Estimation of costs of technical and allocative inefficiency

Abstract

If a firm is both technically and allocatively inefficient its cost will increase. Since allocative inefficiency results from misallocation of inputs, cost of allocative inefficiency (CAI) can be obtained if the input over(under) use can be analytically derived. This is only possible for production functions for which input demand functions can be explicitly derived. Schmidt and Lovell (1979) addressed this problem using a Cobb-Douglas production function with the cost minimizing behavior. In this paper, we propose a mixture of Cobb-Douglas (CD) production functions to get a more flexible system that allows obtaining costs of technical and allocative inefficiency analytically. Inflexibility of the CD function is addressed by making its parameters (input elasticities) functions of environmental/predetermined variables. Our empirical evidence show considerable heterogeneity in parameters and multimodal distributions of many quantities of interest, which support our formulation.