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1
Stochastic Frontier Analysis
It is a parametric technique that uses standard
production function methodology.
The approach explicitly recognises that production
function represents technically maximum feasible
output level for a given level of output.
The Stochastic Frontier Analysis (SFA) technique
may be used in modelling functional relationships
where you have theoretical bounds:
Estimation of cost functions and the study of cost efficiency
Estimation of revenue functions and revenue efficiency
This technique is also used in the estimation of multi-output and
multi-input distance functions
Potential for applications in other disciplines
2
Some history.
Much of the work on stochastic frontiers began in
70s. Major contributions from Aigner, Schmidt,
Lovell, Battese and Coelli and Kumbhakar.
Ordinary least squares (OLS) regression
production functions:
fit a function through the centre of the data
assumes all firms are efficient
Deterministic production frontiers:
fit a frontier function over the data
assumes there is no data noise
SFA production frontiers are a mix of these two.
3
Production Function
It is a relationship between output and a set of
input quantities.
We use this when we have a single output
In case of multiple outputs:
people often use revenue (adjusted for price differences) as
an output measure
It is possible to use multi-output distance functions to study
production technology.
The functional relationship is usually written in
the form:
q f ( x1 , x2 ,..., xN ) v
4
Production Function Specification
A number of different functional forms are used in the
literature to model production functions:
Cobb-Douglas (linear logs of outputs and inputs)
Quadratic (in inputs)
Normalised quadratic
Translog function
N
1 N N
ln q 0 n ln xn nm ln xn ln xm u
n 1 2 n 1 m1
Translog function is very commonly used it is a generalisation of the
Cobb-Douglas function
It is a flexible functional form providing a second order approximation
Cobb-Douglas and Translog functions are linear in parameters and can
be estimated using least squares methods.
It is possible to impose restrictions on the parameters (homogeneity
conditions) 5
Cobb-Douglas Functional form
Linear in logs
Advantages:
easy to estimate and interpret
requires estimation of few parameters: K+3
Disadvantages:
simplistic - assumes all firms have same
production elasticities and that subsitution
elasticities equal 1
6
Translog Functional form
Quadratic in logs
Advantages:
flexible functional form - less restrictions on
production elasticities and subsitution
elasticities
Disadvantages:
more difficult to interpret
requires estimation of many parameters:
K+3+K(K+1)/2
can suffer from curvature violations 7
Functional forms
Cobb-Douglas:
lnqi = 0 + 1lnx1i + 2lnx2i + vi - ui
Translog:
8
Interpretation of estimated parameters
Cobb-Douglas:
Production elasticity for j-th input is: Ej = j
Scale elasticity is: = E1+E2
Translog:
Production elasticity for i-th firm and j-th input is:
Eji = j+ j1lnx1i+ j2lnx2i
Scale elasticity for i-th firm is: i = E1i+E2i
Note: If we use transformed data where inputs are
measured relative to their means, then Translog
elasticities at means would simply be i. 9
Test for Cobb-Douglas versus Translog
Using sample data file which comes with the
FRONTIER program
H0: 11=22=12=0, H1: H0 false
Compute -2[LLFo-LLF1] which is distributed as
Chi-square (r) under Ho.
For example, if:
LLF1=-14.43, LLF0=-17.03
LR=-2[-17.03-(-14.43)]=5.20
Since 32 5% table value = 7.81 => do not reject H0
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Deterministic Frontier models
In this model all the errors are assumed to be
due to technical inefficiency no account is
taken of noise.
Consider the following simple specification:
ln yi xi ui for firms i 1,2,...N
q Deterministic
SFA
OLS
x 15
Production functions/frontiers
OLS: qi = 0 + 1xi + vi
Deterministic : qi = 0 + 1xi - ui
SFA: qi = 0 + 1xi + vi - ui
where
vi = noise error term - symmetric
(eg. normal distribution)
ui = inefficiency error term - non-negative
(eg. half-normal distribution)
16
Stochastic Frontier: Model Specification
We start with the general production function as before and add a
new term that represents technical inefficiency.
This means that actual output is less than what is postulated
by the production function specified before.
We achieve this my subtracting u from the production
function
Then we have
q f ( x1 , x2 ,..., xN ) v u
In the Cobb-Douglas production function with one input we
can write the stochastic frontier function for the i-th firm as:
ln qi 0 1 ln xi vi ui
qi exp( 0 1 ln xi vi ui )
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Stochastic frontiers
yi deterministic frontier
qi = exp(0 + 1 ln xi)
xA xB
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Stochastic Frontier: Model Specification
In general, we write the stochastic frontier model with several inputs and
a general functional form (which is linear in parameters) as
ln qi xi vi ui
We stipulate that ui is a non-negative random variable
By construction the inefficiency term is always between 0 and 1.
This means that if a firm is inefficient, then it produces less than what is
expected from the inputs used by the firm at the given technology.
We can define technical efficiency as the ratio of observed or realised
output to the stochastic frontier output
qi exp(xi vi ui )
TEi exp(ui )
exp(xi vi )
exp(xi vi ) 19
Stochastic Specifications
The SF model is specified as:
ln qi xi vi ui
The following are the assumptions made on the distributions of v
and u.
Standard assumptions of zero mean, homoskedasticity and
independence is assumed for elements of vi.
We assume that uis are identically and independently
distributed non-negative random variables.
Further we assume that vi and ui are independently distributed.
