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# Stochastic FrontierModels

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## Stochastic Frontier Models

0 Introduction
1 Efficiency Measurement
2 Frontier Functions William Greene
3 Stochastic Frontiers
4 Production and Cost Stern School of Business
5 Heterogeneity
6 Model Extensions New York University
7 Panel Data
8 Applications
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## Main Issues in Panel Data Modeling

Issues
Capturing time invariant effects
Dealing with time variation in inefficiency
Separating heterogeneity from Inefficiency
Examining technical change and total factor
productivity growth
Contrasts Panel Data vs. Cross Section
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Technical Change
Technical Change
LnOutputit = f(xit,zi,,t) + vit - uit.
LnCostit = c(xit,zi,,t) + vit + uit.
Independent of other factors, TC = f(..)/t
Change in output not explained by change in factors
or environment shift in production or cost function
Time shift the goal function.
Lnyit = xit + zi + t + vit - uit.
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## Familiar RE and FE Models

Wisdom from the linear model
FE: y(i,t) = f[x(i,t)] + a(i) + e(i,t)
What does a(i) capture?
Nonorthogonality of a(i) and x(i,t)
The LSDV estimator
RE: y(i,t) = f[x(i,t)] + u(i) + e(i,t)
How does u(i) differ from a(i)?
Generalized least squares and maximum likelihood
What are the time invariant effects?
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## The Cross Section Departure Point: 1977

Aigner et al. (ALS) Stochastic Frontier Model
yi x i vi ui
vi ~ N [0, v2 ]
ui | U i | and U i ~ N [0, u2 ]
Jondrow et al. (JLMS) Inefficiency Estimator
(i )
ui E[ui | i ]
2 i

1 ( i
)
u i
i vi ui , , v u , i
2 2

v
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## y(i,t) = x(i,t) u(i) + v(i,t)

Effects model with time invariant inefficiency
Same dichotomy between FE and RE
correlation with x(i,t).
FE case is completely unlike the assumption in the
cross section case
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## The Panel Data Models Appear: 1981

Pitt and Lee Random Effects Approach: 1981
Time
yit x it vit ui fixed
vit ~ N [0, v2 ], ui | U i | and U i ~ N [0, u2 ]
it vit ui
Counterpart to Jondrow et al. (1982)
(i / )
ui E[ui | i1 ,..., iT ] i
1 ( i / )
T i u2 u
i = ,
1 T 2v 1 T
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## Estimating Technical Efficiency

u2 1
2 , i , *i (1 i )( i ), *2i i v2
v 1 Ti
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## Stochastic Frontiers with a Rayleigh Distribution

Gholamreza Hajargasht, Department of Economics, University of
Melbourne, 2013

u u 2
f (u ) 2 exp 2 , u 0
u 2u

E [u ] u
2
4
Var[u ] u2
2
ui u exp(hi )
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## Rayleigh vs. Half Normal

Swiss Railway Data
Technical Efficiency Estimator in the Rayleigh Model
u2 u2 2v i
i Ti i 2 , 2
, *

v Ti u2 2v u2
i

## i (*i ) (i2 2 ) (*i )

TEi
(*i ) i (*i )

Rayleigh

Half Normal
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## Reinterpreting the Within Estimator: 1984

Schmidt and Sickles Fixed Effects Approach: 1984
yit i x it vit
vit ~ N [0, v2 ], i semiparametically specified
fixed mean, constant variance.
Counterpart to Jondrow et al. (1982)
ui max i ( i ) i Time
fixed
(The cost of the semiparametric specification is the
location of the inefficiency distribution. The authors
also revisit Pitt and Lee to demonstrate.)
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## Schmidt and Sickles FE Model

lnyit = + xit + ai + vit
estimated by least squares (within)
u
i = max(j a
j ) - a
i > 0 (for production or profit)
u
i = a
i - min(j a
j ) > 0 (for cost or distance)
Implications: One firm is perfectly efficient.
Either deterministic frontier, or firms
are compared to other firms,
not an absolute standard of zero.
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## Misgivings About Time Fixed Inefficiency: 1990-

Cornwell Schmidt and Sickles (1990)
it 0i 1i t 2i t 2 , u it max( it ) it
Kumbhakar (1990)
uit [1 exp(bt ct 2 )]1 | U i |
Battese and Coelli (1992, 1995)
uit exp[(t T )] | U i |, uit exp[ g (t , T , zit )] | U i |
Cuesta (2000)
uit exp[i (t T )] | U i |, uit exp[ gi (t , T , zit )] | U i |
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## Battese and Coelli Models

In half or truncated normal model
u(i,t) = |U(i)| exp[g(zit , t, )]
U(i) ~ normal, mean = i
variance = ui2
Commonly used formulation. g(...) is flexible.
Time invariant random component is still a major
influence on the model. Results are still vastly
different from models in which the random part
varies with time.
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## Variations on Battese and Coelli

(There are many)
Farsi, M. JPA, 30,2, 2008.

