Revisiting the Decomposition of Cost Efficiency for Non-homothetic Technologies: A Directional Distance Function Approach
In the early 1980’s Kopp and Diewert proposed a popular method to decompose cost efficiency into allocative and technical efficiency for parametric functional forms based on the radial approach initiated by Farrell. We show that, relying on recently proposed homogeneity and duality results, their approach is unnecessary for self-dual homothetic production functions, while it is inconsistent in the non-homothetic case. By stressing that for homothetic technologies the radial distance function can be correctly interpreted as a technical efficiency measure, since allocative efficiency is independent of the output level and radial input reductions leave it unchanged, we contend that for non-homothetic technologies this is not the case because optimal input demands depend on the output targeted by the firm, as does the inequality between marginal rates of substitution and market prices—allocative inefficiency. We demonstrate that a correct definition of technical efficiency corresponds to the directional distance function because its flexibility ensures that allocative efficiency is kept unchanged through movements in the input production possibility set when solving technical inefficiency, and therefore the associated cost reductions can be solely—and rightly—ascribed to technical-engineering-improvements. The new methodology allowing for a consistent decomposition of cost inefficiency is illustrated resorting to simple examples of non-homothetic production functions.
|Keywords||Non-homotheticity ● Technical efficiency ● Allocative efficiency ● Directional distance function|
|JEL||Optimization Techniques; Programming Models; Dynamic Analysis (jel C61), Firm Behavior (jel D21), Production; Capital and Total Factor Productivity; Capacity (jel D24)|
|Persistent URL||dx.doi.org/10.1007/s11123-017-0512-8, hdl.handle.net/1765/130914|
|Journal||Journal of Productivity Analysis|
Aparicio, J, Pastor, J.T., & Zofio Prieto, J.L. (2017). Revisiting the Decomposition of Cost Efficiency for Non-homothetic Technologies: A Directional Distance Function Approach. Journal of Productivity Analysis, 48(2/3), 133–146. doi:10.1007/s11123-017-0512-8