach, to measure bank e-
ciency.26 In the former banks use capital, labor and other non-nancial inputs to provide deposits and advances (Ferrier
and Lovell, 1990). In the latter approach, however, a bank is treated as a producer of intermediation services by trans-
forming risk and maturity prole of funds received from depositors to investment or loan portfolio of dierent risk and
maturity prole. Banks also provide services for which specic charges are levied and monetary value of non-interest
income is sometimes considered another output variable.
Keeping in mind that banks, besides being prot driven, are also forced to take up economic and social responsibilities
like safety of customers, nancing much needed public sector expenditure in various social and economic services, this
study has adopted the intermediate approach by considering three outputs investments (I), performing loan assets
(PLA) and non-interest income (NII), and three inputs xed assets (FA), borrowed funds (BF) and labor (L), which
seems to be eective in analyzing managements success in controlling cost and generating revenues. More importantly,
the essence of taking performing loan assets, as an output measure is more realizable in Indian context, because only earn-
ing asset contributes to revenue of bank and not total loan. So, the three-element input vector is now partitioned into two
sub-vectors: rst one comprising only one xed input, i.e., FA and the second one comprising two variable inputs, i.e., BF
and L. All the monetary values of inputs and outputs that have been deated using wholesale price index deator with base
19931994 are expressed in Indian rupees (Rs.) in crores (Note that Rs. 1 crore = Rs. 10 million).
Concerning the prices of inputs, the unit prices of xed assets, borrowed funds and labor are taken, respectively, as
the non-labor operational cost per rupee amount of xed asset, average interest paid per rupee of borrowed funds and
average sta cost. As regards the output prices, unit prices of investments, performing loan assets and non-interest
income are, respectively, taken as average interest earned on per rupee unit of investment, average interest earned on
per rupee unit of performing loan assets and non-interest fee-based income on per rupee of working funds. The input
and output data as well as their prices have been taken from the various sections of Statistical Tables Relating to Banks
in India, Reserve bank of India and from Indian Banking Association publications.
26
See Berger and Mester (1997) for a comprehensive discussion of these two approaches. However, the distinction between these two approaches seems
to be dubious since the approaches that have been used in the banking studies and that are often viewed as variants of the intermediation approach are the
asset approach and user-cost approach. See Berger and Humphrey (1992) for the detailed discussion on it.
Table 1
Descriptive statistics on outputs, inputs and input prices
Mean Standard deviation Maximum Minimum
Outputs
(O) I 29.5133 67.0121 771.8372 0.0327
(O) PLA 80.3654 192.1476 1877.4454 0.2290
(O) NII 1.1371 2.6918 25.2375 0.0016
Inputs
(I) BF 3.1230 7.7595 67.3494 1.0E06
(I) FA 1.1573 1.9729 16.4188 0.0024
(I) L 11,650 29,248 241,714 8
Input prices
(C) BF 6.9914 20.0677 286.9 0.0089
(C) FA 1.7908 5.7380 83.6187 0.0151
(C) L 0.0005 0.0026 0.0317 2.8E07
Note: All the outputs, inputs and their prices are all measured in crores of rupees (1 crore = 10 million).
4.2. Sample selection
This study covers ve years commencing from nancial year 19971998 in which competition was intensied in the
banking industry with a total of around 100 banks, a shift from around 80 banks in the preceding years. To avoid incon-
sistencies, Regional Rural Banks and small foreign banks have been excluded from our study because the former mostly
serve credit to local farmers and a few small-scale enterprises, and the latter ones primarily operate as clients to serve the
purpose of parent banks abroad. Hence, banks having a minimum of three branches during the entire study period have
been taken in our study. Based on the above criteria, this study is conducted on 78 banks (26 nationalized banks, 28 private
banks and 24 foreign banks) for the 5-year period 19972001.
4.3. Results and discussion
Table 1 exhibits the descriptive statistics concerning mean, standard deviation, minimum and maximum of inputoutput
data based on the balanced panel data comprising 78 companies over ve years.
4.3.1. Results in radial scheme

