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Why empirical cost functions get scale economies wrong

Author

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  • Lijesen, M.G.

    (Vrije Universiteit Amsterdam, Faculteit der Economische Wetenschappen en Econometrie (Free University Amsterdam, Faculty of Economics Sciences, Business Administration and Economitrics)

Abstract

Empirical applications of the translog cost function often conclude that firms operate at increasing returns to scale. From the viewpoint of economic theory, this does not make sense. We demonstrate that empirical cost functions ignore the fact that differences in firm output depends on cost differences between firms. We show graphically and mathematically that ignoring this mechanism leads to an overestimation of returns to scale. We propose a slightly altered specification and test it empirically. The empirical results show that the alternative specification yields better statistical results and is consistent with economic theory.

Suggested Citation

  • Lijesen, M.G., 2009. "Why empirical cost functions get scale economies wrong," Serie Research Memoranda 0004, VU University Amsterdam, Faculty of Economics, Business Administration and Econometrics.
    • Handle: RePEc:vua:wpaper:2009-4
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    More about this item

    Keywords

    costs; firm size; translog; economies of scale;
    All these keywords.

    JEL classification:

    • L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms
    • L25 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Performance
    • L93 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Air Transportation

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