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Using Firm Optimization to Evaluate and Estimate Returns to Scale

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  • Gorodnichenko, Yuriy

    ()
    (University of California, Berkeley)

Abstract

At the firm level, revenue and costs are well measured but prices and quantities are not. This paper shows that because of these data limitations estimates of returns to scale at the firm level are for the revenue function, not production function. Given this observation, the paper argues that, under weak assumptions, micro-level estimates of returns to scale are often inconsistent with profit maximization or imply implausibly large profits. The puzzle arises because popular estimators ignore heterogeneity and endogeneity in factor/product prices, assume perfect elasticity of factor supply curves or neglect the restrictions imposed by profit maximization (cost minimization) so that estimators are inconsistent or poorly identified. The paper argues that simple structural estimators can address these problems. Specifically, the paper proposes a full-information estimator that models the cost and the revenue functions simultaneously and accounts for unobserved heterogeneity in productivity and factor prices symmetrically. The strength of the proposed estimator is illustrated by Monte Carlo simulations and an empirical application. Finally, the paper discusses a number of implications of estimating revenue functions rather than production functions and demonstrates that the profit share in revenue is a robust non-parametric economic diagnostic for estimates of returns to scale.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 3368.

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Length: 74 pages
Date of creation: Feb 2008
Date of revision:
Handle: RePEc:iza:izadps:dp3368

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Keywords: production function; identification; returns to scale; covariance structures;

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References

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Cited by:
  1. Enghin Atalay, 2012. "Materials Prices and Productivity," Working Papers 12-11, Center for Economic Studies, U.S. Census Bureau.
  2. Benoit Dostie, 2011. "Wages, Productivity and Aging," De Economist, Springer, vol. 159(2), pages 139-158, June.
  3. Gorodnichenko, Yuriy & Schnitzer, Monika, 2010. "Financial constraints and innovation: Why poor countries don't catchup," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 341, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  4. Dostie, Benoit & Léger, Pierre Thomas, 2011. "Firm-Sponsored Classroom Training: Is It Worth It for Older Workers?," IZA Discussion Papers 6123, Institute for the Study of Labor (IZA).
  5. Eifert, Benn & Gelb, Alan & Ramachandran, Vijaya, 2008. "The Cost of Doing Business in Africa: Evidence from Enterprise Survey Data," World Development, Elsevier, vol. 36(9), pages 1531-1546, September.
  6. Gorodnichenko, Yuriy & Grygorenko, Yegor, 2008. "Are Oligarchs Productive? Theory and Evidence," IZA Discussion Papers 3282, Institute for the Study of Labor (IZA).

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