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Using Firm Optimization to Evaluate and Estimate Returns to Scale

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  • Yuriy Gorodnichenko

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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13666.

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Date of creation: Dec 2007
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Handle: RePEc:nbr:nberwo:13666

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Cited by:
  1. Benoit Dostie, 2006. "Wages, Productivity and Aging," Cahiers de recherche 06-15, HEC Montréal, Institut d'économie appliquée.
  2. Gorodnichenko, Yuriy & Schnitzer, Monika, 2010. "Financial constraints and innovation: Why poor countries don't catch up," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7721, C.E.P.R. Discussion Papers.
  3. Yuriy Gorodnichenko & Yegor Grygorenko, 2005. "Are Oligarchs Productive? Theory and Evidence," Development and Comp Systems, EconWPA 0512013, EconWPA.
  4. Enghin Atalay, 2014. "Materials Prices And Productivity," Journal of the European Economic Association, European Economic Association, European Economic Association, vol. 12(3), pages 575-611, 06.
  5. 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).
  6. Alvaro Garcia Marin & Nico Voigtländer, 2013. "Exporting and Plant-Level Efficiency Gains: It’s in the Measure," NBER Working Papers 19033, National Bureau of Economic Research, Inc.
  7. Eifert, Benn & Gelb, Alan & Ramachandran, Vijaya, 2008. "The Cost of Doing Business in Africa: Evidence from Enterprise Survey Data," World Development, Elsevier, Elsevier, vol. 36(9), pages 1531-1546, September.

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