COST STRUCTURE AND THE

MEASUREMENT OF ECONOMIC PERFORMANCE

Productivity, Utilization, Cost Economics, and Related Performance Indicators

COST STRUCTURE AND THE

MEASUREMENT OF ECONOMIC PERFORMANCE

Productivity, Utilization, Cost Economics, and Related Performance Indicators

by

Catherine J. Morrison Paul University of California at Davis

Springer Science+Business Media, L L C

Library of Congress Cataloging-in-Publication Data

A C L P . Catalogue record for this book is available from the Library of Congress.

ISBN 978-1-4613-7317-9 ISBN 978-1-4615-5093-8 (eBook) DOI 10.1007/978-1-4615-5093-8

Copyright © 1999 Springer Science+Business Media New York Originally published by Kluwer Academic Publishers in 1999 Softcover reprint of the hardcover 1st edition 1999

A l l rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo­copying, recording, or otherwise, without the prior written permission of the publisher, Springer Science+Business Media, LLC.

Printed on acid-free paper.

To David

Contents

Preface XI

INTRODUCTION TO THE CONCEPTUAL FRAMEWORK

1. What do "Economic Performance" and "Productivity" Mean? 2 2. Productivity Growth Components 5 3. Technical Change 8 4. The Cost Structure 12 5. Market and Regulatory Structure 17 6. Basics of Productivity Measurement 21

TRADITIONAL PRODUCTIVITY GROWTH MEASUREMENT 25 1. Single-Factor Productivity Measures 26 2. Multifactor Productivity Measures 31 3. Growth Accounting 36 4. Technical Change and Productivity 41 5. Primal and Dual Measures 43 6. Technical Change Determinants 46 7. Technical Change Biases 51 8. Further Remarks 55

THE SHORT RUN, CAPITAL, AND CAPACITY UTILIZATION 57

1. Short Run Fixities and CU 58 2. A Primal Economic CU Representation 63 3. A Dual CU Measure 69 4. Fixity, Adjustment Costs, and Dynamics 76 5. Capital Composition and Services 79 6. Further Remarks 86

SHORT AND LONG RUN SCALE AND OTHER COST ECONOMIES

1. Components of the Cost-Output Relationship 2. Cost Economies vs. Technical Change 3. Scale Biases 4. Cost Economies More Generally

4.1 multiple outputs 4.2 multiple fixed inputs and "imperfect" input markets 4.3 overall cost economies

5. Further Remarks

INTERNAL AND EXTERNAL COST ECONOMIES, AND GROWTH

1. A Model with External Effects 2. Returns to Public Capital 3. "Knowledge Capital" and Spillovers 4. Utilization and Scale Interactions 5. Microfoundations and Macro Models 6. Further Comments

MARKET STRUCTURE AND ECONOMIC PERFORMANCE

1. Market Power Modeling 2. Market Power and Economic Performance Measures 3. Input Market Power: Monopsony

3.1 a parametric model 3.2 a non parametric model

4. Market Power Measures and Welfare 5. Further Comments

REGULATORY STRUCTURE AND COSTS

1. Capital Regulations and Costs 2. Restrictions on Input Use: Pesticides

2.1 the literature 2.2 an alternative perspective

3. Lack of Markets: "Bad" Outputs 4. Regulation and Market Power 5. Further Comments

TECHNICAL EFFICIENCY 1. Frontier Modeling 2. Empirical Specification 3. Dual Models 4. Productivity and Efficiency 5. Further Comments

89 90 94 102 106

114

117 119 123 128 134 139 145

147 149 156 161

169 173

175 177 182

196 201 206

209 211 219 228 234 238

UNDERLYING THEORY AND IMPLEMENTATION ISSUES

1. The Basic Production Theory Model 2. Production and Cost Structure 3. Profit Maximization 4. Dynamic Adjustment 5. Distance and Revenue Functions 6. Measures Representing Firm Behavior 7. Further Comments

