Using Firm Optimization to Evaluate and Estimate Returns to Scale

60 Pages Posted: 21 Mar 2006  

Yuriy Gorodnichenko

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Multiple version iconThere are 3 versions of this paper

Date Written: February 21, 2006

Abstract

This paper shows that because of data limitations available 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.

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

JEL Classification: C23, C33, D24

Suggested Citation

Gorodnichenko, Yuriy, Using Firm Optimization to Evaluate and Estimate Returns to Scale (February 21, 2006). Available at SSRN: https://ssrn.com/abstract=892142 or http://dx.doi.org/10.2139/ssrn.892142

Yuriy Gorodnichenko (Contact Author)

University of California, Berkeley - Department of Economics ( email )

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States

HOME PAGE: http://www.econ.berkeley.edu/~ygorodni/index.htm

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Paper statistics

Downloads
126
Rank
132,843
Abstract Views
740