We begin with examining banks average trend behavior of physical CU and its various components27, which are all
exhibited in Fig. 2.
As expected, physical (ray) CU trend is much lower than those of its components, and is hovering around at 40% over
years, which implies that Indian banks are yet to utilize 60% of their physical capacities. It is not all clear whether the use of
additional 60% will enable them to satisfy their cost minimizing behaviors. Therefore, it is necessary to examine the trends
of various components of ray CU. The results show that all the components show improvement trends revealing that banks
exhibit relatively better performance practices in terms of both eciency and economic CU. However, it is not surprising to
see the average values of optimal capacity idleness trend in some years exceeding unity indicating that both capacity fron-
tier and ray economic capacity frontier intersects with each other, a possibility which cannot be ruled out in our proposed
model.
4.3.1.1. Ray capacity utilization vis-a`-vis ownership. We now turn to compare the trend behavior of ray CU across the entire
spectrum of ownership forms, which might yield valuable insights into the factors responsible for driving CU and eciency
dierentials, and ownership-performance relationship. Banks are broadly divided here into two groups: National banks
(NB) and Private Banks (PB), and private banks are again subdivided into two: Indian private banks (PB(I)) and Foreign
private banks (PB(F)). The average trend behaviors of ray CU for both nationalized and private banks are exhibited in
Fig. 3a. Nationalized banks exhibit better physical CU compared to private banks. The trends indicate that ray CU comes
around 50% for nationalized banks while it is around, respectively, 40 and 30% for foreign and Indian private banks.
Instances of higher physical CU for nationalized banks over private banks are not surprising because of the fact that
27
The detailed results concerning measures of ray CU and its various components such as technical eciency, ray economic CU and optimal measure of
capacity idleness for each bank are not reported here due to lack of space. These results are however available upon request from the authors.
1.6 xc/xo
xe/xo
1.4
CU and its Components