DATA CONSTRUCTION FOR ESTIMATION AND MEASUREMENT

1. Non-Capital Output and Input Data 1.1 output production 1.2 labor 1.3 materials inputs 1.4 R&D 1.5 service industries

2. Capital Data Construction 3. Aggregation Issues 4. Further Comments

ISSUES OF ECONOMETRIC IMPLEMENTATION

1. Empirical Specification 2. Functions for Empirical Analysis 3. Functional Forms 4. Some Econometric Issues

4.1 systems of equations 4.2 instrumental variables estimation 4.3 time-series/cross-section data

5. Further Comments

PULLING IT TOGETHER

References

Index

241 242 247 253 255 259 263 268

269 270

281 289 299

301 303 310 313 319

330

331

337

359

Preface

This text is a heavily revised version of my 1992 monograph, A Microeconomic Approach to the Measurement of Economic Performance: Productivity Growth, Capacity Utilization, and Related Performance Indicators, published by Springer Verlag Press. That monograph was out of print within a year, but was still in demand by the late 1990s, so it seemed a second edition was in order.

Like the original monograph, this text is designed to provide a comprehensive guide to students, researchers or consultants who wish to model, construct, interpret, and use economic performance measures. The emphasis of the treatment is on productivity growth and its dependence on the cost structure. The focus is on application of the tools of economic analysis - the "thinking structure" provided by microeconomic theory - to measure technological or cost structure, and link it also with market and regulatory structure, to provide a rich basis for evaluation of economic performance and its detenninants.

Virtually everything that appeared in the first monograph is incorporated somewhere in the current text, so those who wish to use this version similarly will be able to do so. 1 However, both the field of production and productivity analysis and my own work have evolved significantly in the years since the first monograph was prepared. The text broadly follows this path, bringing in some recent applications of production theory while in the process drawing together threads of thought on economic performance representation and measurement from related literatures.

1 An exception to this is the original chapter 8, which overviewed empirical evidence of the "productivity slowdown" which was a crucial focus of productivity analysts in the 1980s when that book was initially written. The empirical literature is referred to within the application chapters in this version, rather than providing the basis for a separate chapter.

xii Introduction to the Conceptual Framework

The text overviews traditional productivity growth measurement techniques and adaptations to take into account various aspects of the technological or cost structure. In particular, it expands the standard growth accounting framework to accommodate various types of cost economies that may be evident in the cost structure, such as utilization and scale economies. Data construction procedures, theoretical foundations, and issues of econometric implementation are also outlined. These themes provided the foundation for the original text, and are further elaborated here.

In this monograph, however, the focus on the cost structure is pursued in more depth to consider additional cost economies or diseconomies affecting productivity patterns, including those from joint production, external factors such as spillovers from R&D and agglomeration effects, and characteristics of market or regulatory structure. Capital issues also are an overriding theme - from issues of "effective" capital or service flow as compared to stock (utilization, obsolescence, quality, composition, regulatory restrictions) to the more general notion of capital as a "knowledge" base deriving from, say, information technology, R&D or human capital. The potential for technical or allocative inefficiencies to affect measured performance is also addressed. These extensions are developed in the context of various literatures in which their impacts have been highlighted, including the macro/growth, industrial organization (10) and efficiency literatures.

The emphasis here is on topics or questions of interest rather than theoretical tools for analysis. The basic productivity growth modeling and measurement practices that result in a productivity residual often called the "measure of our ignorance" are initially developed, and then the different aspects of technological, market and regulatory structure that might underlie this residual are explored. The ultimate goal is to decompose or explain the residual, via the multitude of impacts that determine economic performance of firms, sectors, and economies.

The chapters are organized with three broad goals in mind. The first is to introduce the overall ideas involved in economic performance measurement and traditional productivity growth analysis. Issues associated with different types of (short and long run, internal and external) cost economies, market and regulatory impacts, and other general inefficiencies that might impact these measures are then raised. Finally, some of the tools necessary to justify and implement these models are emphasized.

