Introduction

In the previous chapter, we introduced “allocative inefficiency” into the analysis under the assumption that firms minimize cost. In the cost minimization framework, output is taken as exogenous. This may be reasonable in some situations. For example, in a regulated industry outputs may be determined by government policy and/or quality regulators. However, in many situations, this is a very strong assumption. If output is endogenous, then the estimation of cost frontier results are inconsistent.

If output is not exogenous, then firms need to make a decision on the optimum amount of output to be produced. This optimality has to be defined in terms of some economic behavior. In this chapter, we assume that firms maximize profit in making their decision on input use and the production of output. That is, now one can consider nonoptimal allocation of inputs and output (i.e., allocative inefficiency in inputs and output), in the presence of technical inefficiency. In this case, we measure the effect of inefficiency in terms of foregone profit.

In this setting, we are able to extend the questions we first set out in Chapters 1 and 5. That is, in addition to examining whether, and by how much, a firm can increase its profitability, we are also able to identify how much of this profit increase can be achieved through improvements in technical efficiency and how much can be achieved through an optimal mix of inputs.

For instance, we can reconsider what is the impact of different forms of corporate ownership. As a first step, we might consider state-owned organizations versus private companies and other forms of ownership, and ask, which are more profitable? In the setting of this chapter, we can then dig deeper than this and investigate what drives these differences. That is, overall, what drives this profit loss, is it primarily technical inefficiency or primarily allocative efficiency, does one form of ownership result in an under or overuse of capital?