Stochastic Frontier Analysis

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[edit] Stochastic Frontier Analysis

Stochastic Frontier Analysis has its starting point in the stochastic production frontier models simultaneously introduced by Aigner, Lovell and Schmidt (1977) and Meeusen and Van den Broeck (1977).

A production frontier model can be written as:

where y_i is the observed scalar output of the producer i, i=1,..I, x_i is a vector of N inputs used by the producer i, f(x_i, β) is the production frontier, and β is a vector of technology parameters to be estimated.

TE_i denotes the technical efficiency defined as the ratio of observed output to maximum feasible output. TE_i = 1 shows that the i-th firm obtains the maximum feasible output, while TE_i < 1 provides a measure of the shortfall of the observed output from maximum feasible output.

A stochastic component that describes random shocks affecting the production process is added. These shocks are not directly attributable to the producer or the underlying technology. These shocks may come from weather changes, economic adversities or plain luck. We denote these effects with . Each producer is facing a different shock, but we assume the shocks are random and they are described by a common distribution.

The stochastic production frontier will become:

We assume that TE_i is also a stochastic variable, with a specific distribution function, common to all producers.

We can also write it as an exponential , where u_i ≥ 0, since we required TE_i ≤ 1.

Now, if we also assume that f(x_i, β) takes the log-linear Cobb-Douglas form, the model can be written as:

where v_i is the “noise” component, which we will almost always consider as a two-sided normally distributed variable, and u_i is the non-negative technical inefficiency component. Together they constitute a compound error term, with a specific distribution to be determined, hence the name of “composed error model” as is often referred.

This model was simultaneously proposed by Aigner, Lovell and Schmidt (1977) and Meeusen and Van den Broeck (1977).

[edit] References

1. Aigner DJ, Lovell CAK, Schmidt P(1977) Formulation and estimation of stochastic frontier production functions. Journal of Econometrics 6:21--37

2. Kumbhakar SC, LovellCAK(2000) Stochastic Frontier analysis. Cambridge University Press, Cambridge