AN INPUT DISTANCE FUNCTION APPROACH TO THE MEASUREMENT

OF TECHNICAL AND ALLOCATIVE EFFICIENCY: WITH APPLICATION

TO INDIAN DAIRY PROCESSING PLANTS

by

Tim Coelli

School of Economics, University of Queensland

Satbir Singh

Department of Agriculture, Beribagh, Sahranpur, U.P., India

and Euan Fleming

School of Economics, University of New England.

Draft: 20/2/2003

Abstract

In this paper we describe how one can measure technical and allocative efficiency
relative to a stochastic input distance function. This method avoids many of the
problems that can afflict the cost and/or production frontier approaches, such as non-
optimising behaviour, limited price variation, regressor endogeneity, and the single
output restriction. The method is illustrated using survey data on private and
cooperative Indian dairy processing plants. Our empirical results indicate that the
private firms are not more cost-efficient than the cooperative firms, and also show that
the introduction of reforms to encourage the entrance of new private sector firms did
not have the expected positive effect upon cost efficiency in this industry.

JEL: C16, C21, D20

Key words: distance function, technical efficiency, allocative efficiency, Indian dairy
processing, cooperatives
 1

1. Introduction

The measurement of the cost efficiency of a firm, and its decomposition into technical
and allocative components, has been the subject of a number of papers since the
seminal work of Farrell (1957). Farrell suggested that the degree to which a firm was
operating above minimum cost could be divided into one part resulting from the use
of input quantities in the wrong proportions, given the prevailing prices (allocative
inefficiency), and another part resulting from operation below the production frontier
(technical inefficiency). Farrell showed how these various efficiency components
could be measured, given that one had an estimate of the production technology.1

The calculation of these efficiency components is a fairly straightforward exercise.

However, the estimation of the production technology has proven to be more
challenging. Many possible estimation methods have been proposed over the years.
The two most popular methods have been the stochastic frontier analysis (SFA)
method proposed by Aigner, Lovell and Schmidt (1977) and Meeusen and van den
Broeck (1977), and the data envelopment analysis (DEA) method, developed by
Boles (1966), Afriat (1972) and Charnes, Cooper and Rhodes (1978). SFA involves
the use of econometric methods, while DEA is a linear programming technique. DEA
has the advantage that one does not need to choose a specific functional form or
distributional form for the error terms, while SFA has the advantage that it attempts to
account for the effects of data noise and allows the conduct of standard statistical
tests.

In this paper we utilise the SFA method because we believe that data noise is an
important issue, especially in cases when allocative efficiency is of interest. This is
because DEA forms a frontier by building a piece-wise linear surface over the top of
the sample data. If there is data noise associated with a few frontier points, this will
not only cause the frontier to shift out and overstate the mean level of technical
efficiency, it will also distort the shape of the estimated frontier, leading to
allocatively efficient points being shifted some distance from their correct positions.

1
To be precise, Farrell (1957) used the terms price efficiency and economic efficiency instead of
allocative efficiency and cost efficiency, respectively. However, in this paper we use the terminology
that is in common use today.
2
See Coelli, Rao and Battese (1998) for a discussion of the various frontier estimation methods and
their relative merits.
 2

For further discussion of the relative merits of DEA and SFA methods, see Coelli,
Rao and Battese (1998).

The papers by Aigner, Lovell and Schmidt (1977) and Meeusen and van den Broeck
(1977) showed how one could estimate a stochastic production frontier and measure
(mean) technical efficiency. The issue of allocative and cost efficiency measurement
was later addressed by Schmidt and Lovell (1979), who described how one could
estimate a Cobb-Douglas stochastic cost frontier and then use duality to derive the
implicit production frontier. With these two frontiers, one could then measure cost
efficiency and technical efficiency, and calculate allocative efficiency residually.3

In some cases, the direct estimation of a cost frontier may not be practical or
appropriate. It will not be practical when input prices do not differ among firms. It
will not be appropriate when there is systematic deviation from cost-minimising
behaviour in an industry, for example when political, union or regulatory factors
cause shadow prices to deviate from market prices in a systematic way. In this
situation, the duality between the cost and production functions break down, and the
resulting bias in the cost frontier estimates will make the cost efficiency calculation
and decomposition biased as well.