xrec/xe
1.2 xc/xrec
1.0
0.8
0.6
0.4
0.2
0.0
1997-98 1998-99 1999-00 2000-01 2001-02
Year
Fig. 2. Ray CU and its components over time.
nationalized banks have been operating quite for a long period of time, and dominating the banking business, accounting
for maximum percentage of deposits and advances.
The nature of trend behavior of ray CU of nationalized and private banks can be traced through its underlying causal
sources. The rst such source is the concept of technical ineciency whose trends are all exhibited in Fig. 3b. The trends
reveal that even though eciency dierential between nationalized and private banks was clearly apparent up to the year
19992000 with the former ahead of the latter, nationalized banks could not sustain their eciency accrual in subsequent
years in the appearance of service competition, with Indian private banks clearly ahead of them, and foreign banks coming
almost at par with them. The relatively higher eciency accrual of nationalized banks over private banks in the primal
three years of our study period might be due to their long-held formal status. That is, when Indian banking markets
are characterized by high transaction costs, a banks reputation and legitimation (i.e., the degree to which banks are
socially recognized and accepted in the business environment), facilitates its access to scarce resources such as credit, for-
eign exchange, licenses, skilled labor, etc. that are necessary for ecient production.
However, the increasing eciency behaviors demonstrated by private banks, and by so doing, found them ahead of
nationalized banks in latter years, clearly highlights the possible disciplining role increasing played by the capital market
in improving the weak relationship between market of corporate control and eciency of private enterprise, typically
observed in a developing country. This nding provides an empirical support to the property right hypothesis by Alchian
(1965) and De Alessi (1980) that private enterprises should perform better than public enterprises, which precisely holds
when there is a strong link that exists between market for takeover and eciency of private enterprises. It appears that
a 0.6 b 0.9
0.8
0.5
0.8
0.4 NB NB
Ray CU
PB (I) 0.7
TE
0.3 PB (I)
PB (F) 0.7 PB (F)
0.2
0.6
0.1 0.6
0.0 0.5
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
3.0
c 1.2 d
2.5
1.0
Optimal Capacity
Ray Economic CU
0.8 2.0 NB
Idleness
NB
PB (I)
0.6 PB (I) 1.5
PB (F)
PB (F) 1.0
0.4
0.2 0.5
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
Fig. 3. (a) Ray CU vis-a-vis ownership over time. (b) TE vis-vis ownership over time. (c) Ray economic CU vis-a-vis ownership over time. (d) Optimal
capacity idleness vis-a-vis ownership over time.
the constraints such as information lag relating to companys true performance not being transmitted in its share price,
high transaction costs associated with takeover and the very stringent takeover regulations, which hinder this strong link,
are now increasingly disappearing through competition28 created through nancial sector reforms.
Leibenstein (1966) maintains that an exposure to competition will generate an improvement in X-eciency (or technical
eciency). He argued that enterprises exposed to the bracing atmosphere of competition would respond by eliminating
internal ineciency and seeking out opportunities for innovation. He refers to the productivity gains arising from this pro-
cess as improvement in X-eciency. To Stigler (1976), this X-eciency gain is nothing but simply an increase in the inten-
sity of labor or, equivalently, a reduction in on-the-job leisure. Ganley and Grahl (1988) pointed out that where labor
productivity had increased due to such competition, there was evidence of increased work intensity. A closer look at
our data set reveals that labor productivity shows a monotonic increasing trend conrming the above-mentioned claim
of increased work intensity.
The other two possible sources are the ray economic CU and optimal capacity idleness, whose trends are, respectively,
exhibited in Fig. 3c and d. The increasing trend of ray economic CU and declining trend of optimal idle capacity for both
nationalized and private banks appear to indicating the elimination of excess capacity over time. This is precisely due to the
long-held premise that competitive pressure in the banking sector should eliminate excess capacity in the short run by elim-
inating ineciency,29 the trend of which is already depicted in Fig. 3b.
The marked dierence between sharp declining trend of optimal idle capacity of foreign banks over slow declining trend
of Indian nationalized and private banks reects that foreign banks are mostly strongly exposed to international markets,
and are more sensitive to competitive pressures from outside the country, which are all reected in their cost minimizing
behavior.
4.3.1.2. Ray capacity utilization vis-a`-vis size. We now distinguish banks by size30 to take into account for heterogeneity and
present ray CU estimates for large, medium and small banks over time in Fig. 4a. This gure shows that on the average,
over (physical) capacity is relatively higher for medium size banks, compared to small and large size banks. The possible
explanations for the dierences in excess capacity among small, medium and large size banks could well be traced through
their underlying causal factors. The trend plot of technical eciency is exhibited in Fig. 4b.
