What Is a Production Gap?

A production gap is an economic analytical term denoting the difference between actual industrial production from its perceived potential production. People generally calculate the production gap as the percentage deviation between domestic industrial production and its expected production. The existence and size of a production gap indicate that the economy or a company is underperforming and that productive resources are being underutilized or going unemployed.

Key Takeaways

  • A production gap is a deviation of actual industrial production below full potential output. It is usually measured as a percentage of total potential production capacity.
  • A large production gap in an economy can signal an impending or ongoing recession. A large production gap in a company suggests that the company is underperforming.
  • At the macroeconomic level, industrial production and capacity utilization are used to estimate a production gap, which is somewhat analogous to the unemployment rate in labor markets.
  • At the company level, gap analysis is used to detect and address a production gap.

Understanding a Production Gap

A gap in industrial production below full industrial capacity suggests that some productive resources, especially industrial capital goods, are lying idle and not being used to their potential. In macroeconomic terms, this can provide one signal of sluggish economic performance or even an economic recession.

The National Bureau of Economic Research uses industrial production as one of its key monthly indicators of the U.S. business cycle. According to the U.S. Federal Reserve, the long-run average of total industrial capacity utilization in the U.S. has been 79.6% between 1972-2020, which suggests a normal production gap of 20.4%. This gap tends to increase dramatically just before and during periods of recession and rises rapidly as a recession ends and recovery sets in.

On the other hand, the total absence of a gap in industrial production can be a sign of an overheating economy. When there is no slack at all in industrial activity, supply chain bottlenecks and shortages of intermediate goods can start to occur.

$20.9 Trillion

The GDP of the U.S. in 2020; which is expected to grow to $22.7 trillion in 2021.

Just as there can be a natural rate of unemployment in an economy due to normal frictional and institutional factors, there can also be a normal production gap that does not signal any acute economic distress. 

A production gap measurement in industrial production can be used in conjunction with gaps in the gross domestic product (GDP) and unemployment to analyze the economy at large. Discrepancies between the three gaps may indicate temporal economic factors that lie outside the norm. For example, an economy that shows little or no gap in GDP or industrial production, but does have high unemployment, might be experiencing a growth recession

Company-Level Production Gaps and Gap Analysis

In business management, gap analysis involves the comparison of actual performance with potential or desired performance. If a company squanders or mismanages its resources, or doesn't plan sound investments, the firm may very well produce below its potential.

A gap analysis identifies areas of improvement through assessment, documentation, and strategic planning to improve company performance and close the gap on expected versus actual performance; the difference between a business' requirements and its capabilities. 

One could perform portfolio analysis and identify the need for new product lines. Gap analysis can also identify gaps in the market by comparing forecasted profits to desired profits. Needs may also emerge as consumer trends shift and respond to market disruptors. In the latter case, a gap emerges between what existing products offer and what the consumer demands. The company must fill that gap to survive and grow.

What Is a GDP Gap?

A GDP gap is the difference between the actual real gross domestic product (GDP) and the potential real GDP. If the GDP gap is above zero, that signals a possible inflationary environment. If the GDP gap is below zero, that signals a possible recessionary environment.

What Is a Deflationary Gap?

A deflationary gap is when total disposable income is in a deficit when compared to the current value of all goods produced. This deficit causes a decline in prices and a slowdown in production. A decrease in investments and consumer spending usually causes a deflationary gap.

How Do You Correct an Inflationary Gap?

To correct an inflationary gap, when real GDP is greater than potential GDP, government policies need to be enacted. These policies include a decrease in government spending, an increase in taxes, an increase in interest rates, and reductions in transfer payments. In short, any policy that slows down the growth of the economy.