This organization emphasizes the application of the tools of economic analysis. Basic intermediate microeonomic theory is initially used to motivate most of the fundamental ideas underlying analysis of productivity growth and other crucial indicators of economic performance in the first chapters (Chapters 1-2 and most of 3). Chapter I provides the conceptual basis for traditional productivity measurement and the extensions in this text.

Introduction to the Conceptual Framework Xlll

Chapter 2 overviews the traditional productivity growth literature and measurement procedures. Chapter 3 raises the possibility that short run capital constraints convolute measured productivity patterns so that they mis-measure true technical change and should be adapted to separately identify fluctuations caused instead by changes in capacity utilization.

Somewhat more advanced theoretical concepts, based on functional relationships that should be familiar to graduate students and in most cases upper level undergraduates, are utilized (with some qualification and explanation) in the next few application chapters (Chapters 4-8). These Chapters focus first on the combination of short and long run internal scale economies that affect observed cost efficiency (Chapter 4), and external factors or economies that may drive productivity and growth patterns (Chapter 5). Then market structure and its linkage to cost economies (Chapter 6), costs and benefits of regulatory constraints (Chapter 7), and the potential for technical inefficiency (Chapter 8), are brought in.

The primary theoretical, data and econometric tools providing the base for construction and empirical implementation of cost structure models are overviewed in the last chapters (Chapters 9-11). These chapters are therefore, to some extent, reference chapters, and direct the reader to the more rigorous economic and econometric theory literature for further details. Chapter 9 provides a summary treatment of the duality theory underlying production theory models, Chapter 10 addresses issues of data construction, and Chapter 11 targets some econometric issues of particular relevance to the types of applications overviewed in previous chapters of the text.

The material in this text is not meant to provide an exhaustive overview of contributions to the productivity literature and of methodologies underlying productivity and economic performance measurement. It is instead designed to feature the usefulness of a production-theory approach to the measurement of productivity and economic performance.

It essentially outlines one literature within which I have focused my research efforts for nearly two decades now, and some of its links to related literatures. It thus provides a foundation to facilitate understanding of the literature in this area, to generate and interpret associated empirical measures of productivity growth, and to carry out econometric estimation to identify and quantify important characteristics of production and performance.

The text is in some sense a "wrap-up" of the way my thinking about economic performance modeling and measurement has developed, guided by my colleagues and peers, co-authors, students, personal interests, and current policy concerns. My belief that a detailed analysis of the cost structure underlying production structure and performance is crucial for interpretation and use of any performance measures has intensified as I have utilized cost­oriented models for various applications over the years.

XIV Introduction to the Conceptual Framework

I believe that abstracting from the critical characteristics of the cost structure, which is done at least to some extent in most macroeconomic studies, analyses of market structure, and evaluations of "inefficient" production processes, makes interpretation and use of the associated measures problematic. I hope that this text shows why my thinking has moved in this direction, and perhaps even helps to synthesize some different perspectives, and encourage researchers to think more about cost structure.

Finally, I want briefly to mention a couple of people I would not have been able to do this without. I should first thank many people who have been supportive of me - both personally and professionally - over the past few years that have been particularly difficult ones for me. However, there are too many to mention. Certainly my family and many friends and colleagues have been enormously helpful. This has been particularly true as I have moved into a somewhat different field, and have begun to connect with many new friends and colleagues since I joined the University of California, Davis, Department of Agricultural and Resource Economics. I have met and been encouraged by many great new colleagues in my own department, others I have visited, and those who I have associated with at the USDA.

Particular thanks, however, go to two special people. My recent work with co-author Donald Siegel at Arizona State University West has been a great experience. Don not only has been a joy to work with and a wonderful support both personally and professionally, he is always there to provide help when needed - even when a book manuscript has to be in "yesterday"!

Even more heartfelt thanks, though, go to my best friend and husband David Paul, who makes life wonderful and provides a solid base for whatever I (and we) want to do. It's finally right.

Catherine J. Morrison Paul