Large-size banks are consistently outscoring small and medium-size banks throughout, which is precisely because the
large-size group of 39 banks includes all the 26 nationalized banks and 13 strongly ecient private banks. However, in
terms of faster growth eciency behavior, as expected, small and medium size banks are clearly ahead of large-size banks,
with small-size group comprising mostly foreign banks (12 PB(F) and 3 PB(I)) and medium-size banks comprising mostly
Indian private banks (18 PB(I) and 3 PB(F)). Even though institutional conditions are favorable, the lesser eciency
growth of nationalized banks can be understandable because of specic X-ineciency factors arising from government
ownership,31 which might be argued to be leading to diminishing return to income, reduction in interest spread, and pres-
ence of scale economies due to xed cost, with an increase size.
The trend behavior of ray economic CU and optimal capacity idleness aecting physical CU are exhibited in Fig. 4b and
c, respectively. It is seen that though banks of all sizes appear to have reduced their excess capacity and optimal idle capac-
ity over years, the degree however favors the large-size banks more compared to small and medium-size banks. The trend
of excess capacity in the short run is, though, declining due to increasing competitive pressure, excess capacity in the bank-
ing industry might still persist in the long run because a part of banks xed cost is sunk cost arising from the existence of
long-term customer relationship and from switching costs that give banks both market power on the customer and a com-
petitive cost advantage over other banks in the market. Note that because of the possibility that ray-economic capacity
frontier and ray capacity frontier might intersect, a few banks exhibit greater than unity values for optimal idle capacity
distorting its average trend.
4.3.1.3. Decomposition of cost. It will be enterprising to exhibit results on the decomposition trend of cost gap between
actual cost and short-run minimum cost with respect to both ownership and size. While Fig. 5a exhibits the trends in cost
gap between actual and short-run minimum cost with respect to ownership, Fig. 5bd exhibit components of this cost gap.
28
Several contributions (Caves and Christensen, 1980 and Millward, 1988) have, however, argued that ownership may not matter in the presence of
sucient competition between private and public sector enterprises.
29
However, some scholars argue that the complete elimination of excess capacity may not be possible for the simple reason that banking markets are not
typically characterized by prefect competition where technological or other natural barriers (such as sunk costs) to entry resulting in imperfections could
explain why it is costly to reduce excess capacity.
30
The size-wise classication has been done as per total assets as follows: Small: up to Rs.5000 crore, Medium: between Rs.5000 crore and Rs.20,000
crore, Large: above Rs.20,000 crore.
31
Government ocials are in general more inclined to pursue their own interests, or interest of pressure group, rather than interests of public. Frequently
changing objectives of nationalized banks arising from governments attempts to accommodate diverse interest groups create hindrances in their eciency
growth.
a 0.5
b 0.9
0.5 0.9
0.4
0.8
0.4
0.3 Large 0.8 Large
Ray CU
Medium Medium
TE
0.3 0.7
0.2 Small 0.7 Small
0.2
0.6
0.1
0.1 0.6
0.0 0.5
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
c 1.2 d 4.5
1.0 4.0
Ray Economic CU
Optimal Capacity
3.5
0.8
Large 3.0 Large
Idleness
0.6 2.5
Medium Medium
2.0
0.4 Small Small
1.5
1.0
0.2
0.5
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
Fig. 4. (a) Ray CU vis-a-vis size over time. (b) TE vis-a-vis size over time. (c) Ray economic CU vis-a-vis size over time. (d) Optimal capacity idleness vis-
a-vis size over time.
a 9.0 b 6.0
[C(xo)-C(xe)] (Rs. in crore)
[C(xo)-C(x*)] (Rs. in crore)
8.0
5.0
7.0
6.0 4.0
NB NB
5.0
PB (I) 3.0 PB (I)
4.0
3.0 PB (F) 2.0 PB (F)
2.0
1.0
1.0
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
c 1.4 d
C(xe)-C(xrec) (Rs. in crore)
3.0
C(xrec)-C(x*) (Rs. in crore)
1.2
1.0 2.5
0.8 NB
2.0 NB
0.6 PB (I)
1.5 PB (I)
0.4 PB (F)
PB (F)
1.0
0.2
0.0 0.5
-0.2 1997-98 1998-99 1999-00 2000-01 2001-02 0.0
1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
Fig. 5. (a) Cost gap between C(xo) and C(x*). (b) Cost gap between C(xo) and C(xe). (c) Cost gap between C(xxe) and C(xrec). (d) Cost gap between C(xrec)
and C(x*).
It appears from Fig. 5a that private banks seem to be performing better in terms of utilizing their resources in the short
run at the cost of deterioration in performance of nationalized banks over the years. This nding can be traced through by
looking at their individual component trends. We nd private banks not only revealing relatively better technically ecient
behavior but also using right optimal input-mix in the light of prevailing input prices (see Fig. 5b and d). The cost gap trend
behaviors between technically ecient point and ray economic ecient point seem to be very close for private banks. How-
ever, the average trends being negative in some years indicate that technically ecient frontier and ray economic capacity
frontier intersecting each other, a possibility that cannot be ruled out.
a 6.0
b 4.5
C(xo)-C(xe) (Rs. in crore)