One solution to this problem is to obtain a direct estimate of the primal production
technology, and then derive the implicit cost frontier.4 For example, Bravo-Ureta and
Rieger (1991) estimated a Cobb-Douglas stochastic production frontier, and then
derived the implicit cost frontier. However, one particular inconsistency in the Bravo-
Ureta and Rieger (1991) approach is that a production function is estimated when one
is clearly assuming that the input quantities are decision variables. This leaves the
approach open to the criticism that simultaneous equations bias may afflict the
production function estimates,5 and may explain why it has not been widely adopted.6

3
The cost frontier methods of Schmidt and Lovell (1979) were subsequently extended to the more
flexible translog functional form by various authors, such as Greene (1980) and Schmidt (1984). These
new methods avoided the restrictions inherent in the Cobb-Douglas functional form, but at the cost of
introducing considerable complexity to the modelling exercise. For a thorough review of this
literature, see Kumbhakar and Lovell (2000, chapter 4).
4
Another possible solution is to estimate some form of shadow cost function, where systematic
deviations from allocative efficiency are explicitly modelled. This can be a complex exercise, which
often requires that a number of simplifying assumptions must be made in order to produce a tractable
model for estimation. For examples of this approach see Atkinson and Cornwell (1994a,b) and Balk
(1998).
5
See Marschak and Andrews (1944) for an explanation of this problem.
 3

In this paper, we propose a new approach involving the estimation of an input

distance function that avoids all of the above problems. It does not require price
information that varies across firms, it is robust to systematic deviations from cost-
minimising behaviour, and it does not suffer from simultaneous equations bias when
firms are cost minimisers or shadow cost minimisers.7 The input distance function
can also easily accommodate multiple outputs and hence has an additional advantage
relative to the production function, which is restricted to a single output variable.

The remainder of this paper is organised into three sections. In section 2, the
analytical framework is developed. In section 3 we provide an application of these
methods to survey data on Indian dairy processing plants. The final section provides
a summary and some conclusions.

2. Methodology

The production technology of a dairy plant may be described using input sets, L(y),
representing the set of all (K1) input vectors, x, which can be used to produce the
(M1) output vector, y. That is,

L(y) = {x: x can produce y}. (1)

The production technology is assumed to satisfy the usual axioms, such as convexity
and strong disposability.8 The input distance function, d(x,y), is then defined on this
input set as:

d(x,y) = sup{: (x/) L(y)}, (2)

where is a positive scalar. The distance function, d(x,y), is non-decreasing,

positively linearly homogeneous and concave in x, and non-increasing and quasi-
concave in y. The value of the distance will be equal to one or greater than one if the
input vector, x, is an element of the feasible input set, L(y), ie. d(x,y) 1 if xL(y).

6
Another drawback of the Bravo-Ureta and Rieger (1991) approach is that it involves the use of the
Cobb-Douglas functional form, which is a restrictive functional form. That is, it imposes unitary
elasticities of substitution and constant production elasticities across all firms. In the empirical exercise
in this paper we find that the more flexible translog functional form is not a statistically significant
improvement over the Cobb-Douglas functional form. However, this is unlikely to be the case in all
data sets.
7
See Coelli (2000) for the proof of this result.
8
See Fre and Primont (1995) for further details.
 4

The distance function has a value of unity if x is located on the inner boundary of the
input set.

Figure 1 provides an illustration of an input distance function, where two inputs, x1

and x2, are used to produce output, y. The isoquant, SS/, is the inner boundary of the
input set, reflecting the minimum input combinations that may be used to produce a
given output vector. In this case, the value of the distance function for a firm
producing output, y, using the input vector defined by point A, is equal to the ratio,
OA/OB.