The distributional assumptions are crucial to the estimation of
the parameters. Standard distributions used are:
Half-normal (truncated at zero) ui iidN (0, u2 ).
Exponential
Gamma distribution
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Truncated normal distribution for u
var = 1
var= 4
var = 9
2
mu = -2
1.5
mu = -1
f(x)
mu = 0
1
mu = 1
0.5 mu = 2
0
0 1 2 3 4 5
x
This forms the basis for the inefficiency effects model where
u N ( i , u2 )
i 0 k Z ki 22
k
Estimation of SF Models
Parameters to be estimated in a standard SF model
are: , v2 and u2
Likelihood methods are used in estimating the
unknown parameters. Coelli (1995)s Montecarlo
study shows that in large samples MLE is better than
COLS.
Usually variance parameters are reparametrized in
the following forms.
2 and u / .
2 2
Battese and Corra
Testing for the presence of technical inefficiency
depends upon the parametrization used. 23
Estimation of SFA Models
26
SF Models - continued
Industry efficiency:
Industry efficiency can be computed as the average of
technical efficiencies of the firms in the sample
Industry efficiency can be seen as the expected value of a
randomly selected firm from the industry. Then we have
u2
TE E exp(ui ) 2 u exp .
2
341 0.76900626
342 0.92610064
343 0.81931012
344 0.89042718
mean efficiency = 0.72941885
33
Scale efficiency
For a Translog Production Function (Ray,
1998)
An output-orientated scale efficiency measure
is:
SEi = exp[(1-i)2/2]
where i is the scale elasticity of the i-th firm
and K K
jk
j1 k 1
If the frontier is concave in inputs then <0.
Then SE is in the range 0 to 1.
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Stochastic Frontier Models: Some
Comments
We note the following points with respect to SFA
models
It is important to check the regularity conditions
associated with the estimated functions local and
global properties
This may require the use of Bayesian approach to impose
inequality restrictions required to impose convexity and
concavity conditions.
We need to estimate distance functions directly in the
case of multi-output and multi-input production
functions.
It is possible to estimate scale efficiency in the case of
translog and Cobb-Douglas specifications
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Panel data models
Data on N firms over T time periods
Investigate technical efficiency change (TEC)
Investigate technical change (TC)
More data = better quality estimates
Less chance of a one-off event (eg. climatic) influencing
results
Can use standard panel data models
no need to make distributional assumption
but must assume TE fixed over time
The model: i=1,2,N (cross-section of firms); t=1,2T
(time points)
ln yit xit vit uit ; vit N (0, v2 ); uit N (0, u2 )
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Panel data models
Some Special cases:
1. Firm specific effects are time invariant: uit = ui .
2. Time varying effects: Kumbhakar (1990)
uit 1 exp( bt ct ) ui
2
1
uit exp (t T ui
Sign of is important. As t goes to T, uit goes to ui.
In FRONTIER Program, this is under Error Components
Model.
37
Time profiles of efficiencies
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
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Current research
There is scope to conduct a lot of research in this area.
Some areas where work is being done and still be done
are:
Modelling movements in inefficiency over time
incorporating exogenous factors driving inefficiency
effects
Possibility of covariance between the random disturbance
and the distribution of the inefficiency term
Endogeniety due to possible effects of inefficiency and
technical change on the choice of input variables
Modelling risk into efficiency estimation and
interpretation
40
Current research
We have seen how technical efficiency can be computed,
but it is difficult to compute standard errors.
Peter Schmidt and his colleagues have been working on a
number of related topics here.
Bootstrap estimators and confidence intervals for
efficiency levels in SF models with pantel data
Testing whether technical inefficiency depends on firm
characteristics
On the distribution of inefficiency effects under
different assumptions
Bayesian estimation of stochastic frontier models
Posterior distribution of technical efficiencies
Estimation of distance functions
41
Application to Residential Aged Care
Facilities
Residential aged care is a multi-billion dollar industry in
Australia
Considered even more important in view of an ageing
population.
Aged care facilities are funded by the Commonwealth
government and are run by local government,
community/religious and private organisations.
Efficiency of residential aged care facilities is considered
quite important in view of reducing costs.
CEPA conducted a study for the Commonwealth
Department of Health and aged Care.
Data was collected by the Department from the
residential aged care facilities.
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Application to Residential Aged Care
Facilities
Data:
912 Aged Care Facilities
30% response rate response bias
Data validation
Actual observations used: 787
Methods:
DEA and SFA Methods
Peeled DEA
43
Application to Residential Aged Care
Facilities
Preferred model:
Output variables:
High care weighted bed days
Low care weighted bed days
Input variables:
Floor area in square meters
Labour costs
Other costs
44
General findings
Average technical efficiency was calculated to be 0.83. 17%
cost savings could be achieved if all ACFs operated on the
frontier.
Results consistent between SFA and DEA models
Found variation across ACFs in different states (lowest 0.79
in Victoria and 0.87 in NSW/ACT).
Privately run ACFs has higher mean TE of 0.89.
Average scale efficiency of 0.93 was found.
An average size of 30 to 60 beds was found to be near optimal
scale.
A second stage Tobit model was run to see the factors driving
inefficiency.
Potential cost savings was calculated to be $316 m for the
number of firms in the sample greater savings for the
industry!!
Economies of Scope were examined using new methodology
developed but no significant economies were found.
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