C(xo)-C(x*) (Rs. in crore)
4.0
5.0 3.5
4.0 3.0 Large
Large
2.5 Medium
3.0 Medium 2.0
Small 1.5 Small
2.0
1.0
1.0
0.5
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
c 0.7
d
C(xe)-C(xrec) (Rs. in crore)
C(xrec)-C(x*) (Rs. in crore)

0.6 2.0
0.5
0.4 Large 1.5
Large
0.3 Medium
1.0 Medium
0.2 Small
Small
0.1 0.5
0.0
-0.1 1997-98 1998-99 1999-00 2000-01 2001-02 0.0
Year 1997-98 1998-99 1999-00 2000-01 2001-02
Year
Fig. 6. (a) Cost gap between C(xo) and C(x*). (b) Cost gap between C(xo) and C(xe). (c) Cost gap between C(xe) and C(xrec). (d) Cost gap between C(xrec)
and C(x*).
We now exhibit the trend of cost gap and its various components with respect to size in Fig. 6ad. As expected, the
results appear to be almost the same as those with respect to ownership, indicating the small and medium size banks out-
performing large size banks in all components as bulk of latter size category banks include nationalized banks.
4.3.2. Results in non-radial scheme

It is of interest here only to see physical CU and its link with technical eciency, whose trends are exhibited in Fig. 7. As
expected, physical CU trend remains the same as that in radial scheme due to only one xed input. The trends of technical
eciency scores, though, remain the same; there is an absolute dierence between these two sets of estimates, with non-
radial trend being lower than its radial counterpart, which is due to the problem of inherent slacks in radial measure.
We now exhibit results concerning the trend of cost gap between actual and capacity cost and its various components
with respect to ownership in Fig. 8ad.
A glance at Fig. 8a reveals that private banks appear to be operating well closer towards capacity level as compared to
nationalized banks. The possible reasons could be the relatively lower short-run cost and technical ineciency, as are seen
from their trends in Fig. 8b and d. The negative average trend values found in some years in Fig. 8c are not surprising
because it might be possible that minimum cost at projected input vector of input-oriented non-radial model is lesser than
the estimated short-run minimum cost where xed costs are kept constant.
Now we exhibit the trends of cost gap along with its components vis-a`-vis size in Fig. 9ad. Since large-size banks are
mostly nationalized banks, we do not expect any change in our main nding that private banks perform relatively better by
operating closer towards their capacity level.
On seeing the results obtained from both radial and non-radial models, it appears that private banks appear to exhibit
higher cost eciency. Viewing and analyzing eciency from perspectives of technological capabilities (i.e., information and
skills concerning technical, managerial and institutional) and learning process, private rms are found to take the lead in all
parameters. Even though, old nationalized banks have shown higher eciency level in the beginning period of our study,
0.8
0.7
(xc/xo) and (xe/xo)
0.6
0.5 xc/xo
0.4 xe/xo
0.3
0.2
0.1
0.0
1997-98 1998-99 1999-00 2000-01 2001-02
Year
Fig. 7. Non-radial measure of physical CU and TE over time.

a 10.0 b 8.0
Co-Ce (Rs. in crore)

Co-Cc (Rs. in crore)
8.0 6.0
NB NB
6.0
PB (I) 4.0 PB (I)
4.0
PB (F) PB (F)
2.0 2.0
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
c 2.0 d
Ce-Csr (Rs. in crore)
1.0 3.5
Csr-Cc (Rs. in crore)