Figure 1: The input distance function and the input set

x2 A
S

L(y)

S/

0 x1

The log form of a Cobb-Douglas input distance function, for the case of one output, K
inputs, N firms and T time periods, is specified as:9

K
ln d it = ln yit + + j ln x jit , i=1...N, and t=1...T, (3)
j=1

where yit is the output quantity, xjit is the j-th input quantity, ln represents a natural
logarithm, and , and j are unknown parameters to be estimated.

9
The application in this paper uses panel data on Indian dairy processing plants, which involves
information on one output and four inputs. Hence, we define a model for panel data with one output
and K inputs. The extension to the case of M outputs and/or cross-sectional data is straightforward.
 5

Imposing the restriction for homogeneity of degree +1 in inputs upon this function,
K
j = 1 , we obtain the estimating equation:
j

K 1
ln x Kit = ln yit + + j ln( x jit x Kit ) + it ,
j (4)
where it = vit u it .

Observe that in the above equation we have defined ln dit = it = vit-uit to indicate that
the distance term may be interpreted as a traditional SFA disturbance term. That is,
the distances in a distance function (which are the radial distances between the data
points and the frontier) could be due to either noise (vit) or technical inefficiency (uit).
This is the standard SFA error structure.

To allow us to test for the significance of efficiency change over time, we utilise the
time-varying technical efficiency stochastic frontier model, defined by Battese and
Coelli (1992). That is, we assume that the vit are i.i.d. N(0,v2) and
uit=ui[exp((T-t))], where ui is i.i.d. |N(,u2)|. Given these distributional
assumptions, the values for unknown parameters can be obtained by the method of
maximum likelihood.10

The input-orientated technical efficiency (TE) scores are then predicted using the
conditional expectation predictor:

TEit = E[(exp(-uit)|it)], (5)

proposed by Battese and Coelli (1992).

Once the parameters of the Cobb-Douglas input distance function have been
estimated, we can derive the corresponding parameters of the dual cost function. The
Cobb-Douglas cost function is defined as:

K
ln cit = b 0 + b j ln p jit + a1 ln yit , (6)
j=1

10
Alternative models of time-varying technical efficiency have been proposed by Kumbhakar (1990),
Cornwell, Schmidt and Sickles (1990) and Lee and Schmidt (1993). These models allow a more
flexible pattern of technical efficiency change relative to the single-parameter structure used in this
study. However, given the short time frame in this study (five years), we took the decision that the
extra complexity of these latter models was not warranted in this instance.
 6

where cit is the cost of production, pjit is the j-th input price, and b0, bj and a1 are
unknown parameters.

Using the first order conditions for cost minimisation,

jx K
p K p j = x j x K = , j=1,2,...,K-1, (7)
K x j

we can show (see proof in Appendix 1) that the parameters of the cost and input
distance functions are related as follows:

bj = j, j=1,2,,K.

a1 = , and 11

K
b 0 = j ln j . ( )
j=1

Once we have estimated the parameters of the input distance function, we can predict
the technical efficiency scores using equation (5). We can then predict the technically
efficient input quantities as:

x Tjit = x jit TE it , j=1,2,,K. (8)

The cost-efficient input quantities are predicted by making use of Shephards Lemma,
which states that they will equal the first partial derivatives of the cost function:

cit
x Cjit = = cit b j p jit , j=1,2,,K, (9)
p jit

where cit is the cost prediction obtained by substituting the estimated parameters into

(the exponent of) equation (6).

Thus, for a given level of output, the minimum cost of production is x itC .pit ,12 while

the observed cost of operation of the firm is x it .pit . These two cost measures are then
used to calculate the cost efficiency (CE) scores for the i-th firm in the t-th year:13

11
In the case when there are M outputs in the model, the output coefficients are am=-m, m=1,...,M.
12
The dot in this expression denotes vector multiplication.
13
This cost efficiency score could also be obtained using predictions from the cost function in equation
(6). However, the advantage of our approach is that the vectors of technically efficient and allocatively
efficient input quantities are also calculated.
 7

x itC .pit
CE it = . (10)
x it .pit

Then, following Farrell (1957), allocative efficiency (AE) can be calculated residually
as:

AE it = CE it / TE it . (11)

Each of these three efficiency measures take a value between zero and one, with a
value of one indicating full efficiency.