## log Cit (log xit ) z i t i uit vit

i = fixed effects
uit ui 0 i t i t 2

i 0
~ N ,
i 0
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## Time Invariant Heterogeneity

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Observable Heterogeneity
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## Are the time varying inefficiency models more

like time fixed or freely time varying?
A Pooled Model yit x it vit uit
Battese and Coelli (1992) uit exp[(t T )] | U i |
Pitt and Lee (1981) yit x it vit | U i |

## Where is Battese and Coelli?

Closer to the pooled model or to Pitt and Lee?
Greene (2004): Much closer to the Pitt and Lee model
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## In these models with time varying inefficiency,

yit x it vit gi (t , zit ) | U i |
vit ~ N [0, ] and U it ~ N [0, ],
2
v
2
u

## where does unobserved time invariant

heterogeneity end up?
In the inefficiency! Even with the extensions.
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## Greene, W., Distinguishing Between

Heterogeneity and Inefficiency:
Stochastic Frontier Analysis of the
World Health Organizations Panel
Data on National Health Care
Systems, Health Economics, 13, 2004,
pp. 959-980.
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## True Random and Fixed Effects: 2004

True Random and Fixed Effects Approach: 2004
yit i x it vit uit Time
varying
vit ~ N [0, v2 ], uit | U it | and U it ~ N [0, u2 ]
Time
fixed
i Unobserved time invariant heterogeneity,
not unobserved time invariant inefficiency
Jondrow et al. (JLMS) Inefficiency Estimator
(it )
E[uit | it ]
2 it
1 (it )
u it
it vit uit , , v u , i
2 2

v
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## The True RE Model is an RP Model

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## Skepticism About Time Varying Inefficiency

Models: Greene (2004)

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## Estimation of TFE and TRE Models: 2004

True Fixed Effects: MLE
yit i x it vit uit
vit ~ N [0, 2v ], uit | U it | and U it ~ N [0, u2 ]
i Unobserved time invariant heterogeneity,
not unobserved time invariant inefficiency
Just add firm dummy variables to the SF model (!)
True Random Effects: Maximum Simulated Likelihood (RPM)
yit ( wi ) x it vit uit
vit ~ N [0, 2v ], uit | U it | and U it ~ N [0, u2 ], wi ~ N [0, 2w ]
i Unobserved time invariant heterogeneity,
not unobserved time invariant inefficiency
Random parameters stochastic frontier model
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A True FE Model
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## Schmidt et al. (2011) Results on TFE

Problem of TFE model incidental parameters problem.
Where is the bias? Estimator of u
Is there a solution?
Not based on OLS
Chen, Schmidt, Wang: MLE for data in group mean deviation
form
yit yi [xit xi ] (vit vi ) (uit ui )
Trades fixed effects problem for the problem of obtaining
the distribution of the deviations of the one sided terms.
Derives a "within MLE" estimator.
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## Log likelihood function for stochastic frontier model

2 yi x i
log log

N
log L( , , , ) =
( yi x i )
i 1

log

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## Simulated log likelihood function for stochastic frontier model

with a time invariant random constant term. (TRE model)
2 yit ( w wir ) x it

1 R
log L (,,,, w ) = i 1 log r 1 t 1
S N T

R ( yit ( w wir ) x it )

wir draws from N[0,1].
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## TRE SF Model for 247 Spanish Dairy Farms

u

v

w

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## World Health Organization study of life expectancy (DALE) and

composite health care delivery (COMP)
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## True Random Effects with Heterogeneity: Application

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## The second approach assumes that exogenous

variables do not directly influence the frontier, but
rather impact the cost-inefficiency score.
Consequently, in this approach the environment does
not affect the technology, a strong assumption in
heterogeneous sectors: all the firms share a unique
cost frontier and are evaluated against the same
benchmark. The exogenous variables are modelled to
influence the distribution of the uit and therefore the
distance that separates the firms from the benchmark.
Their effect is included in the inefficiency scores.
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uit
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## Generalized True Random Effects Stochastic Frontier Model

yit Ai Bi x it vit uit
Short run (transient) random components
vit uit Time varying normal - half normal SF
Long run (permanent) random components
Ai Bi Time fixed normal - half normal SF
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## Generalized True Random Effects Stochastic Frontier Model

yit ( w wi | ei |) x it vit uit
Short run (time varying, transient) random components
vit ~ N [0, v2 ], uit | U it | and U it ~ N [0, u2 ],
Long run (time invariant) random components
wi ~ N [0,1], ei ~ N [0,1]
The random constant term in this model has a closed skew
normal distribution, instead of the usual normal distribution.
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## A Stochastic Frontier Model with Short-

Run and Long-Run Inefficiency:
Colombi, R., Kumbhakar, S., Martini, G.,
University of Bergamo, WP, 2011
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## Colombi et al. Classical Maximum Likelihood Estimator

log T ( y i X i 1T , AVA)
log L i 1
N

log q ( R ( y i X i 1T , )) nq log 2
T (...) T-variate normal pdf.
q (..., )) (T 1) Multivariate normal integral.
Too time consuming and complicated. Estimated in two steps.
First step a variant of least squares for .
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## Firm Heterogeneity, Persistent and Transient Technical Inefficiency:

A Generalized True Random Effects Model
Journal of Applied Econometrics. Published online, November, 2012.
Forthcoming.

