Slack — the underutilization of factors of production — varies systematically with development. Using novel and detailed measures of the utilization of labour, 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 per capita. We argue that indivisibilities of inputs are a key driver of capacity underutilization in poor economies. We present a model of capacity choice where firms face indivisibilities in at least one input. Embedded in spatial general equilibrium, the model rationalizes the endogenous emergence of slack in steady state, and generates important predictions for macroeconomic dynamics in low- and middle-income economies. We validate the model using reduced-form estimates of the general equilibrium effects of cash transfers from a large-scale RCT in Western Kenya. We provide transparency and innovate methodologically by pre-registering parts of our structural estimation routine. Consistent with the model, the data show that (1) supply curves are highly elastic, (2) output responses to demand shocks are substantially larger for low-utilization sectors and firms, (3) aggregate inflation in response to the cash transfer shock is low but there exists some inflation in higher-demand regions. The findings suggest that input indivisibilities are a key friction in developing settings, rationalizing the existence of large transfer multipliers in poor economies.

Written with Tilman Graff, Edward Miguel, Felix Samy Soliman, Nachiket Shah, Michael Walker