The above method is illustrated in Figure 2, for the case of a two-input technology.
As in Figure 1, the line SS is the isoquant corresponding to a particular output level,

y.14 In Figure 2, the input vectors x it , x itT and x itC are represented by the points A, B

and C, respectively. Point A is the observed input vector, point B is the technically
efficient input vector, and point C is the cost-efficient input vector, which is the point
at which the isocost line is at a tangent to the isoquant. An isocost line, which has a
slope reflecting the relative input prices, is drawn through each of these three data
points. These three isocost lines are labelled x it .pit , x itT .pit and x itC .pit , respectively.

Figure 2: The decomposition of cost efficiency

x2 A
S

B L(y)
x it .p it

S/
x itT .p it
C
x itC .pit
0 x1

14
Note that in this study we estimate a stochastic input distance function. Hence the position of this
isoquant may vary from firm to firm (even when the output level is the same) as a consequence of the
random error term, vit, which will be added to the intercept parameter, .
 8

3. An Application to Indian Dairy Processing Plants

Prior to 1991, dairy processing in India involved a mixture of private and cooperative
plants. However, the industry was dominated by plants that were run as cooperatives.
This was a result of a government policy that prevented private operators from setting
up in areas where cooperative plants were established. However, in 1991 the
government introduced new regulations that made it easier for private companies to
establish processing plants. This was done to stimulate improved efficiency in the
dairy processing industry. The change in regulations resulted in the establishment of
over 100 new private plants in the 1991/1992 period.15 The purpose of this empirical
analysis is to assess the impact of the new government policy on this industry.

The data in this study are taken from two states, Punjab and Haryana, in the northern
region of India. The northern region is the largest milk-producing region in India. A
questionnaire was used to collect annual data on 23 dairy plants, comprising 13
cooperative plants and 10 private plants, between 1992/93 and 1996/97. The resulting
panel data set involves a total of 100 observations.16

One output variable and four input variables are used in estimating the input distance
function. The output variable is a Fisher multilateral index of the outputs produced by
these firms. The main outputs are ghee (a solid material used instead of cooking oil),
fluid milk and milk powder. These products contribute 38%, 23% and 18% to total
revenue. The remaining 21% of revenue is derived from flavoured milk, butter, milk
cake, sweets, paneer (unprocessed cheese), baby food and various other minor
products. All plants produce two or more products. We observe that all plants
produce ghee, while 17 and 9 plants produce milk powder and liquid milk,
respectively.17

15
See Singh (2000) for further discussion of this reform process.
16
The sampling method used was to approach all plants in these two regions for data. Thus, it was a
census. All cooperative plants provided the requested data. The privately owned plants were not keen
to cooperate, however sufficient information was derived from the annual reports of most of these
companies. We could not get access to the annual reports of a few private companies, but we do not
expect this non-response to introduce any systematic bias in our sample. However, if there is any bias,
it is likely to be an upward bias in the mean efficiency of the private firms (based on an expectation
that those firms that did not supply copies of their annual reports are likely to be the more inefficient
firms). If bias of this type does exist, it would not cause us to question the main conclusion derived
from our empirical results, that the private firms are not more efficient than the cooperative firms.
17
The decision to include only one aggregate output variable in our model was primarily due to the fact
that we wished to conserve degrees of freedom. It was also influenced, to some extent, by the
observations of Klein (1953, p227) who noted that the Cobb-Douglas function imposes a functional
 9

The four input variables are raw materials, labour, capital and other inputs. The
raw materials input involves raw milk and, in some cases, a small amount of milk
powder or butter. Labour expenditure is taken directly from the firms accounts.
Capital expenditure was measured using the reported costs of depreciation, repairs
and maintenance, and interest. The other inputs expenditure variable includes all
other costs of dairy production inputs (eg. administration, fuel, power and insurance).

Price information was used to derive implicit output quantities and implicit input
quantities, by dividing revenues and costs by appropriate price indices. These price
indices were obtained from the Directorate of Economics and Statistics, Government
of India, New Delhi. These price indices are discussed in detail in Appendix 2.

