Lecture 3 Production and Cost Function Estimation

Bronwyn H. Hall Economics 220C, UC Berkeley Spring 2005

Outline
Production, Cost, and Profit functions
uses

Data and estimation issues

Panel data specification Exit and selection
parametric Semi-parametric (Olley-Pakes)
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Why study them?

One piece of supply/demand framework
Needed for any equilibrium computation Form influences model (e.g. learning by doing, networks)

Used to evaluate efficiency effects of policy

Regulation - increasing returns, cost complementarities Mergers cost reduction, synergies

Productivity analysis
Impact of deregulation Impact of public infrastructure Impact of non-market production externalities
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Functions
Production
Output = f(inputs, technical efficiency)

Cost
Dual to production, assuming cost minimization given output Cost = f(output, prices, technical efficiency)

Profit
Profit = Revenue - cost function = f(output, prices, technical efficiency) Similar to cost function, unless a demand model used to construct revenue function
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Production
Start with Cobb-Douglas for firms (or plants) indexed by i Q = A L K
i i i i

or q i = a i + l i + k i
Properties of estimator of (,) depend on the relationship between inputs and disturbance.

where a i = + i

Why is this very simple form useful?

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First order log-log approx., constant elasticity

Identification of higher orders sometimes difficult

Corresponds to growth accounting framework Easy to add additional inputs

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Drawbacks to Cobb-Douglas
Elasticity of substitution always one All tech change is neutral Multiproduct firms merger and antitrust analysis
Cost synergies of interest Explore subadditivity of cost function

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Some alternatives
Functional form # params # params if CRS, Elasticity of (2 inputs) symmetry imposed substitution Cobb-Douglas CES translog Generalized Leontieff (dual)
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2 3 5 (8 with t) --

1 2 3 3

1 for all inputs =1/(1+) for all inputs flexible flexible

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Variances in productivity
Empirical facts
1. Large variance in productivity ai across firms 2. Productivities highly correlated over time (within firm)

Suggests that input choices might depend on the disturbance Sources of dependence
True technology or management differences Measurement error (inputs or outputs) External factors (weather, strikes, breakdowns, etc.)

How do input choices react to these shocks?

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Panel production function

Now assume we have several periods of data for each firm
Add time dummies Consider two types of transitory error (transmitted and not transmitted)

q it = t + l it + k it + u it where uit = i + it + e it
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Production function error

Whats in uit = i+it = i+it+eit?
i = permanent differences in firm productivity (perhaps due to market power or varying product mix), known to firm when it chooses both variable and fixed inputs. it = transitory differences in firm productivity (due to demand or supply shocks), known to firm when it chooses variable inputs, but not fixed (capital) inputs. eit = transitory measurement error (the econometricians problem, but not the firms).

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Measurement problems
Production:
Output usually sales (turnover or revenue) divided by a price index
Most plants and firms have multiple output types Same price for different firms with different product mix For individual firms, reinterpret result as revenus productivity

Labor input usually hours or person-years

No quality adjustment, although some exceptions

Capital aggregates investment of different types at different times using simple depreciation models.

Errors in quantity measurement usually mean errors in corresponding price (dual forms)
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Endogeneity
If inputs respond to shocks (it or i), OLS estimates will be biased
more serious for inputs that adjust quickly like labor and materials

Some solutions
Use panels and try to remove i (more later) Find instruments
Lagged values of inputs problematic given serial correlation Prices if you can find variance across firms unrelated to disturbance
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Example
Selected large U.S. manufacturing firms, 10 years of data from 1986 to 1995.
y = log sales output measure l = log employment labor measure k = log gross P&E capital measure Subtracting labor from both sides of the eq provides an easy test for scale economies:

yit = t + kit + lit + uit

yit - lit = t + (kit lit)+ (+-1)lit + uit uit= i+it

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10

Chev Chev P&G Chev P&G Chev Chev P&G Chev P&G Chev P&G Chev P&G Chev P&G P&G P&G P&G Coke Coke Coke AmCy Coke AmCy AmCy AmCy AmCy CokeAmCy Coke Coke AmCy Coke H-D H-D H-D H-D H-D H-D H-D H-D Coke