3.0
0.0 NB
2.5 NB
-1.0 1997-98 1998-99 1999-00 2000-01 2001-02 PB (I) 2.0 PB (I)
PB (F) 1.5
-2.0 PB (F)
1.0
-3.0 0.5
-4.0 0.0
Year 1997-98 1998-99 1999-00 2000-01 2001-02
Year
Fig. 8. (a) Cost gap between actual cost (C) and capacity cost (Cc). (b) Cost gap between actual cost (C) and TE cost (Ce). (c) Cost gap between TE cost
(Ce) and short-run cost (Csr). (d) Cost gap between SR cost (Csr) and LR capacity cost (Cc).
a 7.0
b 6.0
C-Ce (Rs. in crore)
C-Cc (Rs. in crore)
6.0 5.0
5.0 Large 4.0 Large
4.0 Medium
Medium 3.0
3.0
Small 2.0 Small
2.0
1.0 1.0
0.0 0.0
1997-98 1998-99 1999-00 2000-01 2001-02 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
c 1.0 d 3.5
Csr-Cc (Rs. in crore)
3.0
Ce-Csr (Rs. in crore)
0.5
2.5 Large
0.0 Large
2.0 Medium
-0.5 1997-98 1998-99 1999-00 2000-01 2001-02 Medium 1.5 Small
-1.0 Small 1.0
-1.5 0.5
-2.0 0.0
-2.5 1997-98 1998-99 1999-00 2000-01 2001-02
Year Year
Fig. 9. (a) Cost gap between actual cost (C) and LR capacity cost (Cc). (b) Cost gap between actual cost (C) and TE cost (Ce). (c) Cost gap between TE
cost (Ce) and SR cost (Csr). (d) Cost gap between SR cost (Csr) and LR capacity cost (Cc).
this positive relationship between bank age and eciency has been seen weakened in the end because young private banks,
which entered with upgraded and more innovative technology, have shown their sustained eciency rise, while sunk costs
impede older nationalized banks from shifting towards a more ecient technology. Our nding of higher cost eciency of
private banks over nationalized banks is in line with that of the study by Vining and Boardman (1992).
In terms of cost gap, a clear ordering in the performance of dierent ownership groups that is consistent with the prop-
erty rights and public choice theories is apparent. Foreign banks are found to be the most cost eective than Indian private
banks, which are found to be more protable than nationalized banks. The apparent dierence in the short-run cost min-
imizing behavior between Indian nationalized banks and private banks might indicate that the latter may not dier signif-
icantly from the former in terms of income they generate from their loan portfolio, but they are better in accounting for the
riskiness of their portfolios.
4.3.3. A comparative picture