Summary statistics for the sample input and output quantities are given in Table 1.
From this table we note that the private plants are, on average, over twice the size of
the cooperative plants. This is evident from the fact that the means of output and
inputs (with the exception of labour) are more than twice as large in the private plants.

Table 1: Sample means*

Plants Raw materials Labour Capital Other inputs Output
Cooperative 197.54 17.50 9.54 16.24 200.63
Private 552.25 16.06 27.94 80.03 560.19
Total 328.61 17.11 16.37 40.20 334.05

* All values are in millions of 1996/97 Rupees.

The maximum likelihood estimates of the parameters of the Cobb-Douglas input

distance function are reported in Table 2. One issue of some concern to us in this
paper is the degree to which the use of the Cobb-Douglas functional form may be

form that is convex to the origin in the output dimensions, which is hence not consistent with profit
maximisation. This could be a problem in some cases. However, it is not a problem when there is only
one output variable (as in our study). Furthermore, even if there is more than one output variable, one
could argue that the Cobb-Douglas provides a first-order approximation to the slope of the production
possibility surface at the mean of the data. Hence, if one is focussing on cost minimisation issues, and
not profit maximisation, the model should still provide a reasonable approximation to the underlying
technology, especially in small samples where degrees of freedom are limited.
18
See Singh (2000) for further detail on the data used in this application.
 10

imposing unwarranted restrictions upon the production technology. To address this

question we have also estimated a translog input distance function,19 and used a
likelihood ratio test to test the significance of the ten extra parameters which
differentiate it from the Cobb-Douglas functional form. The log-likelihood function
(LLF) value for the estimated translog model is 93.98, and the likelihood ratio (LR)
test statistic, to test the null hypothesis of the Cobb-Douglas versus the alternative
hypothesis of the translog, is 2(86.1193.98)=15.74. This value is less than the 5%
Chi-square critical value (for ten degrees of freedom) of 18.31. Hence, we do not
reject the null hypothesis and conclude that the extra complexity of the translog is not
warranted in this instance.

The estimates of the coefficients of the inputs in Table 2 are significant with expected
signs. The coefficient of output is less than one in absolute value, indicating
increasing returns to scale in this industry.20 The estimated coefficient of the raw
material input is the largest, at 0.677. According to our survey data, raw material
contributes 82 per cent of the total cost of operation and is the major expenditure
component. Many past studies (eg. Singh and Kalra, 1980; Arora and Bhogal, 1996)
make similar observations. The estimated coefficients of labour and capital are 0.113
and 0.045, respectively. The coefficient of the other inputs variable is calculated
via the homogeneity restriction, and is found to be equal to 0.165.

The estimate of the variance ratio parameter, , is 0.797 and is significant at the 1%
level. This suggests that the technical inefficiency effects are significant in the
stochastic frontier model. Therefore, the ordinary least squares estimation of this
function (ie. a model assuming no technical inefficiency) would not be an adequate
representation of the data. This observation is confirmed by conducting a likelihood
ratio test, to test the null hypothesis of the OLS model against the alternative
hypothesis of the frontier model reported in Table 2. The LLF for the OLS model is
64.20, providing a LR test statistic of 43.81. The corresponding 5% mixed-chi-square
critical value (taken from Table 1 in Kodde and Palm, 1986) is equal to 7.045 for
three degrees of freedom. Thus, the null hypothesis (the OLS model) is rejected in

19
See Coelli and Perelman (2000) for a description of the translog input distance function.
20
Note that the standard returns to scale elasticity, which is regularly reported in production function
studies, is equal to the inverse of the negative of this value. That is, 1/0.911=1.098.
 11

favour of the alternative hypothesis corresponding to the stochastic frontier model.

This suggests that there is significant technical inefficiency in this industry.

