Big and Beautiful? On Non-Parametrically Measuring Scale Economies in Non-Convex Technologies
21 Pages Posted: 9 Nov 2008 Last revised: 11 Nov 2008
Date Written: August 1, 2008
Knowledge on the scale economies drives the incentives of regulators, governments and individual utilities to scale-up or scale-down the scale of operations. This paper considers the returns to scale (RTS) in non-convex frontier models. In particular, we evaluate RTS assumptions in a Free Disposal Hull model, which accounts for uncertainty and heterogeneity in the sample. Additionally, we provide a three-step framework to empirically analyze the existence and extent of RTS in real world applications. In a first step, the presence of scale (and scope) economies is verified. Secondly, RTS for individual observations are examined while in a third step we derive the optimal scale for a sector as a whole. The framework is applied to the Portuguese drinking water sector where we find the optimal scale to be situated around 7 to 10 million m3.
Keywords: Free Disposal Hull, economies of scale, optimal size, water sector
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