Slack and Development

Slack -- the under-utilization of factors of production -- varies systematically with development and predicts a substantial share of the differences in productivity across countries. Using novel and detailed measures of the utilization of labor, capital, and input factors overall from a large representative sample of firms in rural and urban Kenya, we show that utilization is increasing in firm size, market access, and local GDP.
We argue that indivisibilities of inputs are a key driver of capacity under-utilization in poor economies. We present a monopoly model of capacity choice in which one of the inputs is subject to an integer constraint and show how pricing and investment are non-trivial functions of firm size. Embedded in spatial general equilibrium, the model rationalizes the endogenous emergence of slack in steady state, and accounts for differences in productivity in the cross-section.
We validate the model using reduced-form estimates of the general equilibrium effects of cash transfers from a large-scale RCT in Western Kenya. Consistent with our model, the data show that (1) Supply curves are highly elastic, (2) output responses to demand shocks are substantially larger for low-utilization firms, (3) aggregate inflation in response to the fiscal shock is low, but there exists some inflation in high-demand regions, and (4) slack declines in the medium-run in response to a demand shock.
We then derive the aggregate implications of the high share of small firms, and low market access in poor economies for overall productivity and structural transformation, and the impacts of macroeconomic and development policies such as cash transfers and social protection. Our findings rationalize large demand multipliers in poor economies.