Table 2: Maximum-likelihood estimates

Variable Parameter Coefficient Standard error

Constant 9.749*** 0.116

Raw Material 1 0.677*** 0.031

Labour 2 0.113*** 0.024

Capital 3 0.045** 0.022

Other Inputs# 4 0.165*** 0.032

Output -0.911*** 0.022

Variance parameters:

s2 = 2u + 2v 0.034* 0.022

= 2u s2 0.797*** 0.140

0.113 0.148

-0.105** 0.042

LLF 86.11

* Asterisks indicate significance levels: *** 1% level, ** 5% level and * 10% level.
# The estimate of 4 was obtained via the homogeneity restriction. Its standard error was
approximated using a second-order Taylor series expansion.

The trend parameter for the inefficiency effects, , is negative and significant at the
5% level. This indicates that there has been a significant decrease in technical
efficiency over this five-year period, contrary to expectations. It was expected that
the reform process would have led to improvements in technical efficiency, not the
converse.21

21
Note that our model assumes that there has been no technical change over this five-year period.
Based on our knowledge of the technologies used in the plants in the sample, this is a reasonable
 12

The average technical, allocative and cost efficiency scores are reported in Table 3.
These results suggest that private plants are not as cost-efficient as their cooperative
counterparts. This difference is mostly due to extra allocative inefficiency in the
private plants. To see if these differences are statistically significant, we tested the
null hypothesis that the mean efficiency of private plants was equal to the mean
efficiency of cooperative plants, versus the alternative hypothesis that they differed.
The test statistic used was the t-ratio for the case of two large independent samples
(see Kvanli, Guynes and Pavur, 1996, p327). The calculated test statistics were 0.46,
1.04 and 1.37, for TE, AE and CE, respectively. All of these values are less than the
5% critical value of the Standard Normal distribution of 1.96. Hence, we conclude
that the mean efficiencies of private and cooperative plants are not significantly
different. This result is contrary to what the government officials may have expected,
but consistent with what has been reported in some recent empirical comparisons of
private and cooperative organisations in other industries. For example, see the
analysis of the Costa Rican coffee-processing sector by Mosheim (1998).

Table 3: Mean efficiencies*

Dairy Plants Technical efficiency Allocative efficiency Cost efficiency

Cooperatives 0.874 0.904 0.788
(0.083) (0.071) (0.084)
Private 0.846 0.850 0.716
(0.083) (0.056) (0.051)
Total 0.864 0.885 0.763
(0.083) (0.071) (0.082)
* Sample standard deviations are presented in parentheses under each sample mean.

The mean allocative efficiencies reported in Table 3 indicate that some inputs are
being used in incorrect proportions. To investigate which inputs are being over- or
under-used, we can calculate the ratio of the technically efficient input quantity over

assumption. Furthermore, we conducted some preliminary analysis in which a time trend was included
in the model. The resulting coefficient was negative and insignificantly different from zero at the 5%
level, supporting our expectation that technical change was not present in this industry over this time
period.
 13

the cost-efficient quantity (for each input and for each observation). The means of
these ratios are given in Table 4, where we observe that plants have tended to over-
utilise raw materials and capital inputs, and under-utilise labour and other inputs.
In particular, we note that the private firms are under-utilising labour to a greater
extent than the public firms. This could perhaps be a consequence of greater use of
imported laboursaving methods and technologies in private plants. These methods
may be cost-efficient in developed countries, where wages are high, but this may not
translate to low-wage countries such as India.22

Table 4: Input usage ratios*

Dairy plants Raw material Labour Capital Other inputs

Cooperatives 1.46 0.76 1.53 0.52

Private 1.42 0.24 1.34 0.79

Total 1.44 0.60 1.42 0.71

* Note that a value greater than one indicates overuse. Also, note that these are weighted averages,
where the weights are the input quantities.

The government expected that the introduction of new private firms would encourage
competition and hence improve efficiency levels over time. The changes in the
efficiencies of cooperative and private plants over the five-year study period are
presented in Table 5. Average cost efficiencies decline by approximately 5% over
this period. This decline was primarily due to a decline in technical efficiency. This
decline is contrary to the effect that the government would have hoped to achieve
from liberalization.