Log sales

H-D

5
B&J B&J Plaza Plaza Plaza Plaza Plaza Plaza Striker Striker StrikerStriker Striker

B&J B&J B&J B&J B&J B&J B&J B&J

-5

Selected U.S. Manufacturing Firms 1986-1995

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0 Log employment

10
Coke Coke Coke AmCy Coke AmCy AmCy AmCy AmCy AmCy Coke Coke Coke Coke AmCy Coke H-D H-D H-D H-D H-D H-D H-D H-D H-D Coke

P&G P&G P&G P&G P&G P&G P&G P&G P&G

Chev Chev Chev Chev Chev Chev Chev Chev

Log sales

H-D

B&J B&J B&J B&J B&J B&J B&J B&J B&J B&J Plaza Plaza Plaza Plaza Plaza Plaza Striker Striker Striker Striker

0 -5 0

Selected U.S. Manufacturing Firms 1986-1995

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Log capital

10

7
Chev Chev Chev Chev Chev Chev Chev Chev Chev Chev

Log output-labor ratio

6
P&G P&G P&G P&G B&J B&JP&G B&J H-D P&G B&J P&G P&G H-D B&J B&J P&G Coke H-D B&JCoke Coke Coke Coke B&J H-D H-D Coke H-D Coke AmCy AmCy H-D H-D B&J H-D B&J AmCy Coke AmCy AmCy AmCy AmCy Coke H-D Striker Striker Striker Striker

Plaza Plaza Plaza

Plaza Plaza Plaza

4 2 4 6 Log capital-labor ratio

Striker

Selected U.S. Manufacturing Firms 1986-1995

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Panel data estimators

Total Between Within (FE) yit = a + Xit + uit yi = a + Xi + ui
where i subscript denotes firm means

yit -yi = (Xit-Xi) + (uit-ui)

yit =a + Xit + uit=a + Xit + i+it Variance components (RE) Var(uit) = 2+2 First differences yit-yi,t-1 = (Xit Xi,t-1) + uit-ui,t-1 (FE) or yit = xit + uit
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OLS Production function estimates

Dep Var=Log(Sales/L) N=582 1986-1995 (T=10)
Estimation method LogL Log(K/L) s.e. R2 DurbinWatson Totals -.014 (.003) 0.525 (.008) .329 .549 0.182 (.000) Between -.018 (.007) 0.556 (.020) .293 .598 -Within -.072 (.014) 0.237 (.015) .150 .916 0.828 (.000) Var. Comp. -.016 (.005) 0.310 (.009) .411 .319 0.104 (.000) First Diff. -.289 (.020) 0.176 (.018) .132 .205 2.123 (<1.00)

Var btwn=.086; Var within=.022; =0.975 Hausman test: 88.1 with 2 df (p=.000)
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1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1

Fixed Effects Distribution

-2.00 -1.75 -1.50 -1.25 -1.00 -0.75 -0.50 -0.25

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

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1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1

Random Effect Distribution

-1.75 -1.50 -1.25 -1.00 -0.75 -0.50 -0.25

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

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Production function summary

Dynamics appear to be important => endogeneity of inputs Also want to consider selection Next time

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The Dual
Assume cost minimization given output and prices w for labor and r for capital (can be done for C-D, CES, translog, etc.) E.g., Cobb-Douglas:

i 1 ci = + wi + ri + qi + + + +
c i q i = + w i + ri + i

Cobb-Douglas unit cost function with CRS:

When can we use the Dual?

Firms face different prices (geography, taxes) Firm does not choose output level or we have appropriate demand shifters for instruments (or CRS) All inputs can be varied costlessly or we incorporate adj costs (see Nadiri, Prusa, Bernstein and co-authors)

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Cost functions and input demands

Deriving cost function assumed competitive factor markets, which implies factor demand equations Why not use them? E.g., 1 1 ci = + wi + ri + qi i + + + + l i = _ + _ w i + _ ri + _ q i _ i

k i = _ + _ w i + _ ri + _ q i _ i where _ denotes coefficients to be estimated. This model has only one disturbance and is overdetermined. So we will need to think about how to add more error.
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