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

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