Comparative evaluation of radial and non-radial models is analyzed here on the basis of three parameters, viz., physical
capacity utilization, short-run cost and long-run capacity cost. The comparative picture of physical capacity utilization (net
of technical ineciency) with respect to ownership is exhibited in Fig. 10.
Fig. 10. Radial and non-radial measures of CU.
Fig. 11. A comparison of SR cost.
Fig. 12. A comparison of capacity cost.
Irrespective of ownership, the non-radial models are found to exhibit higher CU, which is precisely due to the possibility
that input technical eciency in many cases turns out to be smaller than physical CU in non-radial models; otherwise, non-
radial CU estimates would have been lower than their radial counterparts.
The second interesting comparison concerning short-run costs estimates with respect to ownership is exhibited in
Fig. 11. Non-radial estimates are found to be higher than those in radial models.
Finally, the estimates on ray economic cost and capacity cost obtained respectively in radial and non-radial models are
exhibited in Fig. 12. As expected, non-radial estimates are found to be lower than their radial counterparts. Note that in
both Figs. 11 and 12, the y-axis represents respectively short-run cost and long-run capacity cost in value terms (expressed
in crores of Indian rupees (Rs.) where 1 crore = 10 million).
Notice that expecting for the year 20002001, both short-run cost and capacity cost are consistently increasing over our
study period in both radial and non-radial measures. The period 19992001 is signicant one in the sense that maximum
number of banks are found to be operating with excess capacity (as measured in terms of both percentage of number of
banks with sub-optimal rate of returns to total number of banks, and percentage of average earning assets of banks with
sub-optimal rate of returns to total average earning assets of all banks). This might be the reason for high short-run cost,
and capacity cost in 20002001.
5. Concluding remarks
This paper rst makes a brief review on the existing methods of capacity utilization in non-parametric framework, then
discusses their limitations, and suggests alternatives in lieu of those limitations. We decompose in radial model the physical
CU into technical eciency, ray economic CU (net of technical ineciency) and optimal capacity idleness, and then dem-
onstrate its equivalence in non-radial model. We nally illustrate our method of decomposition on banking rms in India
to examine the trends of physical CU and its components with respect to both ownership and size to assess the nancial
sector reforms.
Our broad empirical results are indicative in many ways. First, while the higher eciency trend of the private banks over
the nationalized banks at the end of our study period highlights the possible stronger disciplining role played by the capital
market in improving eciency, indicating a strong link between market for corporate control and eciency of private
enterprise assumed by the property rights hypothesis. Second, increasing competitive pressure generated after nancial sec-
tor reforms though helps reduce excess capacity in the industry, complete elimination might not be possible due to imper-
fect market structure arising from technological and other natural barriers to entry. Third, the cost gap of short-run cost
from actual cost is higher for nationalized banks over private banks indicating that the former banks though old, do not
reect their learning experience in their cost minimizing behavior due to X-ineciency factors arising from government
ownership. Finally, on empirical comparison between radial and non-radial measures of physical CU and its components,
we nd the former exhibiting lower estimates for physical CU and short-run cost, and higher estimates for long-run capac-
ity cost, whereas the opposite results are revealed in the latter measure.
This study points to avenues for future empirical research. First, by subdividing Indian private banks into two: one
being traded and other being non-traded, one can conduct a study comparing the eciency of nationalized banks with
traded private banks, non-traded private banks and foreign banks (of course not traded) that can shed light on factors
responsible for driving eciency dierentials, and verify the property right hypothesis. Second, since we have considered
each bank as an entity consisting of all its branches simple because of data unavailability of relevant data at the branch
level, the banking application of the proposed methodology can be considered illustrative in nature. Therefore, as a topic
of future research, one can extend this study of decomposing CU into its various components at the bank branch levels
where one can provide some connection between the CU of the bank branches and the measure of CU for the whole
organization.
Acknowledgements
We are sincerely thankful to the two anonymous referees and Robert G. Dyson (Editor) for their constructive comments
and suggestions that proved most useful in improving the rst, second and third drafts of this paper; and to the Japan
Society for the Promotion of Science (JSPS), Japan for its full nancial support by the Grants-in-Aid for Scientic Re-
search (C). The remaining errors, if any, are the responsibility of the authors.
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Decomposing Capacity Utilization in Data Envelopment Analysis

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European Journal of Operational Research 195 (2009) 575594

Decomposing capacity utilization in data envelopment analysis:

Received 30 January 2006; accepted 15 February 2008

Keywords: Capacity utilization; Technical eciency; Optimal idle capacity; DEA

2. Concepts of capacity utilization and measurement

2.1. Measurements of capacity utilization

2.1.1. Physical measure of CU

2.1.2. Economic measure of CU

We now rst present in radial scheme the decomposition of physical CU.

3.1. Radial scheme

We set up the following DEA model [Model I] to estimate physical CU of rm o.

xrec L (y: xv,rec)

Fig. 1. Decomposition of technological CU.

3.2. Non-radial scheme

Let the optimal P solutions of this model be k

4. The empirical application

4.1. The data

4.2. Sample selection

4.3. Results and discussion

4.3.1. Results in radial scheme

CU and its Components

Fig. 2. Ray CU and its components over time.

C(xo)-C(xe) (Rs. in crore)

C(xrec)-C(x*) (Rs. in crore)

4.3.2. Results in non-radial scheme

Fig. 7. Non-radial measure of physical CU and TE over time.

Co-Ce (Rs. in crore)

Csr-Cc (Rs. in crore)

4.3.3. A comparative picture

Fig. 10. Radial and non-radial measures of CU.

Fig. 11. A comparison of SR cost.

Fig. 12. A comparison of capacity cost.

Eilon, S., 1973. Teague On measures of productivity. Omega 1, 565576.

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