Choosing the Technical Efficiency Orientation to Analyze Firms' Technology: A Model Selection Test Approach

We focus on the importance of the assumptions regarding how inefficiency should be incorporated into the specification of the data generating process in an examination of a sector's production or efficiency. Drawing on the literature on non-nested hypothesis testing, we find that the model selection approach of Vuong (1989) is a potentially useful tool for identifying the best specification before carrying out such studies. We include an empirical application using panel data on Spanish dairy farms where we estimate cost frontiers under different specifications of how inefficiency enters the data generating process (in particular, efficiency is introduced as an input-oriented, output-oriented and hyperbolic parameter). Our results show that the different models yield very different pictures of the technology and the efficiency levels of the sector, illustrating the importance of choosing the most correct model before carrying out production and efficiency analyses. The Vuong test shows that the input-oriented model is the best among the models we use, whereas the output-oriented model is the worst. This is consistent with the fact that the input- and output-oriented models provide the most and least credible estimates of scale economies given the structure of the sector. Copyright Kluwer Academic Publishers 2004