When we first saw this decline in technical efficiency, we suspected that it may be a
consequence of capacity utilisation problems, brought about by the sudden

22
One should provide a word of warning about the use of the term allocative efficiency (AE) in this
study. We have measured allocative efficiency among all factors of production. That is, we have not
distinguished between capital and non-capital inputs. Thus, some of the measured AE could actually
reflect errors in forecasting the future relative prices of capital and non-capital inputs, made when
capital investment decisions were taken at some time in the past. Furthermore, some of the measured
AE could reflect input ratios that may appear inefficient in the short run but which are actually efficient
in the long run, given particular predictions of future levels of prices and production. Thus, one could
argue that the AE measures reported in this study are likely to be a lower bound estimate of the ability
of the plant managers to select an optimal input mix.
 14

introduction of a number of new plants into the industry. However, we then recalled
that milk plants in India only collect approximately 10% of the fresh milk produced in
India. The remaining 90% is utilised in the informal sector, where individual farmers
or small operations process a small amount of milk for local consumption. Thus, it is
unlikely that capacity utilisation is contributing to the observed decline in technical
efficiency.

Table 5: Mean efficiencies over time

Cooperatives Private

Year Technical Allocative Cost Technical Allocative Cost

efficiency efficiency efficiency efficiency efficiency efficiency

1992/93 0.897 0.907 0.813 0.886 0.830 0.730

1993/94 0.886 0.910 0.805 0.869 0.868 0.750

1994/95 0.875 0.903 0.788 0.857 0.842 0.719

1995/96 0.863 0.900 0.774 0.819 0.851 0.696

1996/97 0.849 0.899 0.761 0.769 0.873 0.669

4. Concluding comments

The analysis of cost efficiency in the Indian dairy industry, reported in this study, was
designed to shed light on the effects of the reform process. Two questions were of
particular interest. First, has the performance of the cooperative plants improved
since market liberalization was introduced? Second, are the private plants more
efficient than the cooperative plants? The answer to both questions, based on the
empirical evidence in this paper, is no. This suggests the reforms have not achieved
the desired results.

The main contribution of this paper is methodological. We have proposed a new

input distance function approach to the calculation and decomposition of cost
efficiency. This new approach avoids many of the problems inherent in the existing
production frontier and cost frontier approaches. Namely, it does not require price
information that varies across firms, it is robust to systematic deviations from cost-
 15

minimising behaviour, and it does not suffer from simultaneous equations bias when
firms are cost minimisers or shadow cost minimisers. Furthermore, the input distance
function approach can also accommodate multiple outputs, as opposed to the
production frontier approach, which is limited to a single output.

However, having listed a number of the advantages of this new method, we should
also remind the reader of its main shortcomings, and outline some possible areas of
future work. The main concern we have with the method outlined in this paper is the
use of the Cobb-Douglas functional form. This is a restrictive functional form, which
assumes unitary elasticities of substitution and fixed production elasticities. We
found that these restrictions were appropriate for the sample data used in the paper,
but it is unlikely to be the case for all data sets. Hence, one might find it necessary to
use a more flexible functional form, such as the translog, in some cases.

The main down-side of the use of the translog (and other flexible functional forms,
such as the quadratic or generalized Leontief) is that they are not self-dual, and hence
it is not possible to derive the implicit cost function as done in this paper with the
Cobb-Douglas functional form. Hence, one would not be able to identify the cost-
minimizing input quantities using simple calculations, as is done in this paper. In
fact, to calculate the cost-minimizing input quantities relative to a translog production
technology, one is required to solve a non-linear optimization problem for every data
point in the sample. This is a messy and time-consuming exercise.

In addition, one can also run into problems when the estimated translog function does
not satisfy the standard regularity properties (convexity and monotonicity) at all
sample data points. This is not an unusual occurrence. One is unable to solve the
cost-minimising problem for these data points, and must hence find a way to re-
estimate the production technology with these restrictions imposed without sacrificing
the flexibility of the translog form. This is not a simple exercise. Some years ago, we
estimated a translog stochastic production frontier using these dairy plant data, and
found that convexity and monotonicity conditions were violated at some data points.
This led to the development of a Bayesian method to estimate the model with the
required regularity conditions imposed. This method is described by Cuesta, et al
(2001), for the case of the translog production frontier. We intend to extend this
approach to the case of the input distance function in future work.
 16

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 19

Appendix 1: Duality derivation

In this appendix we derive the relationship between the parameters of a Cobb-Douglas
input distance function and the implied dual cost function. The proof is provided for
the case of one output and two inputs, but can be easily extended to the M-output/K-
input case.

