Introduction

In Chapter 1, we introduced a series of questions that the tools discussed in this book are designed to help answer. The production function is the first tool we introduced to answer some of the questions. Although helpful, the production function approach, which focuses only on the input–output relationship, cannot answer some of the important questions for entrepreneurs and policy makers. Note that the production function is merely a technological relationship and there is no economic behavior embedded in it. This is also true of distance functions. Thus, neither of these can be used to help answer economic questions. For instance, whether (and by how much) a firm is able to reduce costs, while maintaining the same level of output/service, is often an important question. This is especially true for firms that are operating in a competitive or regulated environment, where outputs are demand determined, set by governments/regulators (e.g., quality of service), and/or cannot be stored (for example, electricity utilities, telecommunciations companies, transportation services, hospitals, and fire and police services). In this chapter, we introduce the cost frontier model, where the choice variables are the inputs in the production process and the objective is to minimize costs, given the required outputs. This model may help us to answer questions relating to the cost of production such as those outlined here.

By comparing hospitals, can we identify which hospitals can still treat the same number of patients for the same level of care but for lower cost? And, if so, by how much lower could costs be and what are the key drivers of these, currently, higher costs?

Does a takeover or merger with a current competitor makes sense? Among other things, will it result in cost savings through economies of scale and scope? Can the purchaser learn from the takeover target and improve its own cost efficiency or vice versa; that is, is the takeover target worthwhile?