## Extremely involved Bayesian MCMC procedure. Efficiency components

estimated by data augmentation.
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## Technical Efficiency in Competing Panel Data Models: A Study of

Norwegian Grain Farming, JPA, Published online, September, 2012.

## Three steps based on GLS:

(1) RE/FGLS to estimate (,)
(2) Decompose time varying residuals using MoM and SF.
(3) Decompose estimates of time invariant residuals.
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## Maximum Simulated Full Information log likelihood function for the

"generalized true random effects stochastic frontier model"
2 yit ( w wir | U ir |) xit
,
1 R
i 1 R r 1 t 1 ( y ( w | U |) x )

N T
logLS , = log
,

it w ir ir it
w

wir draws from N[0,1]
|U ir | absolute values of draws from N[0,1]
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## Estimating Efficiency in the CSN Model

Moment Generating Function for the Multivariate CSN Distribution
T 1 ( Rri t, )
E[exp(tui ) | y i ] exp tRri 12 tt
T 1 ( Rri , )
(..., ) Multivariate normal cdf. Parts defined in Colombi et al.
Computed using GHK simulator.
ei 1 0 0
u 0 1 0
u i i1 , t = , , ...,

iT
u 0
0 1
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## 247 Farms, 6 years.

100 Halton draws.
Computation time:
35 seconds including
computing efficiencies.
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## Estimated efficiency for farms 1-10 of 247.

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## Kumbhakar, Lien, Hardaker suggest

Time invariant efficiency times
Overall Technical Efficiency =
Time varying efficiency

## .8022 .8337 .8691 .8688 .8725 .8745

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## Cost Efficiency of Swiss Railway

Companies: Model Specification
C = f ( Y1, Y2, PL , PC , PE , N, DA )
C = Total costs
Y1 = Passenger-km
Y2 = Freight ton-km
PL = Price of labor (wage per FTE)
PC = Price of capital (capital costs / total number of seats)
PE = Price of electricity
N = Network length
DA = Dummy variable for companies also operating alpine lines
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Data
50 railway companies, Period 1985 to 1997
Unbalanced panel with number of periods (Ti) varying from 1 to 13
and with 45 companies with 12 or 13 years, resulting in 605
observations
Data source: Swiss federal transport office
Data set available at http://people.stern.nyu.edu/wgreene
Data set used in: Farsi, Filippini, Greene (2005), Efficiency and
measurement in network industries: application to the Swiss
railway companies, Journal of Regulatory Economics
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Model Specifications:
Special Cases and Extensions
Pitt and Lee
True Random Effects
Extended True Random Effects
Mundlak correction for the REM, group
means of time varying variables
Extended True Random Effects with
Heteroscedasticity in vit: v,it=vexp(zit)
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Efficiency Estimates

## TRE Models Move Heterogeneity

Out of the Inefficiency Estimate
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## 2. Cost Efficiency of Norwegian

Electricity Distribution Companies:
Model Specification
C = f ( Y, CU, NL, PL , PC )
C = Total costs of the distribution activity
Y = Output (total energy delivered in kWh)
CU = Number of customers
NL = Network length in km
PL = Price of labor (wage per FTE)
PC = Price of capital (capital costs / transformer capacity)
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Data

## 111 Norwegian electricity distribution utilities

Period 1998 2002
Balanced panel with 555 observations
Data source: Norwegian electricity regulatory authority
(Unpublished)
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Mundlak Specification

Suggests ei or wi may
be correlated with the
inputs.
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Efficiency Estimates
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Appendix A: Implementation
Customized version of NLOGIT 5/LIMDEP 10.
Both instructions exist in current version.
Modifications were:
For the generalized TRE, allow the random constant
term in the TRE model to have a second random
component that has a half normal distribution.
For the selection model, allow products of groups of
observations to appear as the contribution to the
simulated log likelihood
Now available from the author as an update to
LIMDEP or NLOGIT. To be released with the
next version.
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DISTANCE FUNCTION
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## A Distance Function Approach

http://www.young-demography.org/docs/08_kriese_efficiency.pdf
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## Kriese Study of Municipalities

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TOTAL FACTOR
PRODUCTIVITY
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## Factor Productivity Growth

Change in output attributable to change in factors,
holding the technology constant
Malmquist index of change in technical efficiency

## TE(t+1|t) = technical efficiency in period t+1 based on

factor usage in period t+1 in comparison to firms using
factors and producing output in period t.
Index measures the change in productivity
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## TFP measurement using DEA

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## Total Factor Productivity Growth

Spanish Dairy Farms
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## Malmquist Index of Factor Productivity

Growth Spanish Dairy Farms