Consider the Cobb-Douglas input distance function in log form

ln d = ln y + + 1 ln x 1 + 2 ln x 2 , (A1)

where homogeneity implies 1 + 2 = 1, and all notation is as defined in the text.

If we set the distance to one we obtain the equation of the production surface

ln y + + 1 ln x 1 + 2 ln x 2 = 0 . (A2)

Now, making ln x2 the subject of this equation, we can obtain the partial derivative

ln x 2
= 1 , (A3)
ln x 1 2

or equivalently

x 2 x 1
= 1 . (A4)
x 1 x 2 2

Using the first order conditions for cost minimisation we obtain

x 2 x p
= 1 2 = 1 , (A5)
x 1 2 x1 p2

or equivalently

p1x 1 2 p 2 x 21 = 0 . (A6)

With this equation and the cost identity

p1 x 1 + p 2 x 21 = c , (A7)

we have two equations and two unknowns. Next we solve these two equations for x1
and x2 and then substitute these expressions into equation (A2) to derive the cost
function.

Rearranging equation (A6) we obtain

 20

x 2p2 c
x1 = + . (A8)
p1 p1

Substituting equation (A8) into equation (A6) and exploiting the homogeneity
condition (1 + 2 = 1) we obtain, after some algebra

c 2
x2 = . (A9)
p2

Substituting equation (A9) into equation (A8) we obtain

c1
x1 = . (A10)
p1

Now, substituting equations (A9) and (A10) into equation (A2), and again using the
homogeneity condition, we obtain the cost function

ln c = ln y (1 ln 1 + 2 ln 2 ) + 1 ln p1 + 2 ln p 2 . (A11)

Q.E.D.

The proof for the M-output/K-input case follows in the same way. The main
differences are that we utilise K-1 first order conditions in equation (A5) and end up
solving K equations in K unknowns in equations (A6) and (A7), which is best done
using matrix algebra.
 21

Appendix 2: Price Indices

In this appendix we present details on the price indices used in the empirical analysis
in this paper. These price indices, with two exceptions, were obtained from the
Directorate of Economics and Statistics, Government of India, New Delhi. The first
exception is the deflator used for other costs, which is a general index of wholesale
prices in Indian manufacturing, obtained from the Economic Advisor, Ministry of
Industry, New Delhi. The other exception is the wage index, which was obtained
from the Labour Bureau, Simla, India. The wage indices for 1995 and 1996 were not
available at the time the analysis was conducted. Hence, the CPI was used to
approximate the wages indices in these years.

The price indices reported here, with the exception of the wage price indices, are price
indices for India as a whole. Thus it is assumed that prices do not vary significantly
across regions, nor across firms within regions. This is believed to be a reasonable
assumption for these firms. However, it should be kept in mind that if any firms do
face differing prices (perhaps due to geographical disadvantage) the resulting
efficiency scores will be biased.

Table A1: Price indices

Item 1992 1993 1994 1995 1996
Milk 83.01 87.74 96.46 98.37 100.00
Ghee 73.23 72.22 95.07 99.60 100.00
Butter 68.89 68.23 83.68 97.51 100.00
Whole milk powder 87.08 86.79 89.04 91.93 100.00
Skim milk powder 80.84 72.11 70.72 95.96 100.00
Baby food 66.19 65.90 69.29 82.03 100.00
Malted food 71.55 71.93 85.38 90.38 100.00
Dairy products 76.43 74.43 85.29 94.80 100.00
Machinery 86.27 90.05 93.27 95.69 100.00
Other costs 73.21 79.32 87.93 94.69 100.00
Wages - Haryana 67.24 63.01 82.54 92.60 100.00
Wages - Punjab 75.51 82.45 82.54 92.60 100.00