Observed and Unobserved Heterogeneity in Stochastic Frontier Models: An Application to the Electricity Distribution Industry

22 Pages Posted: 11 Nov 2009

See all articles by Maria Kopsakangas-Savolainen

Maria Kopsakangas-Savolainen

Finnish Environment Institute; University of Oulu - Department of Economics, Accounting and Finance

Rauli Svento

University of Oulu - Department of Economics, Accounting and Finance

Date Written: September 30, 2009

Abstract

In this study we combine different possibilities to model firm level heterogeneity in Stochastic Frontier Analysis. We show that both observed and unobserved heterogeneity cause serious biases in inefficiency results if left unmodelled. Modelling observed and unobserved heterogeneity treats individual firms in different ways and even though the mean inefficiency scores in both cases diminish the firm level efficiency rank orders turn out to be very different. The best fit with the data is obtained by modelling unobserved heterogeneity through randomising frontier parameters and at the same time explicitly modelling the observed heterogeneity into the inefficiency distribution. These results are obtained by using data of Finnish electricity distribution utilities and the results are relevant in relation to electricity distribution pricing and regulation.

Keywords: cost efficiency, heterogeneity, electricity distribution, benchmarking, random parameter

JEL Classification: C13, C23, D24, L51, L94

Suggested Citation

Kopsakangas-Savolainen, Maria and Svento, Rauli, Observed and Unobserved Heterogeneity in Stochastic Frontier Models: An Application to the Electricity Distribution Industry (September 30, 2009). Available at SSRN: https://ssrn.com/abstract=1502662 or http://dx.doi.org/10.2139/ssrn.1502662

Maria Kopsakangas-Savolainen (Contact Author)

Finnish Environment Institute ( email )

PO Box 413
Oulu, 90014
Finland

University of Oulu - Department of Economics, Accounting and Finance ( email )

PO Box 4600
FIN-90014 University of Oulu
Finland

Rauli Svento

University of Oulu - Department of Economics, Accounting and Finance ( email )

PO Box 4600
FIN-90014 University of Oulu
Finland

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